This will be a quick post; while I posted about asset allocation and need to increase equity investments, I've come across these few stocks where I believe a speculative bet will help generate some decent profits, and help me satisfy the urge of "gambling".
- IL&FS Investment Managers (IIML): I just concluded this morning that IIML is not a good enough investment for long term, but it might be a reasonable speculative bet, in small amount. I'll keep adding trickles of this stock to my portfolio - I don't see it running away in a hurry, but yes, if macro-economics improve, this stock may be an out-performer.
- Wockhardt Ltd: The stock has fallen from 2000 odd levels to 1200 levels in last 2 months, and is probably over-discounting the recent news of quality concerns with their medicines. It maybe a favorable bet, let's see if risk / reward is good enough. Looking at some numbers quickly, the company has generated an average annual revenue of Rs 4600 crores in last 3 years, and the sales is growing at about 18% annually. Further, the operating profit margin is growing from 24% to 36%. Assuming that the US import restrictions impact top-line by US$ 150 million (taking margin of 50% on what management says), this translates into a hit of Rs 750 crores to annual revenues. Assuming no revenue growth and current revenue level of average(5449 for last fiscal, 4600 as average for last 3 years) = ~Rs 5000 crores, and reducing Rs 750 crores, we get a revenue of Rs 4250 crores for next financial year. At a 30% OPM, this results in Rs 1275 crores of OPM. Now, looking at current numbers, Market Cap / Operating Profit has been around 10, and at current share price of Rs 1200, we get slightly smaller ratio. So, Rs 1200 per share is a reasonable price proxy to the share price before the import restriction, and if the company is able to regain FDI compliance (as management says they'll do it in next 3 months), the stock price can rebound back towards Rs 2000.
Considering the quick analysis above, I feel that the stock can be purchased below Rs 1200 for about 25-40% gains in next 3-6 months, and downside risk is very limited. As for margin of safety, we've taken higher hit on revenues, assumed no growth and a lower OPM, and that should be good enough to justify a small purchase in the stock, of course limited to less than 2-3% of my portfolio.
I'll add more speculative bets if they come, and till I don't hit upper limit of my speculative funds.
Saturday, May 25, 2013
Friday, May 17, 2013
IL&FS Investment Managers - A new look
I had a look at this stock earlier, but quickly decided to stay away then. However, after I posted about asset allocation, I felt the need to have a high dividend yielding position, such that it provides cushion to my portfolio, and i found IL&FS investment managers as an interesting play.
Checkpoint 3: What kind of investment do you consider this business initially? Are you considering it as a long term story, or a medium term play (sorry, short term plays, i.e. for duration less than 3 months, are OUTSIDE the circle of value investors). Write down your initial thought in terms of [Peter Lynch] investment types - High Dividend Yielding, Stalwarts, Cyclical, Fast Grower, Turnaround story or an Asset Play?
a) Is management candid with shareholders? Have they done what they said in the past?
Looking at answers below on checkpoint 6, the management statements reflect that they're candid. They've acknowledged the challenges to business outlook and still tried to deliver the performance (we still want to validate their deep value investing belief, which we'll do towards the end, in checkpoint 7)
b) Does management act rationally?
Yes, they do. As we see below in checkpoint 6, they've invested heavily during the downturn when the valuations became more favorable and this is the most rational thing to do for a long term investor.
c) Do management acts imply integrity?
We've not found any signs of a behavior from management which highlights doubts about their integrity, but we'll keep a tab on this aspect as we analyze MD&A and specifics of investments made in details.
d) Does management demonstrate good capital allocation skills, or they're stuck in institutional imperative? Examples being prudent dividend declarations when no avenues for cash, buying back shares to reduce stock dilution etc.
e) Does senior executive compensation include company stock options, and is it designed to bring sense of loyalty and belief? Are "insiders buying" the stocks when their market price goes down? Is promoter holding a clean holding or shares are pledged to "manage cash"?
I'll go through the checklist that I recently created, and try to eliminate the stock. Let's see how far can this business stand in my screening :-)
Checkpoint 1: Is the business OUTSIDE your circle of competence [Charlie Munger]? Can you talk about it right after you're waked up from sleep? Do you understand the business well? Is it simple enough for an idiot to run [Peter Lynch]? Assume you're no better than an idiot!
IL&FS Investment Managers Ltd. (IIML) is a private equity fund focused in infrastructure and real estate funds. While I don't understand either of real estate or infrastructure (related to real estate) development, I understand the role of a PE fund, and I'll explain below on how I believe this company can be a good side-car investment, apart from providing healthy dividend yield. In this context, I'll focus more on analyzing the management's ability to sustain and grow the returns, more than understanding how the business operates.
Checkpoint 2: What is your main reason to look at this company? Write this down and once we analyze the business, we'll come back to see if our analysis is biased by this presumption [Anchoring bias, Charlie Munger]. If your reason is mainly a recent, sharp decline in share prices, try to find why so many people are selling, and if they know more than what you (prospective buyer) knows, or in other words, are you taking undue risk by investing into something with many unknowns?
Checkpoint 2: What is your main reason to look at this company? Write this down and once we analyze the business, we'll come back to see if our analysis is biased by this presumption [Anchoring bias, Charlie Munger]. If your reason is mainly a recent, sharp decline in share prices, try to find why so many people are selling, and if they know more than what you (prospective buyer) knows, or in other words, are you taking undue risk by investing into something with many unknowns?
I'm interested in IIML due to the following:
- Healthy dividend payout (above 40%), translating into 7% yield for current share price.
- Fund managers have delivered very good performance in the past. This belief, if true, can turn this stock as a very good side-car investment, similar to PEL that I hold today.
Checkpoint 3: What kind of investment do you consider this business initially? Are you considering it as a long term story, or a medium term play (sorry, short term plays, i.e. for duration less than 3 months, are OUTSIDE the circle of value investors). Write down your initial thought in terms of [Peter Lynch] investment types - High Dividend Yielding, Stalwarts, Cyclical, Fast Grower, Turnaround story or an Asset Play?
I consider IIML as the following investment type:
- High dividend yielding
- Asset Play, where value of assets is very good, and a positive catalyst is needed to unlock the value
- Side-car investment due to proven capability of the fund managers, based on past performance of the funds.
Next checkpoint is the most important point for this investment, as we're banking on management's abilities to drive the value creation for shareholder (me).
The following key financial numbers will support the arguments below:
The following key financial numbers will support the arguments below:
Checkpoint 4: A good management is essential to keep a "good business" good, and hence, we must identify whether
a) Is management candid with shareholders? Have they done what they said in the past?
Looking at answers below on checkpoint 6, the management statements reflect that they're candid. They've acknowledged the challenges to business outlook and still tried to deliver the performance (we still want to validate their deep value investing belief, which we'll do towards the end, in checkpoint 7)
Yes, they do. As we see below in checkpoint 6, they've invested heavily during the downturn when the valuations became more favorable and this is the most rational thing to do for a long term investor.
We've not found any signs of a behavior from management which highlights doubts about their integrity, but we'll keep a tab on this aspect as we analyze MD&A and specifics of investments made in details.
Management of IIML has indeed demonstrated good capital allocation skills. Here's the reasons in support of this statement:
- Maintained 30% (or higher) PAT margin %age, for last 7 financial years. This demonstrate good exit (divestment) criteria for investments that the PE fund group holds.
- Consistent ROE higher than 40% except in FY2005-06, when last 7 years are considered.
- Consistent ROE higher than 40% except in FY2005-06, when last 7 years are considered.
- Grown dividend %age consistently in the past, as they've surplus cash, beyond good investment opportunities. IIML has passed on most of the cash as dividends to shareholders, as evident from more than 70% dividend payout ratio of PAT in many fiscals.
- Cash flow from operations has been positive, but erratic compared with net profits. Analysis of Cash Flow statements will be performed in detail when analyzing financial health.
- Business has avoided debt for all of the financial years. Only liabilities are the deferred employee benefit payments.
- Business has avoided debt for all of the financial years. Only liabilities are the deferred employee benefit payments.
- The business has only dealt with share split, bonus issue apart from dividend payouts, but not exercised buy back option. This means that management wants to reward shareholders for long term shareholding with consistent cash flow in form of dividends, and do not want them to "trade upon buyback", despite that management might have felt that share price is beaten down to make it undervalued and lucrative for buyback to reduce equity dilution.
According to Annual Report FY2011-12, the salary of director is Rs. 2.62 crores. The non-executing directors are paid between Rs 20 lacs and Rs 4 lacs. According to P&L statement, the total expense on salaries and allowance for FY2011-12 is Rs 23.2 crores. Understandably, for a PE fund, most of the expenses are employee salaries and benefits, as also evident from P&L statements. Notably, director's compensation is ~10% of total employee compensation, and about 6% of PAT for the year. This is certainly not small, however, we should note that it is P/E fund, and hence such values are also not unreasonably high. Considering that the "team" manages an AUM of $3.2 billion (as of FY2011-12), the salaries for the "team" is Rs 232 million, which is 0.15% of AUM, which indicates a very low "management fees" if this company is treated as a mutual fund.
The company also has policy of ESOPs and encourages to provide performance based bonuses. In this case, director's compensation of Rs 2.62 crores includes Rs 1 crore as performance related pay.
As of 31st Mar 2013, directors of the company (7) hold 5.59% of publicly listed shares of the company, apart from the fact that promotors of the company (IL&FS Ltd) hold ~51% of the total outstanding shares. This means that both promotors and directors of the company believe in the company.
Additionally, Parag Parekh's investment firm (PPFAS Pvt. Ltd.) also acquired a sizable number of shares in 2012 end, and as recent as May 3rd, 2013, IL&FS Ltd. purchased additional 500000 shares from the market at an average price of Rs 21.56
Looking back at 2006, both promotors and employees have increased their %age shareholding.
All this indicates strong confidence of promoters and management in the future prospects of the company.
Overall, we believe that IIML has got a good management team.
Checkpoint 5: Does business possess a strong economic moat [Warren Buffet]? Check the following:
a) Do customers have a bargaining power that keeps an upper bound on prices and margin improvement is limited (cost cannot be lower than 0%)
b) Do suppliers have a bargaining power that keeps a lower bound on costs, such that margins are squeezed?
c) Risk of new entrants, who may play pricing wars and put pressure on pricing, i.e., does business have "earning power" like a brand value that allows it to maintain (or even increase) prices?
d) Is there an alternate product that poses a risk as a substitute to the product / service that business produces? Could it result in a permanent loss of revenue to the business?
e) Is the economic moat sustainable, or just due to luck?
Since IIML is a private equity firm, they generate money as commission to asset sale. Their customers are their clients who provide them with funds, and as a policy, they get a fix management fees of about 2%, and a "carry" of about 20% of profits if they're able to generate returns higher than "hurdle rate" which is about 12%. In this sense, the fund managers either get this "fixed" income or they don't accept funds, and then there's no customer pressure, i.e, they won't 'sell' at reduced profit margins.
Since there're no suppliers (actually clients provide the money supply, and in that sense clients are both suppliers and customers), there's no upside pressure on costs.
The competition are other funds who may snatch the "deal", but a mindless competition will be when acquirers pay insane prices for purchasing assets, or sell assets at lower profits. Both of these acts will reduce returns on investments. This has been the environment during last couple of years when there's liquidity crunch in PE investing, and it's getting difficult to sell assets at good profits. This is like a push and a "near ideal" economy where no P/E player has any moat - if you sell at profits you'd like, you may not be able to sell enough, it's like reducing revenues to maintain profit margins. The good part about IIML is that they chose to maintain profit margins, which keeps their 'carry' and provide them source of income, however, if they can't sell assets 'in time while maintaining hurdle rate', they'll eventually lose money. In this respect, "passing time and slowing asset sales" is a killer for IIML, and this indicates 'weak moat'
There's no alternate product I can think of, which poses a threat of replacement to IIML.
Finally, IIML has been able to maintain profit margins in the past, but we need a thorough, careful analysis on why they were able to do this, because they possess some special 'skills' or it was out of sheer luck? We do not yet know this answer, we'll need deeper study of what they could sell at good margins, and what they've not been able to sell profitably, and the times in which their asset sales were grand successful. We'll analyze this in checkpoints 6 and 7 where we assess risks to the business.
In summary, we believe that the business doesn't have a very strong economic moat.
Checkpoint 6: Since every business is essentially a system which takes in Cash and "is supposed to" generate more cash, such that the Return on Invested Capital (ROIC) is higher than Weighed Average Cost of Capital (WACC). Draw a "cash flow diagram" for the business explaining how it generates cash, and find out whether it has consistently been able to generate higher ROIC than WACC. Consider at least a period of last 5 years.
As mentioned above, here's how IIML makes money:
1. They approach prospective clients who believe in IIML's capability to generate returns that're acceptable to clients.
2. The agreement is, that if there's loss on investment, it is client's. IIML gets a minimum of ~2% as fund management fees on the total "Asset under management (AUM)', and if they make profits on investments greater than "hurdle rate", which is about 8-12%, they get 20% of the profits.
3. This is a "win-win" model for IIML, i.e., if they generate good returns, they get to keep 20% of the returns. If they screw up, they possibly lose the clients.
4. To increase revenues, IIML needs to attract more clients and more money, and to be able to do this,, they should deliver performance, consistently, as we're talking about some serious money.
b) Is operating cash flow poorer than profit (EBIT / EBITDA) on several occasions (consistently positive operating cash flow)?
c) How has working capital requirement changed over years? Is business generating cash faster than it needs (negative working capital)?
d) Is business generating good returns on capex, or it is burning precious cash in attempting to grow by capital spending (incremental return on capex)?
e) Is the debt on balance sheet concerning? Is most of operating cash leaking away in interest payments? Is business able to retire debt and gradually reduce interest burden? How long do you think will it take for the business to bring down debt to advantageous levels? Is dividend being regularly paid despite debt on the books? If so, is "Financial Leverage Index" > 1, indicating that return on investments is greater than cost of debt, and hence the leverage created due to debt is advantageous to the business, and it is good to pay dividends using generated cash, while keeping the debt at advantageous level.
The company also has policy of ESOPs and encourages to provide performance based bonuses. In this case, director's compensation of Rs 2.62 crores includes Rs 1 crore as performance related pay.
As of 31st Mar 2013, directors of the company (7) hold 5.59% of publicly listed shares of the company, apart from the fact that promotors of the company (IL&FS Ltd) hold ~51% of the total outstanding shares. This means that both promotors and directors of the company believe in the company.
Additionally, Parag Parekh's investment firm (PPFAS Pvt. Ltd.) also acquired a sizable number of shares in 2012 end, and as recent as May 3rd, 2013, IL&FS Ltd. purchased additional 500000 shares from the market at an average price of Rs 21.56
Looking back at 2006, both promotors and employees have increased their %age shareholding.
All this indicates strong confidence of promoters and management in the future prospects of the company.
Overall, we believe that IIML has got a good management team.
Checkpoint 5: Does business possess a strong economic moat [Warren Buffet]? Check the following:
a) Do customers have a bargaining power that keeps an upper bound on prices and margin improvement is limited (cost cannot be lower than 0%)
b) Do suppliers have a bargaining power that keeps a lower bound on costs, such that margins are squeezed?
c) Risk of new entrants, who may play pricing wars and put pressure on pricing, i.e., does business have "earning power" like a brand value that allows it to maintain (or even increase) prices?
d) Is there an alternate product that poses a risk as a substitute to the product / service that business produces? Could it result in a permanent loss of revenue to the business?
e) Is the economic moat sustainable, or just due to luck?
Since IIML is a private equity firm, they generate money as commission to asset sale. Their customers are their clients who provide them with funds, and as a policy, they get a fix management fees of about 2%, and a "carry" of about 20% of profits if they're able to generate returns higher than "hurdle rate" which is about 12%. In this sense, the fund managers either get this "fixed" income or they don't accept funds, and then there's no customer pressure, i.e, they won't 'sell' at reduced profit margins.
Since there're no suppliers (actually clients provide the money supply, and in that sense clients are both suppliers and customers), there's no upside pressure on costs.
The competition are other funds who may snatch the "deal", but a mindless competition will be when acquirers pay insane prices for purchasing assets, or sell assets at lower profits. Both of these acts will reduce returns on investments. This has been the environment during last couple of years when there's liquidity crunch in PE investing, and it's getting difficult to sell assets at good profits. This is like a push and a "near ideal" economy where no P/E player has any moat - if you sell at profits you'd like, you may not be able to sell enough, it's like reducing revenues to maintain profit margins. The good part about IIML is that they chose to maintain profit margins, which keeps their 'carry' and provide them source of income, however, if they can't sell assets 'in time while maintaining hurdle rate', they'll eventually lose money. In this respect, "passing time and slowing asset sales" is a killer for IIML, and this indicates 'weak moat'
There's no alternate product I can think of, which poses a threat of replacement to IIML.
Finally, IIML has been able to maintain profit margins in the past, but we need a thorough, careful analysis on why they were able to do this, because they possess some special 'skills' or it was out of sheer luck? We do not yet know this answer, we'll need deeper study of what they could sell at good margins, and what they've not been able to sell profitably, and the times in which their asset sales were grand successful. We'll analyze this in checkpoints 6 and 7 where we assess risks to the business.
In summary, we believe that the business doesn't have a very strong economic moat.
Checkpoint 6: Since every business is essentially a system which takes in Cash and "is supposed to" generate more cash, such that the Return on Invested Capital (ROIC) is higher than Weighed Average Cost of Capital (WACC). Draw a "cash flow diagram" for the business explaining how it generates cash, and find out whether it has consistently been able to generate higher ROIC than WACC. Consider at least a period of last 5 years.
As mentioned above, here's how IIML makes money:
1. They approach prospective clients who believe in IIML's capability to generate returns that're acceptable to clients.
2. The agreement is, that if there's loss on investment, it is client's. IIML gets a minimum of ~2% as fund management fees on the total "Asset under management (AUM)', and if they make profits on investments greater than "hurdle rate", which is about 8-12%, they get 20% of the profits.
3. This is a "win-win" model for IIML, i.e., if they generate good returns, they get to keep 20% of the returns. If they screw up, they possibly lose the clients.
4. To increase revenues, IIML needs to attract more clients and more money, and to be able to do this,, they should deliver performance, consistently, as we're talking about some serious money.
The only investment in IIML is into their fund managers and 'human capital", and hence their's is a very asset-lite model. Looking at financials as above, we find that the business is able to generate a healthy 40%+ ROE. This is a good number considering that the company doesn't need any 'new capital' for operations and their operating cash is obtained out of their revenues (since if no revenues, no performance pay to managers).
Checkpoint 5: Before we go further, we need to make sure that the financial health of the business is good. Answer these sub-points to find this out:
a) Is company sacrificing operating margins to grow revenue (lack of sustainable moat)? We want a business which is able to grow profits at least as fast as sales (maintain / grow operating profit margin).
a) Is company sacrificing operating margins to grow revenue (lack of sustainable moat)? We want a business which is able to grow profits at least as fast as sales (maintain / grow operating profit margin).
No, as we saw above, the business has maintained 30% PAT consistently, and while we need to read further (in checkoint 7) into "divestment policy", the financials show that IIML doesn't sacrifice profit margins to grow revenue.
b) Is operating cash flow poorer than profit (EBIT / EBITDA) on several occasions (consistently positive operating cash flow)?
We find that operating cash flow are erratic and do not match well with net profit. Looking at financial data table above, we see that CFO is always less than PAT, only in FY2008-09, FY2009-10 and FY2011-12, it matches well with PAT. Let us analyse why it is much lower in other years:
- In FY2010-11, there's an increase of over Rs 21 crores in trade receivables, which is about half the PAT. Additionally, the CFO reported for FY2010-11 in Annual Report for FY2011-12 is about Rs 11 crores lesser than reported in Annual Report for FY2010-11, which is because of difference in "change in current investments" and "interest income" between two reports. The breakup in schedule 5 tells that most of it is "other debt"
- In FY2007-08, both trade receivables and payables increased by almost the same amount, causing a net "decrease in cash inflow" of Rs 3 crores, but about Rs 14.5 crores was spent in making new "current investments". The breakup in schedule 5 tells that most of it is "other debt"
- In FY2006-07, there's an increase of over Rs 21 crores in trade receivables, which is more than the PAT. The breakup in schedule 5 tells that most of it is "other debt"
- In FY2005-06, major part of operating profit went into new advances and wasn't realized due to trade receivables. The breakup in schedule 5 tells that most of it is "other debt"
In summary, a significant part of operating profits being in form of "trade receivables" is the reason for smaller net operating cash inflow compared to net profits. Further, in all cases, most of increase in trade payable is recorded as 'other debt', and we need to find further details on what this consistent "other debt" is about?
- In FY2010-11, there's an increase of over Rs 21 crores in trade receivables, which is about half the PAT. Additionally, the CFO reported for FY2010-11 in Annual Report for FY2011-12 is about Rs 11 crores lesser than reported in Annual Report for FY2010-11, which is because of difference in "change in current investments" and "interest income" between two reports. The breakup in schedule 5 tells that most of it is "other debt"
- In FY2007-08, both trade receivables and payables increased by almost the same amount, causing a net "decrease in cash inflow" of Rs 3 crores, but about Rs 14.5 crores was spent in making new "current investments". The breakup in schedule 5 tells that most of it is "other debt"
- In FY2006-07, there's an increase of over Rs 21 crores in trade receivables, which is more than the PAT. The breakup in schedule 5 tells that most of it is "other debt"
- In FY2005-06, major part of operating profit went into new advances and wasn't realized due to trade receivables. The breakup in schedule 5 tells that most of it is "other debt"
In summary, a significant part of operating profits being in form of "trade receivables" is the reason for smaller net operating cash inflow compared to net profits. Further, in all cases, most of increase in trade payable is recorded as 'other debt', and we need to find further details on what this consistent "other debt" is about?
c) How has working capital requirement changed over years? Is business generating cash faster than it needs (negative working capital)?
Yes, working capital is always less than net profits, and in a sense, this indicates that business 'can generate' cash faster than it consumes. This however flows out as dividend payments.
d) Is business generating good returns on capex, or it is burning precious cash in attempting to grow by capital spending (incremental return on capex)?
Since business model is asset-lite, there're no large incremental capex, and capital spend increases proportional to revenue increase.
e) Is the debt on balance sheet concerning? Is most of operating cash leaking away in interest payments? Is business able to retire debt and gradually reduce interest burden? How long do you think will it take for the business to bring down debt to advantageous levels? Is dividend being regularly paid despite debt on the books? If so, is "Financial Leverage Index" > 1, indicating that return on investments is greater than cost of debt, and hence the leverage created due to debt is advantageous to the business, and it is good to pay dividends using generated cash, while keeping the debt at advantageous level.
The business requires very small capital for its operation, and hence it doesn't require any debt, nor has it taken, and there's no significant advantage in increasing debt to benefit from financial leverage.
Overall, we can say that the financial health of the business is decent.
Checkpoint 6: Stocks generally become value picks when they possess a healthy business with an able management, but suffering from a transient problem which drives the stock prices southwards. Is the business suffering from any such condition, and if so, why do you think this is not a permanent change (inflection point)? If you believe it is indeed an inflection point for the business, why do you think business is capable of turning it into an advantage [Andrew Grove]?
The share prices of IIML have been falling since end of 2010 and have dropped down by as much as 60% in last 2.5 years. This is possibly because of the stagnated growth in income and hence the profits. This clearly reflects the fact that company has found it difficult to increase divestment process.
Let us analyze "Chairman's Statement" section across FY2005-06 till date to see if management anticipated this "slowdown", and what have they planned and delivered so far.
- FY2005-06 shows positiveness and optimism that Indian growth has been due to entrepreneurs who have extended their reach beyond India, and PE funds have significantly contributed to this effect.
We still need to see if they really follow what they say, but their voice echos strong value investing principles - deep understanding (circle of competence), management capability (a bad manager can easily destroy an excellent business), minimize risk (don't go where you may die) and timely exit (sell when others are greedy)
- FY2008-09 statement looks at financial upheaval in retrospection, and how company managed to grow the AUM as planned, and they mention that quality and valuation of deals has improved due to slowdown. But this must be read with care - the valuation multiples have come down, and hence divestment generates lesser profits than before, while investments have better margin of safety / better growth potential. Finally, management believes that India will maintain growth rates as a new stable government comes, and investment environment stabilize going forward, at least at a moderate pace. However, there's first indication of growth / profit slowdown as seen in the commentary. Note the fact that management is being candid about dependence of business outlook on macroeconomic environment.
- FY2009-10 statement talks about the eventful decade, where downturn of 2008-09 created challenges and opportunities for PE funds. Specifically, the following text is noteworthy, indicating innovative, prudent and strong value oriented approach of the fund
- FY2010-11 was a tough year across the world, with signs of EU zone cracks appearing, high interest rates in India, etc, and here's what the CEO of the company has to say about fund's performance - they're able to grow AUM (and hence the revenue from management fees which they call annuity). Looking at the financial data table above, they've grown AUM very fast before the downturn, and AUM growth has moderated substantially, so much so that AUM is stagnant at $3.2 billion since FY2010-11. This remains a big risk to the future outlook, that it'd be exceedingly difficult to continue to grow AUM at a reasonable pace.
- FY2011-12 statement from chairman again mentions the impact of downturn in second half of 2011, and how PE fund raising is severely impacted. They also show how the business has still managed to continue investments and divestment in this backdrop
In essence, we see that the business is indeed at an inflection point - the growth is slowing, the environment is becoming tough with high competition, and outlook is gloomy considering that the world economy may remain subdued for many more years to come (leave aside spurs of growth which are highly inconsistent). It is now upto the business leaders of IIML to capitalize this inflection point to their advantage. How can they do it, what are they planning to do about it? Let us try to find these answers while analyzing MD&A sections of recent annual reports and answering next checkpoint about catalysts.
Checkpoint 7: Are there any negative catalysts foreseeable, that may impact the business prospects going forward, like a long term industry slowdown, increasing competition, or a regulatory change? On the other hand, what are the positive catalysts that'll bridge the gap between price and value?
The share prices of IIML have been falling since end of 2010 and have dropped down by as much as 60% in last 2.5 years. This is possibly because of the stagnated growth in income and hence the profits. This clearly reflects the fact that company has found it difficult to increase divestment process.
Let us analyze "Chairman's Statement" section across FY2005-06 till date to see if management anticipated this "slowdown", and what have they planned and delivered so far.
- FY2005-06 shows positiveness and optimism that Indian growth has been due to entrepreneurs who have extended their reach beyond India, and PE funds have significantly contributed to this effect.
Future strategic buyers find it reassuring to deal with a PE funded company, because they know that- FY2006-07 opens up with the following statement, boosting up optimism. They also indicate that capital availability is not a big problem now. However, quality human resources is highlighted as an emerging problem for sustaining long term growth of the company. Still no signs of concern about a potential slowdown or recession or difficulty in divestment.
governance and accounting will be up to standards. Institutional investors also attach significant value to PE
funded companies – this leads to a re-rating of the stock, thereby adding value to all stakeholders
The onward march continues. A trillion dollar economy, India’s future growth has been accepted as here to stay, rather than viewed as a passing phenomenon
In harnessing this growth, availability of capital is now largely being seen as an addressable issue. A positive investment climate ensures that an entrepreneur today has a variety of options for raising capital, as long as the matrix of past performance, reputation and project bankability measure up to the risk appetite of the investor- FY2007-08 statement mentions for the first time about the concerns of global turmoil and indicates that the smooth ride of past 4 years for India growth have seen first signs of problem, in terms of higher inflation, food crisis, depletion of investible funds globally. However, an important point in this statement is about "pro-active risk management" as a learning from the global problems. They indicate that IIML has developed such system of conservative yet productive risk management in their investments. Here's what they say:
We still need to see if they really follow what they say, but their voice echos strong value investing principles - deep understanding (circle of competence), management capability (a bad manager can easily destroy an excellent business), minimize risk (don't go where you may die) and timely exit (sell when others are greedy)
- FY2008-09 statement looks at financial upheaval in retrospection, and how company managed to grow the AUM as planned, and they mention that quality and valuation of deals has improved due to slowdown. But this must be read with care - the valuation multiples have come down, and hence divestment generates lesser profits than before, while investments have better margin of safety / better growth potential. Finally, management believes that India will maintain growth rates as a new stable government comes, and investment environment stabilize going forward, at least at a moderate pace. However, there's first indication of growth / profit slowdown as seen in the commentary. Note the fact that management is being candid about dependence of business outlook on macroeconomic environment.
- FY2009-10 statement talks about the eventful decade, where downturn of 2008-09 created challenges and opportunities for PE funds. Specifically, the following text is noteworthy, indicating innovative, prudent and strong value oriented approach of the fund
- FY2010-11 was a tough year across the world, with signs of EU zone cracks appearing, high interest rates in India, etc, and here's what the CEO of the company has to say about fund's performance - they're able to grow AUM (and hence the revenue from management fees which they call annuity). Looking at the financial data table above, they've grown AUM very fast before the downturn, and AUM growth has moderated substantially, so much so that AUM is stagnant at $3.2 billion since FY2010-11. This remains a big risk to the future outlook, that it'd be exceedingly difficult to continue to grow AUM at a reasonable pace.
- FY2011-12 statement from chairman again mentions the impact of downturn in second half of 2011, and how PE fund raising is severely impacted. They also show how the business has still managed to continue investments and divestment in this backdrop
In essence, we see that the business is indeed at an inflection point - the growth is slowing, the environment is becoming tough with high competition, and outlook is gloomy considering that the world economy may remain subdued for many more years to come (leave aside spurs of growth which are highly inconsistent). It is now upto the business leaders of IIML to capitalize this inflection point to their advantage. How can they do it, what are they planning to do about it? Let us try to find these answers while analyzing MD&A sections of recent annual reports and answering next checkpoint about catalysts.
Checkpoint 7: Are there any negative catalysts foreseeable, that may impact the business prospects going forward, like a long term industry slowdown, increasing competition, or a regulatory change? On the other hand, what are the positive catalysts that'll bridge the gap between price and value?
TBD
Risk Log: Based on analysis above, following are the risks to the future prospects of the business:
- Strong dependence of business performance on macroeconomic environment. If India doesn't grow like it did during 2004 - 2007, IIML may not be able to generate commendable returns as in the past.
- Since they're one of the largest PE funds in India, they might not have big scope to grow organically, mainly due to increased competition. (On the other hand, their large size may help them attract new capital if the PE investment environment regains the steam going forward)
- As performance is the key to maintain and grow AUM in this industry, inability to deliver good returns (timely divestment while maintaining profit margins) main negatively impact the future growth of both top-line and bottom-line for the business.
- IIML depends heavily on the performance of their fund managers, and if they can't deliver what they did in the past, the profits of the business can be severely hampered.
Stock Valuation
Even before we start 'calculations', based on risk log above, we must be conservative and assume:
- No growth, which means, we must assume constant 'free cash flow' going forward, and this constant can be taken as average FCF for last 3 years.
Quick valuation first. The business generates around Rs 400 million per year in cash flow from operations, and almost whole amount is free. Assuming no growth, a discount rate of 10% (risk free rate / base opportunity cost), we get a valuation of FCF, as of today at Rs 4 billion. The current market cap of the business is Rs. 437 crores, i.e., more than Rs. 4 billion. This means, there's no margin of safety in FCF valuations, contrary to the initial perception that the stock is probably available at very attractive valuations.
UPDATE as on 25th May 2013
I was 'away' for about a week, and I thought about IIML, and went through this "mirror test", to find any obvious reasons to drop the stock. I could not find strong reasons to either buy or ignore the stock - there're good deal of risks to the future growth / sustainability of AUM, and the past performance may not repeat. Incidentally, I also got to read about IIML's analysis here, and this adds to my belief that the risks of reduced profits from investments is quite high. On the other hand, if management can "maintain" the cash flow, there's a decent chance of 7% dividend yield from the stock. If things turn positive, it could be a black swan positive surprise and the stock can even generate capital appreciation.
In this context, there're large changes of negative catalysts over-weighing the possible positives, since the performance improvement for the business depends on macro-economic improvement, another boom in real estate (we didn't yet analyze, but a quick look at assets shows a large investment into real estate), and ability of management to generate returns as in the past - all of them happening will certainly be a positive black swan event. On the other hand, if any of these turns negative, it'll impact the business prospects, which will lead to reduced cash flow and dividend yield.
Hence, without further analysis of the stock, I tend to believe that the risk reward ratio is NOT favorable to hold this stock for long term. An annuity with 7% yield, but will a non-trivial downside risk, is not a Graham like pick, and definitely, the business moat doesn't warrant a strong conviction either. I'd therefore stay away from a long term relation with the stock. However, considering the potential for significant upside in the "best case scenario', this stock may be a potential addition to the "speculative" part of portfolio.
In summary of this "long post", this is certainly not a low risk, high dividend yielding stock as I originally started, but I'll keep IIML in the "sin stock watchlist" and add to the positions slowly, limiting a total exposure to less than 2% of the overall portfolio. Since I don't see the stock running away in near future, I'll wait for better opportunities before I start committing any serious money in the stock.
Risk Log: Based on analysis above, following are the risks to the future prospects of the business:
- Strong dependence of business performance on macroeconomic environment. If India doesn't grow like it did during 2004 - 2007, IIML may not be able to generate commendable returns as in the past.
- Since they're one of the largest PE funds in India, they might not have big scope to grow organically, mainly due to increased competition. (On the other hand, their large size may help them attract new capital if the PE investment environment regains the steam going forward)
- As performance is the key to maintain and grow AUM in this industry, inability to deliver good returns (timely divestment while maintaining profit margins) main negatively impact the future growth of both top-line and bottom-line for the business.
- IIML depends heavily on the performance of their fund managers, and if they can't deliver what they did in the past, the profits of the business can be severely hampered.
Stock Valuation
Even before we start 'calculations', based on risk log above, we must be conservative and assume:
- No growth, which means, we must assume constant 'free cash flow' going forward, and this constant can be taken as average FCF for last 3 years.
Quick valuation first. The business generates around Rs 400 million per year in cash flow from operations, and almost whole amount is free. Assuming no growth, a discount rate of 10% (risk free rate / base opportunity cost), we get a valuation of FCF, as of today at Rs 4 billion. The current market cap of the business is Rs. 437 crores, i.e., more than Rs. 4 billion. This means, there's no margin of safety in FCF valuations, contrary to the initial perception that the stock is probably available at very attractive valuations.
UPDATE as on 25th May 2013
I was 'away' for about a week, and I thought about IIML, and went through this "mirror test", to find any obvious reasons to drop the stock. I could not find strong reasons to either buy or ignore the stock - there're good deal of risks to the future growth / sustainability of AUM, and the past performance may not repeat. Incidentally, I also got to read about IIML's analysis here, and this adds to my belief that the risks of reduced profits from investments is quite high. On the other hand, if management can "maintain" the cash flow, there's a decent chance of 7% dividend yield from the stock. If things turn positive, it could be a black swan positive surprise and the stock can even generate capital appreciation.
In this context, there're large changes of negative catalysts over-weighing the possible positives, since the performance improvement for the business depends on macro-economic improvement, another boom in real estate (we didn't yet analyze, but a quick look at assets shows a large investment into real estate), and ability of management to generate returns as in the past - all of them happening will certainly be a positive black swan event. On the other hand, if any of these turns negative, it'll impact the business prospects, which will lead to reduced cash flow and dividend yield.
Hence, without further analysis of the stock, I tend to believe that the risk reward ratio is NOT favorable to hold this stock for long term. An annuity with 7% yield, but will a non-trivial downside risk, is not a Graham like pick, and definitely, the business moat doesn't warrant a strong conviction either. I'd therefore stay away from a long term relation with the stock. However, considering the potential for significant upside in the "best case scenario', this stock may be a potential addition to the "speculative" part of portfolio.
In summary of this "long post", this is certainly not a low risk, high dividend yielding stock as I originally started, but I'll keep IIML in the "sin stock watchlist" and add to the positions slowly, limiting a total exposure to less than 2% of the overall portfolio. Since I don't see the stock running away in near future, I'll wait for better opportunities before I start committing any serious money in the stock.
Thursday, May 16, 2013
Three (and not Two) sectors which I don't understand well, but still want to invest in
UPDATE on 27th May 2013
In addition to sectors below, Auto sector is another one where I want to invest but don't understand very well. I only understand that India still has a large scope for improved automobiles, and will grow further, but yes, there're concerns of mileage sensitivity and high interest rates impacting new vehicle sales. Yes, I believe a good fund manager can choose the right automotive stocks and benefit from this long term growth prospect.
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This is an old debate in my mind; you believe in long term prospects of a sector / industry, but since you don't understand the business well enough (specifics which go behind the scenes), you're not comfortable analyzing individual businesses in these sectors. In my case, these are:
1. Banking & Financial Services
2. Oil and Natural Gas
3. Energy & Power (conventional and alternate sources)
For each of these, I've a 'macro' viewpoint why these sectors will perform well in the long run, here're they:
1. Oil and Natural Gas is mainly burdened due to under-recoveries arising out of subsidies, and as I wrote last year, there're very strong reasons to gradually reduce fuel subsidy and make these products 'free tradable'. There're already strong signs of that happening, and as things improve, it'll very positively impact businesses in this industry.
2. As inflation lowers, interest rates reduce and infrastructure spending resumes, the first sectors to benefit would be power and energy - India cannot grow without improving the infrastructure to deliver good quality power to the industries, and there's a huge scope of improvement in these sectors. A lot of capital goods investment will be needed to make the power generation & transmission more efficient (and hence my strong belief in BHEL and Crompton Greaves), and this will benefit all the businesses that're involved in power generation, transmission or distribution. In addition to conventional sources of energy, a lot of focus is needed to improve the competitiveness of alternate sources of energy, failing which, India cannot bridge the "power deficit".
3. If the above two hold true, and infra spending comes back to good levels, a lot of problems related to NPAs and asset quality for PSU banks will be reduced, as these businesses will have cash flow to pay back interest and principal to banks. More new loans will be taken and this will further improve "topline" of banks.
Now, the problem part - why is it difficult to analyze these businesses?
a. Banks, especially PSU banks have a high influence from government, and this "ensures" that the asset quality of banks can deteriorate without any prior notice, banks may need to make "bad capital allocation" decisions under this influence. A large part of this also holds true for PSU companies in Oil, Natural Gas and Energy sector, and this brings the "factor of high uncertainty" and skews the risk-reward ratio to an unfavorable degree for individual investments.
b. Private players (most of them) in the sector have "bad reputation" of being un-ethical managers, or they're known to be involved closely with Indian politics and this again brings another high uncertainly factor.
c. There's a huge polarization within banking sector - private sector banks are quite expensive while PSU banks are cheap, and it's difficult to chose which ones to pick for individual investment.
Overall, there're compelling reasons to invest in these sectors, but the risk of individual stock picking is high and potential rewards don't justify taking so much risk. Additionally, most of these shares have "high market" price and hence a "basket investing' in selected stocks is also not easy for a small investor like me.
Why not choose passive index funds? Well, I'm not aware of any index funds for Oil and Gas sector or Energy sector, and the banking index funds have expense ratio nearly same as mutual funds mentioned below (HDFC Top 200 Direct Plan has an expense ratio of less than 1.75%, only marginally more than the cheapest banking ETF, and it's not too expensive for an actively managed fund which can 'avoid' investing in questionable stocks, which may still be part of passive index funds)
Hence, I'm planning to invest in a mutual fund that holds significantly in these sectors. I started analyzing the large cap (most of the good businesses in these sectors are too large to be small / mid cap stocks) funds I like, and incidentally, HDFC Top 200 holds more than 57% of it's holdings in these 4 sectors (capital goods included), as can be seen from blow table:
In addition to sectors below, Auto sector is another one where I want to invest but don't understand very well. I only understand that India still has a large scope for improved automobiles, and will grow further, but yes, there're concerns of mileage sensitivity and high interest rates impacting new vehicle sales. Yes, I believe a good fund manager can choose the right automotive stocks and benefit from this long term growth prospect.
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This is an old debate in my mind; you believe in long term prospects of a sector / industry, but since you don't understand the business well enough (specifics which go behind the scenes), you're not comfortable analyzing individual businesses in these sectors. In my case, these are:
1. Banking & Financial Services
2. Oil and Natural Gas
3. Energy & Power (conventional and alternate sources)
For each of these, I've a 'macro' viewpoint why these sectors will perform well in the long run, here're they:
1. Oil and Natural Gas is mainly burdened due to under-recoveries arising out of subsidies, and as I wrote last year, there're very strong reasons to gradually reduce fuel subsidy and make these products 'free tradable'. There're already strong signs of that happening, and as things improve, it'll very positively impact businesses in this industry.
2. As inflation lowers, interest rates reduce and infrastructure spending resumes, the first sectors to benefit would be power and energy - India cannot grow without improving the infrastructure to deliver good quality power to the industries, and there's a huge scope of improvement in these sectors. A lot of capital goods investment will be needed to make the power generation & transmission more efficient (and hence my strong belief in BHEL and Crompton Greaves), and this will benefit all the businesses that're involved in power generation, transmission or distribution. In addition to conventional sources of energy, a lot of focus is needed to improve the competitiveness of alternate sources of energy, failing which, India cannot bridge the "power deficit".
3. If the above two hold true, and infra spending comes back to good levels, a lot of problems related to NPAs and asset quality for PSU banks will be reduced, as these businesses will have cash flow to pay back interest and principal to banks. More new loans will be taken and this will further improve "topline" of banks.
Now, the problem part - why is it difficult to analyze these businesses?
a. Banks, especially PSU banks have a high influence from government, and this "ensures" that the asset quality of banks can deteriorate without any prior notice, banks may need to make "bad capital allocation" decisions under this influence. A large part of this also holds true for PSU companies in Oil, Natural Gas and Energy sector, and this brings the "factor of high uncertainty" and skews the risk-reward ratio to an unfavorable degree for individual investments.
b. Private players (most of them) in the sector have "bad reputation" of being un-ethical managers, or they're known to be involved closely with Indian politics and this again brings another high uncertainly factor.
c. There's a huge polarization within banking sector - private sector banks are quite expensive while PSU banks are cheap, and it's difficult to chose which ones to pick for individual investment.
Overall, there're compelling reasons to invest in these sectors, but the risk of individual stock picking is high and potential rewards don't justify taking so much risk. Additionally, most of these shares have "high market" price and hence a "basket investing' in selected stocks is also not easy for a small investor like me.
Why not choose passive index funds? Well, I'm not aware of any index funds for Oil and Gas sector or Energy sector, and the banking index funds have expense ratio nearly same as mutual funds mentioned below (HDFC Top 200 Direct Plan has an expense ratio of less than 1.75%, only marginally more than the cheapest banking ETF, and it's not too expensive for an actively managed fund which can 'avoid' investing in questionable stocks, which may still be part of passive index funds)
Hence, I'm planning to invest in a mutual fund that holds significantly in these sectors. I started analyzing the large cap (most of the good businesses in these sectors are too large to be small / mid cap stocks) funds I like, and incidentally, HDFC Top 200 holds more than 57% of it's holdings in these 4 sectors (capital goods included), as can be seen from blow table:
I understand that many of these stocks have become expensive, but since I have a decent belief in this theory, as well as asset allocation capabilities of fund managers of these funds, I'll go ahead with a prudent, incremental investment in these funds. I already have small investment in HDFC Top 200 Fund, and I now plan to increase investment in these two funds. I'll start SIP in Franklin Bluechip fund, and will make incremental top-ups to HDFC Top 200 Fund (easy as I can do a switch from HDFC Cash management fund just with an online click)
I welcome criticism on this plan - and will wait for the "idea soak in period" before acting :-), especially to let the 'dis-appointing feeling of missing the train (I got this thought first when NIFTY was at 5000 in Jan 2012, and I'm revisiting this when NIFTY is flirting with it's all time high levels)
Friday, May 10, 2013
Revisiting MOIL
I recently completed updating my investment checklist as well as asset allocation. Now it is time to start revisiting my existing investments and the stocks in watchlist, and see if there's any change needed. First one on the list is MOIL, since I've started to doubt my belief in the 'understanding of the business", which is like failing on the very first checkpoint in the checklist. So, here're my new thoughts on MOIL.
Here're the first two checkpoint:
Checkpoint 1: Is the business OUTSIDE your circle of competence [Charlie Munger]? Can you talk about it right after you're waked up from sleep? Do you understand the business well? Is it simple enough for an idiot to run [Peter Lynch]? Assume you're no better than an idiot!
Checkpoint 2: What is your main reason to look at this company? Write this down and once we analyze the business, we'll come back to see if our analysis is biased by this presumption [Anchoring bias, Charlie Munger]. If your reason is mainly a recent, sharp decline in share prices, try to find why so many people are selling, and if they know more than what you (prospective buyer) knows, or in other words, are you taking undue risk by investing into something with many unknowns?
My main reason to have invested in MOIL dates back to Nov 2010. This was around the time when MOIL IPO came on the street, and I had invested considering the comments from Mr. Udayan Mukharjee. I then watched CNBC regularly, and Udayan pointed out that MOIL was an industry leader, lot of cash on books, no debt, decent business and was trading at less than 10 P/E multiple, and hence it was a good buy. All good. Come Dec 2012 and we find the same company trading at less than 5 P/E if cash is discounted, and I started buying and took the stake to nearly 10% of my portfolio.
However, now, after soaking in lots of concept and having "experienced" value investing for more than an year, I realize one big mistake in having bought MOIL shares - I prooably don't understand the business very well, even if it is somehow a simple business that even an idiot can run. The major items that I don't understand well are:
- Manganese is used as a raw material in production of steel, and since MOIL extracts a large portion of their total ores for steel production, MOIL's performance is strongly dependent on how the demand of steel and hence manufacturing of steel fares. There're 4 layers involved here - demand and sale of steel, steel inventory levels, manganese demand and finally, the manganese inventory levels.
- This means, that for manganese prices to improve, steel production should increase to such levels that manganese inventory levels go down and production of manganese has to start again in larger quantities. This is a long chain of dependency, and the time to realize the benefits will be longer.
- I do not understand how steel demand will rise - yes, as infrastructure development improves, steel demand will improve, but considering this 4-layer structure through which benefit of infrastructure spending will pass on to MOIL, the time to realize these gains will be elongated.
- I already hold a sizable amount of my investments in form of capital goods companies like BHEL and CROMPGREAV (where I've better conviction than about increase in MOIL margins), and hence, continuing to hold MOIL will further skew and increase downside risk due to uncertainties in improvement in infrastructure spending.
Here're the first two checkpoint:
Checkpoint 1: Is the business OUTSIDE your circle of competence [Charlie Munger]? Can you talk about it right after you're waked up from sleep? Do you understand the business well? Is it simple enough for an idiot to run [Peter Lynch]? Assume you're no better than an idiot!
Checkpoint 2: What is your main reason to look at this company? Write this down and once we analyze the business, we'll come back to see if our analysis is biased by this presumption [Anchoring bias, Charlie Munger]. If your reason is mainly a recent, sharp decline in share prices, try to find why so many people are selling, and if they know more than what you (prospective buyer) knows, or in other words, are you taking undue risk by investing into something with many unknowns?
My main reason to have invested in MOIL dates back to Nov 2010. This was around the time when MOIL IPO came on the street, and I had invested considering the comments from Mr. Udayan Mukharjee. I then watched CNBC regularly, and Udayan pointed out that MOIL was an industry leader, lot of cash on books, no debt, decent business and was trading at less than 10 P/E multiple, and hence it was a good buy. All good. Come Dec 2012 and we find the same company trading at less than 5 P/E if cash is discounted, and I started buying and took the stake to nearly 10% of my portfolio.
However, now, after soaking in lots of concept and having "experienced" value investing for more than an year, I realize one big mistake in having bought MOIL shares - I prooably don't understand the business very well, even if it is somehow a simple business that even an idiot can run. The major items that I don't understand well are:
- Manganese is used as a raw material in production of steel, and since MOIL extracts a large portion of their total ores for steel production, MOIL's performance is strongly dependent on how the demand of steel and hence manufacturing of steel fares. There're 4 layers involved here - demand and sale of steel, steel inventory levels, manganese demand and finally, the manganese inventory levels.
- This means, that for manganese prices to improve, steel production should increase to such levels that manganese inventory levels go down and production of manganese has to start again in larger quantities. This is a long chain of dependency, and the time to realize the benefits will be longer.
- I do not understand how steel demand will rise - yes, as infrastructure development improves, steel demand will improve, but considering this 4-layer structure through which benefit of infrastructure spending will pass on to MOIL, the time to realize these gains will be elongated.
- I already hold a sizable amount of my investments in form of capital goods companies like BHEL and CROMPGREAV (where I've better conviction than about increase in MOIL margins), and hence, continuing to hold MOIL will further skew and increase downside risk due to uncertainties in improvement in infrastructure spending.
In short, I do not have conviction on how MOIL's profit margins will revert back, and how long they'll take.
What is the opportunity cost of holding and NOT holding MOIL's stock? This is an important question when making a buy / sell investment decision. Let us try to find out:
If I sell off MOIL, and the business conditions improve, it is possible that the stock can rebound to it's previous highs around Rs 450 when business conditions return back, and that's a gain of 100% over my existing purchase cost. However, as I described above, I've little conviction that this will happen anytime soon.
On the other hand, if I keep holding MOIL stock, I may lose upon opportunities like MCX India, IL&FS Investment Managers and other businesses I'm considering. For sure, I've conviction that I can generate better returns than MOIL in either these alternate stocks (if the analysis proves to be positive), or re-allocate the money into a good mutual fund and generate better returns.
Hence, I decide to sell off all my holdings in MOIL. However, I'll sell MOIL as I buy another investment, and hence, I'll start selling only after I've identified another investment opportunity.
Goodbye MOIL :-)
Asset Allocation
While I'm working on the revised checklist, I also thought that I should get my portfolio asset allocation right. In this short post, I try to pen down what would be my asset allocation strategy.
Since my human capital is "bond type', as I strongly believe that my job is reasonably secure, I must keep a large portion of my investments into stocks / equities. Hence, I plan to keep the following allocation
NOTE: I do not consider real estate as an investment right now, and hence I'll NOT count it in this allocation. Also, cash investments like providend funds are also kept aside from this asset allocation.
1) Set aside sufficient money for daily expenses, committed annual expenses and emergencies, maintained in savings bank account, apart from some money (encashable in 2-3 days) in liquid fund. This part of money is NOT for investment.
2) Remaining available funds are for long term investing and limited speculation. This is partitioned as
- At least 10% in fixed maturity bonds and balanced fund. I do not choose bank fixed deposits as I believe that the post tax return on these are disadvantageous and do not compensate positively for inflation. I plan to keep this part of investment in HDFC Prudence Fund, as it is a good balanced mutual fund and has performed well during deep market corrections.
- Up to 15% in commodity investments like GOLD and others.
- At least 60% in equity investments, most of which would be direct stock investments, while a small portion (mostly through SIP route) into healthy equity mutual funds. As I wrote earlier, these investments will be directed into the following mutual funds. Note that mutual fund investments will be increased only when there're little chances to directly invest into stocks.
Large Cap focussed
- Franklin India Bluechip Fund
- HDFC Top 200 Fund
Amongst the direct equity investments, the following allocation looks reasonable on the diversification and balancing front:
- At least 10% in High Divident Yielding (3-5% or higher dividend yield) stocks. These stocks will provide cushion to the equity portfolio. Some of the potential stocks in this category of watchlist are:
- Up to 30% in large, stable businesses (stalwarts) from which I expect to generate 30-50% return in not more than 2-3 years. I believe that these businesses are decent but would not be suited for a very long term investments, and when they fall due to some transient problems, they can be picked up for decent returns. Some of these in my portfolio / watchlist are
- Remaining investments into Turnaround and long term stories. By turnaround, I mean businesses which are sufferring some structural problems right now (like an evolving industry or the business is transforming), but the long term prospects look good and I have the conviction to hold them for a long period of time, expecting to generate multi-bagger returns. Some of the investments in this category are:
Since my human capital is "bond type', as I strongly believe that my job is reasonably secure, I must keep a large portion of my investments into stocks / equities. Hence, I plan to keep the following allocation
NOTE: I do not consider real estate as an investment right now, and hence I'll NOT count it in this allocation. Also, cash investments like providend funds are also kept aside from this asset allocation.
1) Set aside sufficient money for daily expenses, committed annual expenses and emergencies, maintained in savings bank account, apart from some money (encashable in 2-3 days) in liquid fund. This part of money is NOT for investment.
2) Remaining available funds are for long term investing and limited speculation. This is partitioned as
- At least 10% in fixed maturity bonds and balanced fund. I do not choose bank fixed deposits as I believe that the post tax return on these are disadvantageous and do not compensate positively for inflation. I plan to keep this part of investment in HDFC Prudence Fund, as it is a good balanced mutual fund and has performed well during deep market corrections.
- Up to 15% in commodity investments like GOLD and others.
- At least 60% in equity investments, most of which would be direct stock investments, while a small portion (mostly through SIP route) into healthy equity mutual funds. As I wrote earlier, these investments will be directed into the following mutual funds. Note that mutual fund investments will be increased only when there're little chances to directly invest into stocks.
Large Cap focussed
- Franklin India Bluechip Fund
- HDFC Top 200 Fund
Small / Mid cap focused
- DSP Blackrock Small & Mid-cap fundAmongst the direct equity investments, the following allocation looks reasonable on the diversification and balancing front:
- At least 10% in High Divident Yielding (3-5% or higher dividend yield) stocks. These stocks will provide cushion to the equity portfolio. Some of the potential stocks in this category of watchlist are:
- IL&FS Investment Managers (~7% dividend yield at CMP)
- Up to 30% in large, stable businesses (stalwarts) from which I expect to generate 30-50% return in not more than 2-3 years. I believe that these businesses are decent but would not be suited for a very long term investments, and when they fall due to some transient problems, they can be picked up for decent returns. Some of these in my portfolio / watchlist are
- Infosys
- Possibly BHEL & Crompton Greaves, but these two would also fit into the next category
- Remaining investments into Turnaround and long term stories. By turnaround, I mean businesses which are sufferring some structural problems right now (like an evolving industry or the business is transforming), but the long term prospects look good and I have the conviction to hold them for a long period of time, expecting to generate multi-bagger returns. Some of the investments in this category are:
- Piramal Enterprises
- Bharti Airtel
- CARE ratings
- MCX India
- Amara Raja Batteries
- Possibly BHEL & Crompton Greaves, but there's confusion as they also fit the above category, and my conviction is NOT very strong enough to hold them for more than 5 years (as I believe that very long term return may be below average returns)
- Mazda, but since this is a small cap, I need to build that conviction again through a deeper analysis.
I'll now work towards reviewing my existing holding and re-allocating based on benefiting from opportunities and maintaining a reasonable asset allocation.
UPDATE as on 25th May 2013
Here're the charts showing my current asset allocation
As can be seen from charts above, my current portfolio is heavily inclined towards "retirement investments", and I need to balance the same. Here's what I need to do:
1. Need to infuse new capital, as I can't reduce Provident Fund and re-allocate it into other investments
2. Need to increase investments in the following asset classes
- Stalwarts (medium term horizon)
- All forms of mutual funds, including a dividend plan which would generate regular income
- Withdrawable bonds, like Fixed Deposits. This is to ensure we always have liquid funds for emergency needs, and which can be withdrawn within couple of days. It may so be the case that I'll maintain a minimum investment in liquid debt fund and not go for a separate investment, but considering the size of my current portfolio, I need to infuse new capital for any new investments, and the current size of HDFC Cash Management Fund only covers for "withdrawable bonds' category.
UPDATE as on 25th May 2013
Here're the charts showing my current asset allocation
As can be seen from charts above, my current portfolio is heavily inclined towards "retirement investments", and I need to balance the same. Here's what I need to do:
1. Need to infuse new capital, as I can't reduce Provident Fund and re-allocate it into other investments
2. Need to increase investments in the following asset classes
- Stalwarts (medium term horizon)
- All forms of mutual funds, including a dividend plan which would generate regular income
- Withdrawable bonds, like Fixed Deposits. This is to ensure we always have liquid funds for emergency needs, and which can be withdrawn within couple of days. It may so be the case that I'll maintain a minimum investment in liquid debt fund and not go for a separate investment, but considering the size of my current portfolio, I need to infuse new capital for any new investments, and the current size of HDFC Cash Management Fund only covers for "withdrawable bonds' category.
Wednesday, May 08, 2013
Checklist
After a lot of business at work, I'm now back with trying to set a regular routine, and before I go ahead an start analyzing the stocks I listed in my last post, I must write down the checklist - my checklist based on my latest learning. I did make a "huge" checklist last year, but over time, I've realized:
- The bigger the checklist, the bigger the resistance to adhere to it
- It is very important to bring together ideas (mental models) from different people and perspectives into the checklist to make us think in different dimensions. While this doesn't eliminate the risk of "black swans (unknowns) [Nasim Taleb]", it does help to reduce it.
- It is very important to bring together ideas (mental models) from different people and perspectives into the checklist to make us think in different dimensions. While this doesn't eliminate the risk of "black swans (unknowns) [Nasim Taleb]", it does help to reduce it.
- We tend to flow away into details when we solve a problem, and we 'forget' the big picture and the original problem we were solving - the same happened with my old checklist, it grew too big and I forgot the first reason why I needed a checklist!
The first reason we need checklist is to make sure we don't forget - and we don't go where we can die. Instead, I kept making a checklist which had so many items, without the focus on the main objective. Hence, I derive the following new checklist, with the main objective in mind - "don't go where you may die"...and yes, I'm getting more and more influenced by what Mr. Munger has said, and I'm reading and planning to read more of what the legendary investor has written, especially on behavioral finance.
So, we start, and once again, keep the following in front of mind:
- Don't go where you may die
- Invert, always invert, for there can be infinite ways to prove something, but only one exception is needed to disprove, hence the "process of elimination" or Inverting the problem is a more efficient way, and no wonder why science has used it for such a long time, successfully
Most importantly, the checkpoints are eliminating - if you can't provide a very convincing answer to move to next checkpoint, you should probably let go the stock and look for others :)
And before we start eliminating based on checklist, let us write down the following two point - our "initial perspective" about the business / stock:
TBD: Where do we add checks about finding scuttlebutt [Philip Fisher], behavioral biases, checks about black swans (really possible?). Pre-mortem?
Checkpoint 1: Is the business OUTSIDE your circle of competence [Charlie Munger]? Can you talk about it right after you're waked up from sleep? Do you understand the business well? Is it simple enough for an idiot to run [Peter Lynch]? Assume you're no better than an idiot!
Next, we try to eliminate the business based on management quality, for, a good manager may not be able to turn a bad business into a good one, but a bad manager can certainly damage a great business, irreversibly, and hence we must be very careful of the management.
Checkpoint 2: A good management is essential to keep a "good business" good, and hence, we must identify whether
a) Is management candid with shareholders? Have they done what they said in the past?
b) Does management act rationally?
c) Do management acts imply integrity?
d) Does management demonstrate good capital allocation skills, or they're stuck in institutional imperative? Examples being prudent dividend declarations when no avenues for cash, buying back shares to reduce stock dilution etc.
e) Does senior executive compensation include company stock options, and is it designed to bring sense of loyalty and belief? Are "insiders buying" the stocks when their market price goes down? Is promoter holding a clean holding or shares are pledged to "manage cash"?
Checkpoint 3: Does business possess a strong economic moat [Warren Buffet]? Check the following:
a) Do customers have a bargaining power that keeps an upper bound on prices and margin improvement is limited (cost cannot be lower than 0%)
b) Do suppliers have a bargaining power that keeps a lower bound on costs, such that margins are squeezed?
c) Risk of new entrants, who may play pricing wars and put pressure on pricing, i.e., does business have "earning power" like a brand value that allows it to maintain (or even increase) prices?
d) Is there an alternate product that poses a risk as a substitute to the product / service that business produces? Could it result in a permanent loss of revenue to the business?
e) Is the economic moat sustainable, or just due to luck?
Checkpoint 4: Since every business is essentially a system which takes in Cash and "is supposed to" generate more cash, such that the Return on Invested Capital (ROIC) is higher than Weighed Average Cost of Capital (WACC). Draw a "cash flow diagram" for the business explaining how it generates cash, and find out whether it has consistently been able to generate higher ROIC than WACC. Consider at least a period of last 5 years.
Checkpoint 5: Before we go further, we need to make sure that the financial health of the business is good. Answer these sub-points to find this out:
a) Is company sacrificing operating margins to grow revenue (lack of sustainable moat)? We want a business which is able to grow profits at least as fast as sales (maintain / grow operating profit margin).
b) Is operating cash flow poorer than profit (EBIT / EBITDA) on several occasions (consistently positive operating cash flow)?
c) How has working capital requirement changed over years? Is business generating cash faster than it needs (negative working capital)?
d) Is business generating good returns on capex, or it is burning precious cash in attempting to grow by capital spending (incremental return on capex)?
e) Is the debt on balance sheet concerning? Is most of operating cash leaking away in interest payments? Is business able to retire debt and gradually reduce interest burden? How long do you think will it take for the business to bring down debt to advantageous levels? Is dividend being regularly paid despite debt on the books? If so, is "Financial Leverage Index" > 1, indicating that return on investments is greater than cost of debt, and hence the leverage created due to debt is advantageous to the business, and it is good to pay dividends using generated cash, while keeping the debt at advantageous level.
Checkpoint 6: Stocks generally become value picks when they possess a healthy business with an able management, but suffering from a transient problem which drives the stock prices southwards. Is the business suffering from any such condition, and if so, why do you think this is not a permanent change (inflection point)? If you believe it is indeed an inflection point for the business, why do you think business is capable of turning it into an advantage [Andrew Grove]?
Checkpoint 7: Are there any negative catalysts foreseeable, that may impact the business prospects going forward, like a long term industry slowdown, increasing competition, or a regulatory change? On the other hand, what are the positive catalysts that'll bridge the gap between price and value?
At this point, you'd have either closed down, or successfully written down your understanding about the points above, and find that the business is healthy enough to pursue the analysis further. Before going further and performing a more detailed analysis, let us write down the expectation
Refer to a different post on guidelines for TBD stock valuation.
Risk Log: This is a concept used in large engineering projects. It is a way to write down risks involved in the project, and how to mitigate each of them. Borrowing this concept to investing, it'd make sense to create a risk log after having analyzed the points above, so that we know how much risk is involved in this investment, and are we going to get compensated enough for taking this risk [Charlie Munger]?
Stock Valuation: Do you expect the transient problem to go away / last for a small time, say a few months, and the temporary depression in stock can be used to make a small investment and benefit from it, i.e., do you consider this a stalwart [Peter Lynch]? If so, perform a "relative valuation" and find the "right buying price". If you've chosen this stock as any other form of valuation play (live a high dividend yielding stock), other than a long term holding, write down here and explain what is the right buying price, and why do you believe that you have adequate Margin of safety to justify this medium term investment's risk is well calculated.
However, if you still hold your "initial view" and plan to hold the stock for long term, perform a more detailed absolute and relative valuation and take sufficient margin of safety to address the concerns pointed out above in business analysis.
Opportunity Cost: Before taking the final decision, make sure that you're not overlooking the opportunity cost in this investment - can you allocate money elsewhere and get better returns with better margin of safety?
Final Decision: Does "initial view" still hold true? Is our analysis above somehow biased by those presumptions? After your analysis indicates that you should buy this stock, perform the following:
a) Keep the stock under "watch" for a week, and DO NOT buy or sell.
b) Post on blog and seek critical feedback. Seek contrary opinions, dis-confirming evidences, and try to find what you do not know [Charlie Munger].
c) At the end of the week, if your conviction in the business and stock's prospects is intact or stronger, go and BUY :-)
And before we start eliminating based on checklist, let us write down the following two point - our "initial perspective" about the business / stock:
- What is your main reason to look at this company? Write this down and once we analyze the business, we'll come back to see if our analysis is biased by this presumption [Anchoring bias, Charlie Munger]. If your reason is mainly a recent, sharp decline in share prices, try to find why so many people are selling, and if they know more than what you (prospective buyer) knows, or in other words, are you taking undue risk by investing into something with many unknowns?
- What kind of investment do you consider this business initially? Are you considering it as a long term story, or a medium term play (sorry, short term plays, i.e. for duration less than 3 months, are OUTSIDE the circle of value investors). Write down your initial thought in terms of [Peter Lynch] investment types - High Dividend Yielding, Stalwarts, Cyclical, Fast Grower, Turnaround story or an Asset Play?
TBD: Where do we add checks about finding scuttlebutt [Philip Fisher], behavioral biases, checks about black swans (really possible?). Pre-mortem?
Checkpoint 1: Is the business OUTSIDE your circle of competence [Charlie Munger]? Can you talk about it right after you're waked up from sleep? Do you understand the business well? Is it simple enough for an idiot to run [Peter Lynch]? Assume you're no better than an idiot!
Next, we try to eliminate the business based on management quality, for, a good manager may not be able to turn a bad business into a good one, but a bad manager can certainly damage a great business, irreversibly, and hence we must be very careful of the management.
Checkpoint 2: A good management is essential to keep a "good business" good, and hence, we must identify whether
a) Is management candid with shareholders? Have they done what they said in the past?
b) Does management act rationally?
c) Do management acts imply integrity?
d) Does management demonstrate good capital allocation skills, or they're stuck in institutional imperative? Examples being prudent dividend declarations when no avenues for cash, buying back shares to reduce stock dilution etc.
e) Does senior executive compensation include company stock options, and is it designed to bring sense of loyalty and belief? Are "insiders buying" the stocks when their market price goes down? Is promoter holding a clean holding or shares are pledged to "manage cash"?
Checkpoint 3: Does business possess a strong economic moat [Warren Buffet]? Check the following:
a) Do customers have a bargaining power that keeps an upper bound on prices and margin improvement is limited (cost cannot be lower than 0%)
b) Do suppliers have a bargaining power that keeps a lower bound on costs, such that margins are squeezed?
c) Risk of new entrants, who may play pricing wars and put pressure on pricing, i.e., does business have "earning power" like a brand value that allows it to maintain (or even increase) prices?
d) Is there an alternate product that poses a risk as a substitute to the product / service that business produces? Could it result in a permanent loss of revenue to the business?
e) Is the economic moat sustainable, or just due to luck?
Checkpoint 4: Since every business is essentially a system which takes in Cash and "is supposed to" generate more cash, such that the Return on Invested Capital (ROIC) is higher than Weighed Average Cost of Capital (WACC). Draw a "cash flow diagram" for the business explaining how it generates cash, and find out whether it has consistently been able to generate higher ROIC than WACC. Consider at least a period of last 5 years.
Checkpoint 5: Before we go further, we need to make sure that the financial health of the business is good. Answer these sub-points to find this out:
a) Is company sacrificing operating margins to grow revenue (lack of sustainable moat)? We want a business which is able to grow profits at least as fast as sales (maintain / grow operating profit margin).
b) Is operating cash flow poorer than profit (EBIT / EBITDA) on several occasions (consistently positive operating cash flow)?
c) How has working capital requirement changed over years? Is business generating cash faster than it needs (negative working capital)?
d) Is business generating good returns on capex, or it is burning precious cash in attempting to grow by capital spending (incremental return on capex)?
e) Is the debt on balance sheet concerning? Is most of operating cash leaking away in interest payments? Is business able to retire debt and gradually reduce interest burden? How long do you think will it take for the business to bring down debt to advantageous levels? Is dividend being regularly paid despite debt on the books? If so, is "Financial Leverage Index" > 1, indicating that return on investments is greater than cost of debt, and hence the leverage created due to debt is advantageous to the business, and it is good to pay dividends using generated cash, while keeping the debt at advantageous level.
Checkpoint 6: Stocks generally become value picks when they possess a healthy business with an able management, but suffering from a transient problem which drives the stock prices southwards. Is the business suffering from any such condition, and if so, why do you think this is not a permanent change (inflection point)? If you believe it is indeed an inflection point for the business, why do you think business is capable of turning it into an advantage [Andrew Grove]?
Checkpoint 7: Are there any negative catalysts foreseeable, that may impact the business prospects going forward, like a long term industry slowdown, increasing competition, or a regulatory change? On the other hand, what are the positive catalysts that'll bridge the gap between price and value?
At this point, you'd have either closed down, or successfully written down your understanding about the points above, and find that the business is healthy enough to pursue the analysis further. Before going further and performing a more detailed analysis, let us write down the expectation
Refer to a different post on guidelines for TBD stock valuation.
Risk Log: This is a concept used in large engineering projects. It is a way to write down risks involved in the project, and how to mitigate each of them. Borrowing this concept to investing, it'd make sense to create a risk log after having analyzed the points above, so that we know how much risk is involved in this investment, and are we going to get compensated enough for taking this risk [Charlie Munger]?
Stock Valuation: Do you expect the transient problem to go away / last for a small time, say a few months, and the temporary depression in stock can be used to make a small investment and benefit from it, i.e., do you consider this a stalwart [Peter Lynch]? If so, perform a "relative valuation" and find the "right buying price". If you've chosen this stock as any other form of valuation play (live a high dividend yielding stock), other than a long term holding, write down here and explain what is the right buying price, and why do you believe that you have adequate Margin of safety to justify this medium term investment's risk is well calculated.
However, if you still hold your "initial view" and plan to hold the stock for long term, perform a more detailed absolute and relative valuation and take sufficient margin of safety to address the concerns pointed out above in business analysis.
Opportunity Cost: Before taking the final decision, make sure that you're not overlooking the opportunity cost in this investment - can you allocate money elsewhere and get better returns with better margin of safety?
Final Decision: Does "initial view" still hold true? Is our analysis above somehow biased by those presumptions? After your analysis indicates that you should buy this stock, perform the following:
a) Keep the stock under "watch" for a week, and DO NOT buy or sell.
b) Post on blog and seek critical feedback. Seek contrary opinions, dis-confirming evidences, and try to find what you do not know [Charlie Munger].
c) At the end of the week, if your conviction in the business and stock's prospects is intact or stronger, go and BUY :-)
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