CARE IPO Analysis

While I'd normally just let go most IPOs, but I somehow feel the urge to analyze this company. And since it's an IPO, I'll be extra cautious to analyse this, hence, start with Charlie Munger's way of 'always invert'...

Invert the question "why should you invest in CARE IPO" that so many "analysts" have answered on Friday (just google CARE IPO and you'll find) to:

WHY SHOULD YOU NOT INVEST IN CARE IPO

- It's an IPO which is a means to exit the investment for existing early shareholders like SBI, IDBI etc. If these 'professional' institutions are selling, why should you buy?

- None of IPO proceeds will go to the business, and hence IPO doesn't bring any fundamental improvement to the business

(BTW, same was the case for MCX IPO few months back)

- There's likelihood that after an initial jump, the stock price comes down and is available at cheaper price after a couple of months

- Equity markets have run up quite a lot since June 2012, and they might be around the top and might either decline or stay at current levels for a long time from now, and in such sentiments, the IPO stocks might not do very well and can easily come down to more favourable levels.

- I do not understand the business of CARE and it's industry dynamics very well, and hence my analysis of businss might be grossly wrong.

- All the brokerage coverage of this IPO can be 'mis-guided' and brokerages, as almost always, might have vested interests in promoting the IPO

- Owing to the fact that CARE is a rating agency, SEBI has exempted the rating of CARE IPO, possibly since sharing internal financial information to competition can be detrimental to CARE. This means that there's no standard rating for this IPO, and hence the risk of incorrect valuation prevails.

So, we analyze the risk that, even if the business has good fundamentals, the stock may be overpriced in IPO and there's chance of buying it at better levels post IPO. Let us, however, not be conclusive and go ahead to analyze the stock, since there's no strong reason right now to indicate weak business. Here's the next step to do a qualitative analysis of the business.

QUALITATIVE BUSINESS STRENGTH

What does the company do?

Credit Analysis and Research Ltd, CARE Ratings Ltd. was established in 1993 and since then, it has grown as the second largest Indian credit rating agency after CRISIL.

CARE ratings has experience in rating:

- Debt Instruments
- Bank loans
- IPOs
- Insurance companies' capacity to pay claims
- Mutual Funds
- Recovery
- Corporate Governance, etc...

CARE has a subsidiary, CARE Research, which provides research reports and custom research on a multitude of industries like Banking, Retail, Automobiles, Infrastructure, Textiles, etc.

What is outlook for credit rating industry in India?

With the introduction of BASEL III system in India, the business volume for rating agencies is going to grow further, since regulation norms are getting stricter and require more financial transactions and credit instruments to be formally rated. Moreover, in my opinion and understanding, the reputation of rating industry plays a big role in getting deals through quickly, since for example, a positive rating by CARE or CRISIL will weigh more positively on a credit instrument like a debt restructuring, than any unknown rating agency. In this respect, CARE and CRISIL will benefit from regulatory reforms in credit markets and they can leverage their positions to grow their top-lines  while maintaining healthy profits margins that they currently enjoy.

Having said that, there's certainly a threat from international competitors like S&P, Moody's etc. If the landscape changes and these big companies expand in India, it can be a risk of margin erosion for CARE.

Also, from a shorter term (1-3 years) standpoint, as interest rates come down, more investments will be made and hence volumes of business rating will increase, which is a positive development. However, it'll also mean that restructuring business will take hit since more businesses will be able to service their current debts and requirements for further restructuring will reduce. Overall, it'll depend on concentration of business for CARE on how declining interest rates will impact their revenues and profits. However, as per RHP, CARE mentions that increasing interest rates negatively impact their business, and hence, if interest rates turn southwards from here on, as is very likely given the current macroeconomic situation and RBI indications, next 12-24 months can be good for CARE business.

Where is the business of CARE concentrated, and is there any concern due to this concentration?

As mentioned in RHP, more than 85% of revenue for CARE is generated from rating of debt instruments. While CARE is trying to diversify into other areas of ratings, it may turn out to be diworsification and waste of precious cash. On the other hand, over-concentration in debt instruments can be detrimental to the business health in case the general debt instrument transactions are to reduce in volume going forward due to various reasons.

On the other hand, given the stability in debt instrument transactions and the fact that they'll grow as macroeconomic situation improves, concentration can be helpful for CARE.

How does CARE stand in credit rating Industry?

CARE is now the second largest rating industry in India, after CRISIL and while latest data is not available, CARE roughly controls about 20-25% market share today.

Does CARE has a strong business moat?

CARE does have at least a moderate business moat owing to the following:

- Established position and experience of 20 years gives them a reputation and CARE (and CRISIL) ratings are valued well by investors. This means more clients go to CARE and CRISIL and hence both these companies enjoy "barrier to competition" due to loyalty of their brand names. This of course, also means that CARE might lose business to CRISIL on similar grounds, but CARE can grow (and has shown to grow as we'll see shortly) its business by capturing market share from smaller players, and hence enjoys the benefit from "high switching cost", since a client doesn't benefit from switching away from CARE to a smaller player as investors won't like this (an example is large drop in share prices of OPTO CIRCUIT when they decided to change their rating agency; while they're switching to CRISIL, the fact that they're changing rating agency brings questions to investor minds). This factor can help CARE ratings to maintain and grow their revenue, while maintaining profit margins.

- "Operational efficiency" of centralized back-end operations in Ahmadabad. This helps reduce costs of duplicate database, reliance on third party data services and inaccurate information. Use of integrated information interface ("i3 interface") by analysts also help improve operational efficiency. This helps keep "costs low" and hence better profit margins.

SWOT Analysis for CARE Business

Strengths

- Established position and experience of 20 years

- Strong management with rich experience from banking industry (IDBI roots)

Weaknesses

- Over-concentration in debt instruments

Opportunities

- Leverage current position and capitalize the growing market (due to better macroeconomics and Basel III norms, etc)

Threats

- Diversification efforts fail and erode capital

- Competition from foreign players like S&P (via CRISIL) and alike.

- "IRB Approach" by banks can damage revenue avenues, as highlighted by the company in RHP risks section.

- Inability to recover annual surveillance fees

- Corporate governance issues can severely damage the reputation of company and can impact the revenues and margins negatively.

- Growth rate can reduce going forward due to larger base and stiff competition can dent profit margins

- Acquisitions may not work out so well

- Regulatory changes can impact business negatively. This document highlights some areas where regulatory changes can hamper the business for rating agencies.

- Delay in regulatory approvals can impact business negatively

- Pending litigation against senior management or company, if decided against the company can severely impact the reputation and hence the business for CARE

Financial History and Summary

According to RHP, the following are salient points for last 5 years of financial performance:

- Very low levels of debt / equity, standing at 0.02 as of latest balance sheet

- Growth of 20%+ in net worth over last 5 years

- PAT growth of 44% over last 5 years and sales growth of 41% in the same period (profit growing faster than sales)

- Consistent positive cash flow from operations

- Regular dividend payment since last 18 years, growing during last 5 years from 45% in 2008 to 100% in 2012. At upper band of IPO price (Rs 750), this is a dividend yield of at least 1%

- Return on Net Worth / ROE of more than 25% in last 5 years

Stock Valuation

By now, we find that the business is healthy, growing, and despite risks from competition and regulation, this is still a very good business justifying efforts to do some quantitative valuation.

Some useful numbers:

- Upper band price: Rs 750 per share

- Current book value: Rs 137 per share

- Current Net Worth: Rs 427 crores

- Current EPS: Rs 37 per share

- Current P/E ratio: 20.27

PEG based valuation

Since this is a fast growing, healthy business, let us first value it using PEG ratio, which comes out to be 0.5 considering ~40% PAT growth. This is very good for such a healthy business that generates 25%+ ROE with zero debt and consistent positive cash flow.

DCF based valuation

Performing 3 different DCF, assuming discount rate of 12%:

- 20% growth for next 5 years and 2% thereafter, fair value is Rs 762 per share, very close to offer price

- 30% growth for next 5 years and 2% thereafter, fair value is Rs 1090 per share, which is more reasonable considering 44%+ CAGR of profits in the past

- A very conservative DCF with 15% PAT growth for next 7 years and no growth thereafter gives a fair value of Rs 660 per share

This tells us that using DCF, CARE IPO is reasonably prices at upper band, if not available at a deep discount.

Relative Valuation

CRISIL and ICRA trade at P/E multiples of 40 and 25 respectively, and hence, CARE IPO is again under-priced at Rs 750 and a P/E multiple of 20. This again supports healthy price for the share.

Summary

While we've used very simple valuation methods, considering the health of business, it is not unreasonable to say that the CARE IPO is fairly priced at Rs 750. It may not be a deep value bargain, but market revaluations can easily take the share price to at least Rs 1000 such that it trades at 30x, more comparable to what CRISIL enjoys. Even a conservative estimate can be about 25% return from the IPO in next one year.

Yes, there're risks, but the risk to reward ratio is favorable to investors. Let us now see how the institutional buyers subscribe to the IPO, and accordingly we can take a call on Tuesday morning to subscribe, depending on liquidity. But at the least, it'd do no harm to subscribe to one lot (20 shares) at upper band price.

Another mistake...

This is stupid! How could I have sold the best performer in my portfolio, when I knew it's a healthy business, growing well, and I had bought it so cheap. Yes, I started buying EMAMILTD at Rs 327 in early January 2012, and I had accumulated ~5% of my portfolio in this stock for an average price less than Rs 400, by April.

However, then I did a stupid mistake. Can't remember which one, but I sold off EMAMI at ~Rs 500 because I thought I had better opportunities and EMAMI would not rise further.

In retrospect, I realize the hard way, that sell decision should be taken extremely carefully. Unless you have reasons, very strong reasons, you should not sell. And I sold possibly the best stock to re-allocate. i should have sold the worst stock in my portfolio.

However, still happy to have committed this mistake and learnt the hard way. Now, I'll formalize a mechanism to take sell decisions, and also create a checklist that I must fill up before selling, and only if checklist says so.

Assimilate the learning

Here we go! Its Diwali night and I'm beginning the next phase of journey, after having frozen my portfolio to ride on the 'mother of bull run' as Mr. Rakesh Jhunjhunwala advocates...

I'll now try my best to learn more and more, continue and resume reading so many books and articles and assimilate the knowledge. Since there's so much to do, I try to list down the order in which I'll read, and prioritize and organize it all...here's the list

Note that I've kept the items A and B at top since they form a foundation which can then be used to build the knowledge further.

A. The Checklist Manifesto. I've started believing, both based on experience at work, as well as reading about investing and from people like Vishal, that creating checklists and using them to 'filter' things is a great way to keep in discipline. My target is to finish reading this book and gain more insight into checklists. This is on top of the list since thereafter, I'll extract some checklist points from learning assimilated from each further step, and grow my eventual checklist for finding great investment opportunities.

B. I'll next read writings from Nasim Taleb, especially, 'The Black Swan' and 'Fooled by Randomness', which give a different perspective on how to handle uncertainties in life, and this topic is very important in investing.

Thereafter, I'll focus on following, ongoing activities, and as time permits, explore the points starting from 1:


a) This one will continue along with other items. I've not been able to follow up of late, but will now dedicate time to analyze Buffet letters to shareholders and participate in nice discussions on SN forum.

b) Another series has started is to assimilate learning from what Munger has said. I'll also pick up and get to speed on this yet another interesting discussion series. Of course, as I participate in this, I've also read 'Psychology of human misjudgement'

c) I'll continue reading Prof. Sanjay Bakshi's blog posts and gather learning from him. After all, he's one from whom we learnt about the idea of vicarious learning :-)


1. Complete reviewing 'One Up on Wall Street' and then create a 'Peter Lynch Investing style checklist'. One's already at the end of the book, but we need to sanitize it in current times and Indian context.

One of the major questions to answer is - while Mr. Lynch always tells to invest in boring business that're ignored by wall street, we need to think about how to avoid stories that'll remain undervalued since major players in market will always keep ignoring them. This is one big question that keeps worrying me, and I've tried to find answer to this one here and here, but still need to refine and get a conclusive 'checklist' to find crisp answers.

2. That's what my next exploration would be - to find the good take away from Mr Lynch style. Understandably, we can't blindly follow what worked 20 or 50 or 70 years back, and need to refine the philosophies...

Next step is to complete reading the following books:

3. Common stocks and Uncommon profits. This will give me insight into Fisher style, and importance of finding scuttlebutt...

4. Based on several discussions, and some real life experiences, I've learnt that business moat is a huge thing, and one must pay very big attention to it while analyzing businesses. Pat Dorsy's 'Little book that builds wealth' is known to be a good book talking about business moats, and I plan to read this book, at least the review of this book written by Sanjeev to assimilate and then extend my idea of moat valuation to make it more practical.

5. Security Analysis. I've read part of this book, but need to complete it and learn about various quantitative methods Graham has taught us, and then categorize them into their application in various situations.

6. Next is to focus on portfolio allocation, i.e. that of equity portion, and to choose various styles and selection approaches, while staying within circle of competence and learning from my own mistakes, like this, and create some 'elimination checklists' to keep a healthy composition of portfolio.

Its a lot of work, let's see how much time can I take out from the busy schedule of next 6 months in my life...wishing myself all the best :-)

My Big Investment Mistake :-(

Just trying to dump my emotions...I got interested in UNITED SPIRITS in early March 2012 when it came crashing to Rs 500 a piece. I bought more and more as it ride up, and by end of May, I had about 105 of my portfolio invested in this stock for an average cost of ~Rs 600.

Then, a thought came to me - am I buying the stock of a company which is owned by an egoist, and possibly cruel leader, who would not deal well with employees of his airlines, yet take away the profits from his liquor business...is he ethical...am I ethical in investing in UB group companies...

And then, I sold all UB group stocks I had at a loss! And decided never to invest in a company whose management is not ethical.

Come Diageo deal, and in retrospection, I tend to think of the following:

- I bought USL in the hope that a mjor stake sale will have to occur to keep the group afloat
- I forgot that, when stake is sold, it'll no longer remain a 'King of good times' company!!! How could I miss this simple point.

Then, if it had occured to me, I could have even analyzed the company as a turnaround - the management will change, and it'll become part of the world leader in liquor industry, was that not a great deal then to hold a part of global, successful business at such throw away prices?

If this had occured to me, I'd have analyzed Diageo and its business and management, etc etc, but would have held on to USL stock.

Yes, I'm losing almost 15% on my portfolio! The stock is close to 2.5 times my average purchase price, not to mention the further potential loss in years to come if Diageo can make it an even better business, and when Mr. Mallya loses almost all controlling stake in the company.

Anyways, I'll take this as a learning and analyze the big picture next time when I think of staying away from a stock because of ethical reasons. Also, a great practical example to delve into the world of turnarounds :-)

Re-allocated

While I tried hard to control and stick to the plan, something inside me told me to act fast...and I decided to:

- Buy MAZDA around Rs 110, higher than my target of Rs 98. I was sensing MAZDA will move and possibly never come back to sub 100 levels for a long time now

- Sell SRF around 225, below my target of Rs 235. I was fearing that it'll possibly have many more poor quarters, and due to dividend, will never come back to Rs 235 in next few months.

So, I acted and reduced my holding in SRF by ~45% and increased by holding in MAZDA by ~80%, so that now both are nearly 4-5% of my portfolio. I did not get enough chance to catch MAZDA below Rs 110 since it has run away in last 3 days. But I'll now wait for it to cool down a bit before making my final trance of purchase.

Additionally, I made another purchase. After CROMPGREAV fell ~10% post results, I made about 55% of my original holding and increased stake in CROMPGREAV. The rationale is

- Losses have been due to ongoing restructuring in EU
- The stock will easily move back to 125+ levels in next few weeks
- I can buy low and sell high and reduce my average cost for holding it for long term.

I know, this is not the best rule, but I had surplus funds, and no other opportunity, and a very strong conviction that in the current environment, CROMPGREAV will easily more up to 125-130 levels when next leg of rally comes, and I'll trim back my holding to 10% of portfolio level. The plan is next to use the rally to trim back CROMPGREAV & BHEL to 10% level, and possibly also exit PNB completely at around Rs 130, Rs 260 and Rs 830 levels. Yes, they might move even higher, but I won't be greedy. I can use this cash proceed to pay off some short term debt that'll soon enter my balance sheet, or otherwise re-allocate in some other opportunity I spot that's better to help my portfolio diversity (about which I'll soon write...)

Next, I'll write about the following topics:

- Portfolio allocation

- Market valuation gap, trying to analyze Amara Raja batteries from a different perspective. This is another stock that has run over 20%+ in last 3 days.

Re-allocation within small caps

I was waiting for results of SRF and MAZDA, and here're they are:

- SRF has declining sales and profit for last few quarters, and there's risk to lower revenues due to carbon credit benefit expiring next year.

- While I believe in SRF, but as I mentioned in recent post, I want to reduce my exposure in an individual small cap until I learn more, and to reduce risk of being into value trap.

- SRF has reduced half-yearly dividend from Rs 7 a share to Rs 5 a share, which brings down my yield to < 5%

Now, MAZDA

- MAZDA has shown superb growth in both sales and profits yet again

- It has a better outlook compared to SRF

- Expect to get better dividends due to better profits

Hence, without too much deliberation, I'm deciding to sell ~50% stake in SRF and re-allocate that money into MAZDA. This will even out and make the contribution of both these stocks at 5% each in my portfolio.

However, since on Monday, both these stocks will have a result reaction, I'll wait and watch. I plan to place orders to sell SRF above Rs 235 and by MAZDA below Rs 98, but if they don't trade, I'll wait so that market digests news of results, and hopefully in about a month, they'll again trade at reasonable prices.

Since I have some cash, I won't mind buying additional 3% stake of MAZDA before cash proceeds from SRF come in. I can wait to sell SRF at reasonable price, and also because I've learnt that SRF makes highs just before the result and crashes thereafter...

Portfolio Status

After lot of thought, I've decided on the following:

1. Wait to put stake in Amara Raja, it's quite expensive and run up very fast in last 2 months. Sold off at break even

2. Up my stake in Piramal Enterprises. I'm fairly confident that Mr. Piramal can do better justice than I can...and now I can go and spend time studying more.

3. Freeze further addition to my portfolio. No more fresh purchases. Having said that, yes, I'll sell stocks if they reach my targets, like PNB and INFY, the stalwarts...and rotate the money into other depressed stalwarts. For example, I'm eyeing HEROMOTOCORP, but later on that...

So, here's my new portfolio:

In the next post onwards, I'll focus on new learning and topics I want to focus...the new session of classroom begins :-)

Exit Plan

Now that I've decided to freeze further purchases in my portfolio for next 6-12 months, I should also be ready with an exit plan given markets run away too fast and I should take some profits to deploy in better opportunities that I'll find in this study period.

Essentially, over last few weeks, I've found that my portfolio contains some decent stocks, but I can find better stories. The following are the reasons:

1. My portfolio primarily contains quantitatively undervalued stocks, not necessarily qualitatively great stocks at right price. I'm shifting towards finding businesses with strong moat and buying them undervalued when all hell is loose...times that come rarely, like in Dec 2011, June 2012 (for a subset of businesses), Oct-2009 to Mar 2010 and alike.

2. I risk holding some value traps, like SRF, MAZDA, not because they're bad businesses, but market may never re-rate their valuations. Hence, I'll freeze any further addition to these positions, and rather exit them for some profit (I've a strong conviction that markets will move towards all time high in next one year, more chances of this happening than a crash back to sub 5000 levels)

3. I'm already finding better opportunities, though they're expensive now, like Amara Raja Batteries, Shriram Transport Finance, etc, and will need funds for these when markets revert back again later, after hitting a peak.

Ok, so here's the exit plan - in order in which I'll sell them

SRF - Based on the concerns of this being a value trap, I plan to

- sell 30% of my holding when SRF crosses Rs 240 or so. Looking at the trend, I may sell just before dividend, since it always falls post dividend payments (ex-date)

- offload another 20-30% when it reaches towards Rs 300

PNB

As mentioned, if it goes above 950 - 1000, I'll exit this stock. Good bank, but risk of asset quality is not justified at Rs 1000, at least until FY14.

INFY

Again, its a stalwart dumped by market, and I'll exit (at least 30%) this when it again starts trading above a P/E of 20.

Other than these, I might exit some stake in other stocks, in general if they run up too fast, but only if I have great confidence to be able to re-allocate them to better opportunities.

Ok, final word - no more purchases until study progresses a good deal, exceptions being

- PEL falls below Rs 450

- Amara Raja falls below Rs 200

- IGL falls below Rs 210

- MAZDA falls below Rs 82

Otherwise, I'm happy to stick to 90% invested status and focus on studies... :-)

What all can go wrong with SRF

While I posted all good about SRF recently, considering some new learning in recent past, and the fact that I'm finding new, supposedly better opportunities, and the fact that SRF represents 11%+ of my portfolio currently (and when I get 100% invested, it'll still be 10% of my portfolio), a reality check is needed.

Let's see what all can go wrong with this business and the stock.

Business Moat

1. Strong Brand: SRF is a leader in its industry - man-made fibres. However, since this industry has a small barrier to entry, there's no strong brand, but yes, SRF does enjoy a leadership position.

2. Distribution network: Searching for 'SRF distributors' does bring up many links on Google, and considering they're growing sales at a decent pace of 20%+ in last 3-5 years, SRF does have a moderately strong distribution network.

3. Intellectual Property: Yes, SRF has a strong team of chemical scientists and does have some strength of IP rights. As mentioned, all business verticals are engaged in development of newer molecules, and this will help SRF bring newer products with better quality that competition can't bring, and hence some moat here as well.

4. Lowest Cost: Not really, but yes, operating margins are improving.

5. Barrier to switching: Somewhat. Since the consumers are into industrial businesses, it is not safe to change the suppliers without risk of quality issues, and hence SRF does enjoy a protection against losing existing customers, provided they maintain quality and competetive pricing.

Ok, so business moat is decent to moderately good, and given cheap valuations, risk of a significant downgrade in Intrinsic value of the business is limited, if not zero.

One risk is that of increasing debt, due to expansion and which could eat into profits and hence dividend yield. Let's consider a bear case. If profits were to decline by 40%, with current dividend payout rate of 20% of profits, there's a good deal of risk to lower dividends, given the outflows in increasing interest and debt payments.

Second is that due to an economic slowdown. If industrial output falls further, there'll be a hit on topline growth, or even a decline in topline for SRF.

Market re-rating is another risk. Historically, the P/E ratio for SRF has on an average been around 3-5 range, and hence scope for a large increase in P/E is unlikely.

However, the good part is that SRF stock has seen a steep fall in prices due to recent quarter poor performance. Current P/E of 3.88 is against an annual PAT of Rs 326 cr. However, assuming best case, the profit can jump back to 400+ levels, and then at a P/E of 4, the stock price can come back to 300 or so levels.

Having said that, it is unlikely that SRF will ever trade above the Intrinsic Value, which is significantly higher at Rs 450+.

All in all, it makes sense to hold this to milk the nice 3.5% half-yearly dividend due in November and then the rest 3.5% in March (this is the annual track record of dividend payment by SRF), and sell it when it starts tading at PE 4.5 or higher, simple reason being that chances of this stock generating low returns is larger than anything. It may not crash further, but it is a kind of stock which trades mostly undervalued, at a discount to the IV, and hence, the only gain possible is through dividends & increase in IV, with market price discount remaining constant.

So, the final action is to wait and watch - no reduction in stake given dividend income and improving market sentiments, and the very attractive purchase price of Rs. 207, but the change is that I won't hold it for very long term...

Amara Raja Batteries

This is an exciting story which I've come across, both on forums, and found it in my stock screens too.

Here's a nice analysis of this business. I'm fairly confident that this business has a growing moat that can keep the profits growing for next 5-10 years.

Here I perform my own analysis of fair value:

1. The business has a 3y average EBIT of Rs 15.5 / share. Based on debt capacity bargain criteria of 1.75X debt capacity, or EV/EBIDTA of 7 or lesser, certainly the stock is expensive. This way, the fair value using 3y average is Rs 108, and using current EBIT (since the company is growing fast), it is Rs 152.

Note that I've ignored cash and investment and dividend to offset debt on the books.

2. The PEG for the company is certainly less than 1. In fact, at P/E of 16, it is still trading less than 20%+ growth rate in profits, and a significant re-rating is possible given the valuation multiples of Exide are much higher.

3. The current price of Rs 230 / share is all right - its fairly valued, and given strengths of business, and growing moat, it can sustain revised valuations of about 15X P/E or even higher.

However, the following are the risks:

1. If EXIDE falters and its downward rating happens, Amara Raja may not be able to sustain higher valuations and can come down (I really wish that happens)

2. If economy weakens further, demand may dampen and this poses risk to topline growth.

3. The management addresses the risks in AR, but seems a little too optimistic about being able to handle them. Specifically, they say the following:

a. They've reached a large base and it is difficult to continue growing fast
b. Even then, they want to double their topline in next 3-4 years!

Certainly, this is a little too optimistic, and will have to be funded through debt. So, there's a risk to reduced EBIT and hence PEG may go more than 1 very soon. This could pose risk to downside in stock price if macro economics remains bad for months and years to come.

In essence, I see a risk that stock price has run up quite fast, and chances are that price may not go much higher, if bad things happen. Hence, best case scenario is that it'll continue to grow and rerating continues and stock can easily move up to 300+ very soon from today's level of 240

But the bear case tells us that stock is fully pricing all positives at current price, and there's little to zero margin of safety right now.

Hence, I'll not take major position until it comes down to Rs 200 or below. In fact, I'll only take large positions if it drops below Rs 175

However, to make sure I don't miss out best case scenario and then repent for not having bought a spectacular business, I'll do the following:

1. Keep accumulating on dips up to a maximum of 4% of my portfolio.
2. When it crashes below Rs 175, slowly catch it to accumulate up to 10% of my portfolio.

Patience is going to be the key here. However, certainly it looks a great business, at fair price, and hence I'll start putting my bets, slowly and carefully, and wish markets start falling :-)

Portfolio status and expectation

In the last few days, I've made many incremental purchases, and I'm getting closer to going 100% invested in my target portfolio (~45% of net-worth in equity). If I ignore illiquid investments, this composes about 70% equity and 30% debt + cash.

Ok, I've increased stake in Piramal Enterprises, Mazda and IGL, while completing full investment in many others. Here's the composition.

Note that I've taken a small tracking position in Amara Raja Batteries. At this point, I'm about to freeze my portfolio for next 6-12 months, with the following decisions:

1. No increase in number of stocks any further.
2. No increase in investments in top 7 stocks (BHEL, SRF, BHARTIARTL, CROMPGREAV, INFY, MOIL, OPTOCIRCUITS)
3. Need to analyze SRF again, and see if it would be prudent to reduce it, purely due to the concern of a little higher debt level, slower growth outlook and risk that it is a small company, relatively. Needs more analysis.
4. PEL is about 6.7% of my portfolio, but before I take it to full 10% level, need to stock and do some some critical analysis...primarily on the fact that can I buy it lower in next few months, and the fact that whether there're some serious concerns about the pharma business and infusion into real estate and financial divisions.
5. No further increase in IGL, as I wrote in the post. It is good business, but to balance the risk of pricing regulations, I decide to limit the exposure.
6. Choose if it makes sense to further increase stake in MAZDA, or if Amara Raja Batteries turns out to be a better bet.

In all, I've about 10% surplus funds, and need to choose which makes the best investment out of PEL, MAZDA and AMARA RAJA batteries. As far as PNB is concerned, I won't liquidate it - it can give decent returns + dividends when market bull phase comes back in full swing.

I performed an expectation analysis also, here's the summary:

Stock Holding	Purchase Price / CMP	Fair Value Estimate	1.5X fair value reversion	Potential upside due to 1.5X fair value reversion	3y average dividend yield
BHEL	Rs.        220.50	Rs.        322.00	Rs.        483.00	119.05%	2.61%
BHARTIARTL	Rs.        263.90	Rs.        300.00	Rs.        450.00	70.52%	0.38%
SRF	Rs.        206.73	Rs.        480.00	Rs.        720.00	248.28%	6.77%
CROMPGREAV	Rs.        129.28	Rs.        100.00	Rs.        150.00	16.03%	1.49%
MOIL	Rs.        251.11	Rs.        314.00	Rs.        471.00	87.57%	2.26%
Opto circuits	Rs.        128.96	Rs.        180.00	Rs.        270.00	109.37%	2.97%
INFY	Rs.    2,249.88	Rs.    2,318.00	Rs.    3,477.00	54.54%	1.96%
PEL	Rs.        472.86	Rs.        680.00	Rs.    1,020.00	115.71%	2.46%
PNB	Rs.        709.07	Rs.    1,143.00	Rs.    1,714.50	141.80%	3.10%
IGL	Rs.        261.49	Rs.        221.00	Rs.        331.50	26.77%	1.85%
MAZDA	Rs.          98.63	Rs.        134.00	Rs.        201.00	103.79%	3.55%
AMARA RAJA BATTERIES	Rs.        227.13	Rs.        150.00	Rs.        225.00	-0.94%	1.66%
				102.15%	2.64%

As you can see, I've listed my average purchase price, my calculated Intrinsic Value / fair price and the 3 year average dividend payout, and accordingly, my portfolio dividend yield is a decent, if not great, 2.64%. Also, assuming markets will revert to mean in next 3 years, my portfolio can earn about 102% profits, which amount to a handsome 26% CAGR!!! Not to account for 2.64% annual dividends, yielding to a total expected return or about 30% from this portfolio.

While this might be a little overstretched, but then, we know a very bullish market can become highly irrational, and that's the time to take some profits and channelize into better opportunities.

I'll now soon freeze my portfolio (except selling if something flies away too fast, potential candidates being PNB, INFY and smaller stocks...) and focus back on continuing reading. Need to structure the reading, so much to read, but need to prioritize...just need to spend couple more weeks on completing this choice of 10% incremental investment in MAZDA, PEL or AMARA RAJA, and think if need to reduce stake in SRF

Let's see how things unfold...

Will come back again, IL&FS

I found this interesting business in my stock screen, but looking at annual report, I'm not very confident if I can analyze it today, so just keeping it in my watchlist and will come back soon...

I really like Amara Raja Batteries, and have taken a small tracking position also, and this will be the stock I'll analyze before freezing...and accordingly re-adjust capital based on my conviction.

I've kept two more stocks in my watchlist (SWARAJ ENGINES & ECLERX SERVICES), but will not analyze them right now as I'm deciding to freeze my portfolio for next 6-12 months. Will spend time on studying books and reading good articles on value investing...

A re-look at IGL

Since last one week, I've been analyzing new opportunities (MAZDA, PEL) and find that maybe, they're safer bets compared to IGL. No doubt IGL is a good business, but given the risk / reward ratio, I'd be more comfortable to put my bet on MAZDA due to a simple business with decent moat, able management, small enough to keep growing and a good deal of undervalued stock, and PEL due to skills of Mr. Piramal and the fact that this company has a lot of cash to look out for good opportunities, and I'm getting an entry into drug discovery + pharma + healthcare analytics as a debt capacity bargain.

Hence, I bought some more yesterday at rs 256 and finalize the infusion in IGL. I'll stop for now, and only think again about IGL if

1. It drops below Rs 200 with no further degradation in fundamentals
2. I have surplus cash and no other better opportunity (after exhausting the limit of 7% on MAZDA and 10% on PEL)

I still have some position and can benefit the rise in IGL due to PNG growth in NCR, which is my primary reason to like the stock. And due to small concerntration in portfolio, the risk of further pricing regulation is contained.

Next post, to resolve confusion on SRF and take a call for reducing or maintaining the position...

Clearing Confusion - MAZDA

In the last post, I analyzed my stock portfolio holdings and said that I'm confused about SRF, MAZDA and IGL.

I took some time to analyze these further, starting with MAZDA, and here's what I find:

- Another independent research on this business:

http://valueinvestinginpractice.blogspot.in/2012/04/mazda-limited-engineering-value-play.html

Good analysis, pros and cons and I more or less agree and would do the same...

- Management compensation. While it is high in percentage terms (15% of net profit), looking at the history, for last 5 years, the three executive directors' salaries have been around Rs 30 lacs each, and occasional bonus / commission. This is still high in percentage terms, but reasonable in absolute terms considering the performance they've generated - consistent OPM and NPM of 15% and 10% roughly, and an ROE of 18%+ (except this year) with nearly zero debt

- Custom engineering business means lesser competition and hence lower risk of profit margin erosion.

- Crolles technical collaboration is a plus, with equal risk of losing competetive advantage if terms go bad with crolles.

All in all, this looks a decent business, undervalued substantially and low risk of things going wrong. Hence, even though it is small, I've decided to increase and build up to 5% stake in my portfolio. I've started buying more below Rs 100 (my initial IV calculation was Rs 87, but considering management has bough shares from market at that price, its unlikely prices will come down to Rs 87 soon, and I'm only buying it about 10% higher than my target.

Next is on IGL and SRF in another post :-)

Health Check

Over the last 24 hours, quite a few emotional tides, and finally today's post on SN helps me settle down.

I was getting excited about finding these small caps trading so cheap, and added to watchlist, and was even thinking of adding small positions in the following counters:

HALDYN GLASS
NAVIN FLOURINE
PUNEET RESINS

Most likely, all three of above are out of the list already, a big relief :-)

Also thinking about reshuffling betweek SRF and MAZDA.

But before I do anything, I'll step back and analyze my existing positions. Let's start:

Healthy Ones:
BHEL, MOIL, INFY, CROMPGREAV

These are debt free companies, very good ROE of 30%+ over past 5 years, consistent and stable growth and decent valuations, adjusting for market reputation. My purchase prices too are all right, maybe a little expensive, but still quite good compared to historical levels. I'll be very comfortable to hold them and not be worried due to transient down quarters and slowdown in growth.

Cautious One:
BHARTIARTL, OPTOCIRCUIT

Good, promising businesses, but concerns of declining margins for Bharti, while cash flow concerns for Opto Circuits. Since I believe in long term prospects of the businesses, and the fact that they're available at deep discounts, I'll still hold them, but yes, I understand the risk is higher in these investments, but then rewards are equally good.

Comfortable, but exit on rise:
PNB is one stock where I believe its decent, but not a stock I'll hold for long term. Its more of a positional stock - buy when it crashes below Rs 680, and sell when it goes above Rs. 900. But never increase beyond 7% of portfolio.

Confused:
SRF, MAZDA and IGL.

For IGL, I believe in story, but then, concerns that its a little more expensive, and risk of further margin contraction due to PNGRB decisions. Right now, have invested 3% of portfolio in IGL, but given the discovery of new potentially better opportunities, will need to re-think before making further purchase.

For SRF, the new concern about "small caps being value trap" is on my mind, and if I do conservative analysis, I find cyclical profit margin contraction (is it really cyclical?), increasing debt, and some other concerns I've posted today. I'll analyze more and see if I should take some profits off, if not a complete exit.

MAZDA, looks good, but need to do a critical analysis and make sure chances of this turning as a value trap are minimal, and only then I'll add more positions. In any case, I'm not comfortable having more than 15% of my portfolio in small caps, so i I have to add positions, it'll only be when I'm convinced it is better than SRF.

Excited!!!
Piramal Enterprises. Every time I look at it, I'm more convinced its a great opportunity. Yes, it might not rebound fast, but given Mr. Piramal's skills, I consider this as a stock to hold for long term. I've added about 1.4% of my portfolio in PEL stock, and will add below Rs 470.

Finally, there're few more stocks in my watchlist which I need to analyze. I'll probably wait for while, let excitement stabilize and then take a decision - whether to freeze my portfolio (except only exiting stocks on rise where I'm not very comfortable or want to exit at a certain price) and spend time studying and reading long pending list of items, or to continue this churn. Certainly, considering short term financial obligations coming my way, the former choice looks better. Not that I'm underinvested, even if I clean up and freeze, I'll still have 50%+ of my investments in equity, so not a bad figure and not a risk of missing the next boom, if it has started :-)

Let's sleep and relax, its a great way to control irrational exuberance.

Re-allocation

I purchased some more Infosys when it crashed 8% yesterday after results, at Rs 2345. Rs 15 will be returned back in a month as dividend, so if I assume I reinvested dividend on my total stake in INFY, my incremental cost is Rs 2267, and my new average cost being Rs 2250.

I also completed my purchase in OPTO CIRCUITS, for a total average cost of Rs 129 and ~10% stake in portfolio.

I also decide that Piramal Enterprises is a far better opportunity than MAZDA, and I'm still not comfortable to put my stake in a small cap company compared to an excellent sidecar opportunity. Hence, I'll exit the small tracking position I took in MAZDA and start putting more money in PEL, the cash generated from sale of ALBK and PNB...

Here'e the new portfolio composition:

The balancing is happening now...only IGL and PEL need to get more stake, while others are fixed now. PNB, well, if it drops back to Rs 660, I'll consider buying, and will exit above Rs 1000 or so...

Piramal Enterprises

As I wrote 2 days back, today I perform the detailed analysis of Piramal Industries, earlier known as Piramal Healthcare.

Let me first write my reasons to research this stock, they'll help remove some biases:

1. Its been discussed few times in value investing forums.
2. Prof. Sanjay Bakshi analyzed it an year back and found it attractive, the price has not moved yet and there're more reasons for the business to be more attractive than an year back.
3. Mr. Ajay Piramal is known for his superb capital allocation skills, and I think he can make better use of my money than I can do.
4. PEL now owns 11% stake in Vodafone India. Below I analyze if this stake is undervalued in PEL stock.

Ok, so, first step in valuation of PEL is to find a value for Vodafone India. Vodafone India has about 16.4% market share of Indian telecom (cellular, GSM) market, which currently stands at about 911 million subscribers, according to a report by TRAI. Since Bharti Airtel, the largest subscriber owns 19.62% market share, a reasonable estimate of Vodafone's revenue is 16.4/19.6 * 416038 million = ~Rs 350000 million for year 2011-12. Taking an average Net Profit Margin of 20% for the industry, we can arrive at Earning for Vodafone as Rs 70000 million for year 2011-12. Now, under current distressed industry situation, Bharti trades at 17P/E, and it won't be unreasonable to assume that if Vodafone India were public it'll trade at least at 15 times its earnings. This gives a total market cap of Rs 105000 crores to Vodafone India, of which, PEL owns 11%.

Thus, the market value estimate for the stake in Vodafone India alone is Rs 10500 crores. Taking a margin of safety of 40% on this calculation, we can at least assume Rs 6000, which is what is roughly PEL paid to acquire the stake. So, this gives a good confident that book value of vodafone stake in PEL is at least slightly undervalued, and Mr. Piramal has struck a good deal.

So, net of Vodafone Investments + Cash - Long term Debt is Rs 300 per share (6000 cr + 57 cr - 892 cr = 5150 cr = 46% of book value) = Rs 300 roughly, and there's a lot of margin due to Vodafone valuation with 40% discount.

The question now is, at current price of Rs 470, what else within the business makes it still undervalued compared to rest of Rs 170 per share price. Let's try to analyze:

DRG Acquisition
Referring to Analysts presentation, DRG is a healthy business, with high barrier to entry, negative working capital, consistent 20%+ revenue growth and even high profit growth, debt free, diversified client portfolio, and PEL has acquired it for $635M, when DRG is expected to have a revenue of $160M in FY2012. This is 4X revenue valuation, in line with market valuations for such businesses in US.

Assuming current profit of 20%+, earnings for FY2012 are expected to be about $35M. Assuming 2 stage DCF, with 18% growth in FCFF for next 8 years and 2% thereafter, we arrive at a fair value of $650M, very close to what PEL paid. Thus the value of DRG in each share of PEL is about Rs 180.

Due to bridged acquisition over 18 months, starting May 2012, with 1:1 payment through equity and debt, and debt being at 5.5% cost. They plan to raise debt against DRG asset itself in US. Can we count the value of DRG today? There'll be increase in debt upto an amount of $320M on books of DRG, which can be easily serviced (interest cost will be $17.5M per year). Even if debt is carried on books of PEL, it can be easily serviced from available cash (or potential cash inflow from dividends that might be generated from DRG profits). The equity part will be paid out of cash inflow to come from Abbott over next 3 years ($1.2B) and from sale of Vodafone stake, which they say is a short term investment. Hence, we should NOT add Rs 180 into value for PEL, maybe something between Rs 90 and 180.

Before we move forward, let's stop and revise and tally. Sale to Abbott would generate a total cash inflow of $2.2B as one time, received in 2010, and then, $400M annually from 2011 to 2014. Till now, $2.2B + $400M is received and is on books ending FY2011-12. ll this total amount is sufficient to cover purchase of Vodafone and DRG and still leave surplus cash, so debt arising from DRG should not worry us, but as a conservatism, let's account for only 70% of Rs 180 from DRG, and hence total value accounted is now rs 300 due to Vodafone and Rs 125 due to DRG. This leaves Rs 45 more to be accounted, NOT counting any surplus cash inflow remaining from Abbott by 2014.

Pls note that we've been very conservative in valuing Vodafone and DRG so far, and yet only left behind with Rs 45 to be accounted for remaining businesses that PEL holds.

Financial Subsidaries
Let's start with the INDIAREIT Fund advisors and Investment Management compaty, along with PHL finance pvt ltd. These were acquired for a total consideration of Rs 225 cr, summing to Rs 11.63, net's knock off Rs 10 as the value from remaining Rs 45. Sime reason being a belief in Mr. Piramal's value investing skills, he won't pay more that value, and then we can say Rs 10 per share of PEL is a good value for these INDIAREIT companies.

Let us also not count any further value for other financial subsidaries.

Now remains Rs 35. Sales from all the Pharma and Healthcare related businesses (accounting for over 80% of total consolidated sales) was Rs 1988 cr in FY2011-12. Average profit margin is 16%+, and this means a  total Operating Profit - Depreciation (EBIT) of over Rs 318 - Rs 140 cr or equivalently, Rs 180 cr = Rs 10.5 per share.

This gives a debt capacity of Rs 10.5 / 3 / 0.09 = Rs 39 per share for healthcare related business. This means, that if we leave aside Vodafone and DRG and financial acquisitions at cost (and believe in Mr Piramal's skills to equate purchase price as fair value), the remaining business, in current state is available at Debt Capacity!

Can you buy a pharma business today at debt capacity? Not really, all pharma businesses enjoy high valuations, owing to stability of their business fundamentals. Hence, I believe Piramal Enterprises is still quite undervalued and I can enter below Rs 470 a share quite comfortably. Of course, it'd make sense to stagger the buying, so I'll now start increasing my stake in PEL gradually, buying on dips below Rs 470, upto 10% of my portfolio.

The belief is in excellent skills of capital allocation of Mr. Piramal, and the fact that he's driving the enterprise to be in the right businesses in pharma world, and building a portfolio of right verticals. I still need to read in details the analysis Prof. Bakshi did 17 months back, but now I won't be biased - I have performed my analysis and can make it more pruned by reading what the revered professor has to say.

Another sidecar investment. Its good to analyze sidecar opportunities and invest while you're still learning to do independent research :-)

Here I come Piramal Enterprises...and next post will tell the new action plan.

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Here's a structured calculation of IV to find at what margin of safety is the stock trading right now.

1. Valuation of Vodafone stake is Rs 10500 cr.
2. Valuation of DRG stake is NOT counted, since it is yet to come on books. instead, we count the cash inflow of 3 x $400M = $1.2B = Rs 6000 cr (@ 50$ - INR = 50). Let's be double conservative and consider only upto 70% will go to good use (this also discounts future cash flows), and hence, effective value comes at Rs 4000 cr.

3. We found that debt capacity for all pharma related business is about Rs 667 cr. Taking Graham's minimum value of common stock as 1.75X of debt capacity, we can assume a value for Rs 1160 cr. for pharma business.

4. Finally, we reduce total liabilities of Rs 2600 cr.

Ignoring other businesses, we find the value for Piramal Industries as Rs 10500 + 4000 + 1160 - 2600 = Rs 13000+ cr. This translates to Rs. 680 per share. Since a good part of this is cash, which will be paid to buy DRG, we should still take some decent margin of safety.

At CMP, we're getting this company at 30% margin of safty. I think it's a decent margin of safety for such a well managed enterprise, in hands of an excellent investor. I'll be doubly confident to buy this stock now :-)

A new opportunity

Well, this is one stock I've heard quite a few times, and I'm analyzing it these days. Piramal Industries (earlier Healthcare)...yes, interesting company, but still need some time for detailed analysis, so took a tracking position in it.

Since this will now become 11th stock, and I have two small caps, SRF and MAZDA now, I'm thinking about balancing capital betweek SRF and MAZDA, such that the risk of getting into two 'value traps' reduces. The rationale is that while both SRF and MAZDA are healthy businesses, the risk of not getting a higher valuation by market is prevalent due to small company profile, boring business and not so strong moat. So, from current ~14% level of SRF, I plan to bring down level to ~6% and fill MAZDA will the flows. Of course, the key is to way for the right moment to reduce SRF and increase MAZDA. I'll buy more of MAZDA below Rs 87, while reduce SRF when it returns to 230+ levels.

Now that this is a new thought, I should also wait for it to sink it before taking action, so, let's wait for the result reason to begin and see how overall market behaves.

Of course, till then, I'll also analyze Piramal Industries and maybe something changes on this thought...let's wait and watch :-)

Goodbye Allahabad Bank

Well, I was not feeling comfortable holding more than 17% of my portfolio in BFSI stocks, especially after they ran up 25% in last 45 days. Finally, I decided to reduce BFSI to below 10%, and exited ALBK completely, while reduce 33% of PNB holding. Due to bad investments in ALBK in the past, I stand at an all time loss of 3.5% in this stock, but yes, since the last purchase, I've had over 12% profit. Goodbye, when you again get dumped to drain, I'll pick you again...

In PNB also, since I was invested upto my limit of 11% per stocks in portfolio (BHEL is an exception...), and I sense it has also run up beyond my calculated IV, too fast in last 45 days, its prudent to reduce some exposure. Now my total BFSI exposure is 8.2% and only stock being PNB, which I still believe, my current average cost is around 710 (after a net loss to date of about 15% of my current holding.

Since I reduced about 14% invested amount by these actions, I also reallocated some money, and completed purchase in BHARTIARTL to 11%. Yes, I bought it a little expensive, but given the fact that it's making a very strong base around 260 levels, and my conservative IV calculation only gives a 10% lower price, I'm comfortable in buying a good business with healthy prospects at a slightly higher price than my IV. This is a classic example where my conviction in business future prospect is stronger than my confidence in correctness of IV calculation.

Additionally, now that I've 9 stocks, I also have room to add a new stock, and out of my watchlist, MAZDA is one business which I like. There has been some good discussion on SN forum, and its been few weeks that we've waited to assimilate the discussion, and my gut feel says - go ahead. Strong business fundamental, undervalued by a conservative IV calculation method, healthy record of cash flow generation, decent dividend yield, and no debt. Just the right kind of company you'd want to buy in. Yes, Ideally I'd like to buy below Rs 87, but again, giving benefit of doubt in IV calculation, since its only about 12% higher, and started buying in small amounts. As it falls, I've surplus cash from sale of banking stocks to gradually build up exposure in MAZDA. Thanks Sanjeev Ji for analyzing this good stock.

Finally, here's my new portfolio allocation, by stocks:

And this is by sector. Yes, my exposure in Capital goods sector is above 30%, primarily due to good run up in BHEL and the fact that BHEL alone stands at 17% in my portfolio. But I strongly believe in the business prospects, and in long term, both BHEL and CROMPGREAV will deliver - they're healthy businesses, run by able management, and there's a huge potential for both these companies to grow further given the large power infrastructure need in India. Yes, there's competition, but these are good brands which enjoy reputation of quality products, and eventually, quality wins in such mammoth investment spaces.

Readjustments

I took the first step of what I mentioned in planned investments. The new allocation looks as below

Here's the detail:

1. ALBK has run up from a low of Rs 117 odd to Rs 150 in last 40 days. This is quite fast. I did some bottom fishing around Rs 125 and below, and considering that I only took it as a beaten down stock, and not really a great long term investment, I should reduce some exposure and take profits. I did so, and reduce about 14% holding yesterday at Rs 150. As the stock will increase further, I'll offload further, and bring down portfolio contribution of ALBK to less than 7%, and possibly exit completely if I stop a much better opportunity.

2. CROMPGREAV has also run up from a low of Rs 103 to Rs 130 pretty fast. Again, prudent to reduce some exposure considering quite high a cost in comparison to IV as mentioned in my post earlier. It'll come down when people get sense out of this liquidity driven rally, and then I'll buy back again when it comes below the IV. Yes, it may not happen, but then I'll only offload upto 20% of my holdings. I reduced about 12.5% yesterday, and will take another offloading to reduce cost and risk (considering I really have a negative margin of safety on this stock)

3. I took some more exposure in IGL & BHARTIARTL. As I mentioned in my post on these company, I strongly believe in future prospects, and although current price is about 10% higher than my IV calculations, I'm taking some risk in buying a bit higher since I believe that long term growth prospects offset the risk adequately. This is a classic case of buying slightly higher than calculated fair price if you believe that IV will grow in the future, and opportunity cost of investment is justified (more on this topic soon...)

Let's wait more for this rally to unfold, will take some more prudent calls to reduce exposure in opportunities where I don't believe quite strongly and which are more of Graham like opportunities (ALBK, PNB, and CROMPGREAV to reduce risk due to negative MoS), and wait for downhill movement to pick more of BHARTIARTL, IGL and INFY.

On OPTOCIRCUITS, I'll hold further purchase till I get time to analyze it deeper, especially the incremental return on capital and success of acquisitions and goodwill writeoff.