Anda di halaman 1dari 176

Level 1: A primer to investing in the stock markets .................. 3 A guide to investing in stock markets ..........................................

3 Numbers jungle unfurled ........................................................... 6 Cash flows vs income statements .............................................. 10 Cash flows: The health parameter ............................................. 12 The dividend attraction ............................................................. 14 Look (at the downside) before you leap ...................................... 16 Troubleshooting for retail investors ............................................ 19 Level 2: How to put a price to stocks ...................................... 22 Book value: Weighing on assets ................................................ 22 Stocks: Measuring expectations................................................. 27 Valuing super normal growth .................................................... 32 P/E ratios: Reality check .......................................................... 35 EVA Another barometer for corporate performance ................... 40 Perception vs Valuation: Directly proportionate? .......................... 44 Dow Theory: An insight ............................................................ 47 Net asset value: unlocks hidden potential ................................... 50 Level 3: How to create your own portfolio .............................. 55 Equitymaster Portfolio: Revisited ............................................... 55 Equitymaster portfolio A review .............................................. 59 The Core, Stars and Flyers ..................................................... 64 Other Investment Avenues ..................................................... 69 Gold is GOLD .......................................................................... 69 As good as gold! ...................................................................... 72 Understanding Debt Markets .................................................. 74 Debt markets: The other alternative .......................................... 74 The different measures of debt. ................................................. 79 Risks associated with bond ....................................................... 82 The yield curve........................................................................ 86 Identifying stocks: Do's and dont's ........................................ 90 Identifying an aluminium stock: Dos and donts .......................... 90 Identifying an auto stock: Dos and Donts................................... 94 Identifying an auto anc. stock: Dos and donts ......................... 100 Identifying a banking stock: Dos and Donts ............................. 104 Identifying a cement stock: Dos and donts .............................. 107 Identifying a construction stock: Dos and donts ....................... 111 Identifying a domestic pharma stock: Dos and donts ................ 115 Identifying an engineering stock- Dos and donts ...................... 119 Identifying an FI stock: Dos and Donts ................................... 123 Identifying an FMCG stock: Dos and donts .............................. 126 Identifying a hotel stock: Do's and don'ts ................................. 129 Identifying an MNC pharma stock: Dos and donts .................... 132 Identifying a paint stock: Dos and Don'ts ................................. 136 Identifying a power stock: Dos and Donts ............................... 140

Equitymaster-Knowledge Centre-Intelligent Investing

Identifying Identifying Identifying Identifying Identifying Identifying Identifying Identifying

a a a a a a a a

refinery stock: Dos and Donts ............................. 144 Retailing stock: Do's and Don'ts ............................ 147 shipping stock: Dos and donts............................. 151 software stock: Dos and donts ............................ 156 steel stock: Dos and donts.................................. 159 sugar stock: Dos and Donts ................................ 162 telecom stock: Do's and Don'ts ............................. 165 textile stock: Dos and donts................................ 172

Equitymaster-Knowledge Centre-Intelligent Investing

Level 1: A primer to investing in the stock markets A guide to investing in stock markets
How would you decide whether Hindustan Lever is a better buy in today's market or is Infosys Technologies? Or for that matter should you be investing in stocks at all? Well, to answer these questions it requires nothing short of a thesis. Nevertheless (the ideal solution is better avoided!) we make an attempt to equip the retail investor with a tool that will help him identify an investment opportunity. The diagram below is a representation of a classical Top Down approach to investing in stock markets.

In order to capture the essence of the top down approach to investing, lets evaluate each one of these investment criterions. Politics Politics has a very strong bearing on stock markets. Investment decisions continue to be weighed down by prospects of instability in the government. Indian investors are well versed with the fallout of such a scenario. Then again, investors must analyze or look into policy initiatives of the government and weigh whether they will be pursued at all or not. One example of this is the disinvestment of holdings in the domestic energy and telecom sector, which comprises public sector companies such as Mahanagar Telephone Nigam Limited (MTNL) and Bharat Petroleum Corporation Limited (BPCL).

Equitymaster-Knowledge Centre-Intelligent Investing

These companies have failed to move in sync with a bullish market largely due to the uncertainty regarding government policy. Other policy initiatives of the government, like the decision to participate in the World Trade Organization (WTO) also have a bearing on the markets. For example, in India's case, we require a stable government with a strong sense of fiscal discipline. At the same time, there is a need to push through the second phase of reforms. If the incumbent government were not to deliver on any of these counts, one can expect an adverse fallout on the bourses (surely in the long run). Economy How the economy performs is influenced to a great deal by the political climate in the country. To put it another way, the economy cannot continue to post robust growth in absence of a conducive policy environment. Moreover, with India becoming a member of the WTO and foreign capital finding its way into the country, the need to track the global economy has never been felt as much. In the Indian case, performance of the agricultural sector is a key factor affecting overall economic growth. This is not only due to the fact that this segment accounts for over 25% of domestic GDP. But it employs over half the Indian population, which looked at it in one-way, is a massive consumption base. Therefore if the agricultural sector were to falter (due to a weak monsoon or for some other reason) overall economic growth will surely be affected. Companies with a high exposure to rural markets (or agriculturally dependent) will be worst affected. Another factor that needs to be looked into is the fiscal deficit of the government. This can be met either from borrowings or creating money. While exercising the first option puts upward pressure on interest rates, the latter contributes to inflation. Thus, either option, if not handled well, can have adverse consequences for the economic environment and stock valuations could be hurt. Investors must also take note of developments in foreign trade and forex reserve position of the government. Exchange rate movements too can have significant impact on corporates. These are just some of the important economic indicators that need to be looked into while deciding where to invest. Industry After having looked into the broader parameters, an investor must carefully analyze the industry in which he proposes to invest. For example, an investor can assess the industry on certain factors like: demand, supply, bargaining power of suppliers, bargaining power of customers, threat of substitutes and existing competition (akin to Michael Porters model). Such an analysis will clearly bring to light the state of the sector. For the sake of an example lets analyze the cement sector in brief.

Equitymaster-Knowledge Centre-Intelligent Investing

Demand for cement is estimated to grow at over 8% per annum over the next few years even as capacity additions slow down to a trickle. Demand growth in FY00 was put at 15%, marginally lower than the increase in supply. Growth in future will benefit from increased spending on infrastructure i.e. roads and housing. As there is no substitute for cement, there is no threat of an alternative for now. However, there is intense competition in the sector, which has led to a pressure on realisations. Indeed, in FY00 realisations increased only marginally despite the surge in demand. Consequent to this, the bargaining power of customers is also higher. However recent consolidation in the sector is a step towards limiting the level of fragmentation in the sector. As consolidation gains pace the sector can benefit from lesser price competition and in turn possibly better realisations. Management Lets suppose an investor zeroes in on the cement sector. The next step is to identify the promoter/management he wishes to invest in. Taking our example forward, during the recent slowdown in the Indian economy, a number of cement manufacturers posted a sharp decline in profits. However, Gujarat Ambuja Cements came out relatively unscathed. Credit for this needs to be given to the management. Investors must choose proactive managements, which are capable of generating above industry average returns. Company After having seen that the policy environment in conducive, the economy is expected to remain buoyant and the industry scenario for, say, cement is positive, there is a need to decide on a company to invest in. A company in the cement sector can be expected to do well only if the other macro factors are favourable. However, within the sector companies earn differential returns mainly due to company specific factors. For example, for a cement company location (with reference to markets and raw material deposits) is of prime importance. Cement companies in south India are facing intense competition and are facing a decline in realisations. However, the situation in the eastern markets is better. Then there are issues pertaining to financial performance, efficiency and costs of production. These are just some of the factors that need to be evaluated. Lets take another example. In the software sector some companies earn higher margins mainly due the value added nature of their work. Infosys, which is gradually venturing into software products, commands margins that are substantially higher than, say, NIIT, which draws a large part of its revenues from the highly competitive computer education business. Then issues such as employee turnover need to be looked into, as people are their key assets. Among the other factors that are of importance are the customer profile and their geographical spread (North American markets usually yield the highest returns).

Equitymaster-Knowledge Centre-Intelligent Investing

The top down approach is a tool with the help of which investors are likely to find sound investment opportunities in stock markets. Such an approach helps bring much needed objectivity to the decision making process and must be made use of by investors.

Numbers jungle unfurled


With improvement in technology there is a whole load of financial information now easily accessible. In fact, users now have access to content that probably analyse the stocks to death. So before it kills you, Equitymaster.com has attempted to identify some key ratios and what they signify to help you traverse the numbers jungle alive. Operating Profit Margin (OPM) OPM = EBIDTA / Sales * 100 EBIDTA = PAT + interest + depreciation + tax Company ACC Madras Cement Sales Operating (Rs m) Profit (Rs m) 31,385 4,977 1,688 OPM The operating profit of a company is calculated as the earnings before interest,

5.4% depreciation, tax and other amortisations. 1,316 26.4% OPM is the acid test of a company's operating efficiency. In can be compared across

companies in an industry to identify the lowest cost producer. However, it may not give a fair picture when compared across industries. Company Guj. Ambuja Sales Operating (Rs m) Profit (Rs m) 13,025 OPM NPM Both these players are leaders in their respective fields. However, the

Hind. Lever 109,176

3,693 28.4% 12.9% numbers indicate that Gujarat Ambuja 12,201 11.2% 9.8% is more efficient than Hindustan Lever Ltd. (HLL), which is not necessarily true.

HLL has to incur substantially higher costs in the post manufacturing stage. This includes packaging, distribution and advertising expense (advertising / sales = 7%). Although, Ambuja incurs costs under similar heads, in percentage terms these heads constitute a smaller fraction of its costs (advertising / sales = 1%). Therefore, across industries the OPM may not show the real picture. At the net profit level the margins are almost the same between HLL and Ambuja. Being an asset intensive company, Ambuja incurs higher post operating expenses in percentage terms i.e. depreciation and interest. The company's capital requirement will be more to set up an asset

Equitymaster-Knowledge Centre-Intelligent Investing

base. Consequently, it will incur higher depreciation costs on these assets and incur higher costs for servicing its capital. Return on Net Worth (RONW) RONW = PAT / Networth * 100 Networth = Equity capital + Reserves + Preference capital RONW is a measure of the return on shareholders funds. It reflects the efficiency with which the management has utilized the shareholders funds that are at its disposal. Company ACC Gujarat Ambuja PAT (Rs m) Networth (Rs m) RONW (589) 1,686 Intra industry comparisons will

10,456 -5.6% highlight companies with better 15,075 11.2% operating efficiencies and consequently, managements that

have been able to utilize shareholders fund more efficiently. Company Gujarat Ambuja Hind. Lever the businesses. To set up a cement plant Gujarat Ambuja needs to invest more heavily in assets. It needs to achieve economies of scale to remain competitive. Consequently, its business model is less scalable and its requirement for initial capital will be higher. HLL on the other hand will need to spend heavily on building brands. However, the model is more scalable. It can test market a product and then undertake a gradual national rollout. Therefore, the expansion can be funded by internal accruals and consequently, the initial capital requirement is lower. The difference in returns also shows that as an industry the fast moving consumer goods (FMCG) business is more lucrative than the cement business. HLL is in a 'product' based business, in the retail segment and meets the impulsive demand of consumers, which enables it to command higher margins. Ambuja on the other hand is in the commodity business, in the wholesale (bulk buyers) segment and demand is cyclical (economy dependent). PAT (Rs m) Networth (Rs m) RONW 1,686 10,699 However, inter industry comparisons

15,075 11.2% prima facie will not exhibit a true 21,033 50.9% picture. At a more discerning level it brings forth certain characteristics of

Equitymaster-Knowledge Centre-Intelligent Investing

Return on Invested Capital (ROIC) ROIC = EBIT / Invested capital * 100 Invested capital = Equity capital + Reserves + Preference capital + Long and short term debt Company ACC EBIT Invested (Rs m) Capital (Rs m) 1,029 25,330 ROIC 4.1% Invested capital is the capital employed in the business. ROIC is a critical parameter in analyzing companies. It reveals the efficiency with which the management has been able to utilize the entire resources that are at their disposal. The factors guiding RONW also hold true for ROIC. Company Gujarat Ambuja Hind. Lever EBIT Invested (Rs m) Capital (Rs m) 2,941 10,923 ROIC ROIC tells the company the return it earns

Gujarat Ambuja 2,941

26,899 10.9%

from the business before it can service its 26,899 10.9% capital. This investment return percentage 22,805 47.9% can be analysed along with the cost of servicing the capital invested. The resultant

spread between the two percentages will indicate the economic profit / loss percentage attained by the business. It will give an indication of the esoteric economic value added (EVA) earned in percentage terms. Debt to Equity Ratio (D/E) D / E = Total debt / Equity shareholders funds Total debt = long + short term debt Equity shareholders funds = equity capital + reserves One can dig a little deeper to determine the constitution of the company's capital, which reveals the proportion of debt and equity shareholders funds carried on its books. It will reveal the leveraging capacity available with the company. Company Total Debt Equity- D/E (Rs m) shareholders funds (Rs m) 14,873 11,824 10,456 1.4 15,075 0.8 Company Total Debt Equity- D/E (Rs m) shareholders funds (Rs m) 11,824 1,773 15,075 0.8 21,033 0.1

ACC Gujarat Ambuja

Gujarat Ambuja Hind. Lever

Equitymaster-Knowledge Centre-Intelligent Investing

However, the ratio should not be looked at in isolation but along with the interest coverage available with the company. Interest Coverage Ratio Interest Coverage Ratio = EBIT / Interest charges Company ACC Gujarat Ambuja Hind. Lever EBIT Interest EBIT / Interest (Rs m) charges (Rs m) charges 1,029 2,941 10,923 1,618 1,255 224 0.6 2.3 48.8 At a more discerning level it not only signals the extent to which the company can leverage its equity but also indicates whether the company is enjoying cash profits.

Dividend Yield Dividend Yield = Dividend per share / Market price * 100 Many a times the yield can put a floor to the price of a stock. An important point to remember is that dividends are tax free in the hands of the investor. Hence, the effective yields - based on the investors tax bracket - to that extent are higher. The yield assures a steady stream of income (like a fixed income security) while it also makes available the benefits of any upside potential. Company Gujarat Ambuja Hind. Lever Hind. Petroleum Castrol DPS Market DPS / Market (Rs) Price (Rs) price 4 3 11 20 141 184 139 204 However, the sad part is that there could be a

downside to the stock, which will eat into the 3% effective yield. Therefore, a more in-depth 2% study of the company is required. The

8% investors should ascertain and satisfy 10% themselves that the fundamentals of the company remain strong and it can continue to

sustain paying dividends. Such a scenario is applicable to utilities, which witness strong earnings growth but as penetration levels saturate the growth rate slows down. However, the utility continues to enjoy strong earnings and accumulates cash, which can be distributed to the shareholders. Consequently, these stocks have higher dividend yields.

Equitymaster-Knowledge Centre-Intelligent Investing

Price to Earnings Ratio (PER) PER = Market price / Earning per share (EPS) EPS = (PAT - preference dividend) / shares outstanding This is the mother of all ratios. It suggests how many times current earnings the stock price is trading at. Therefore, at a more discerning level, it indicates the number of times the company's earnings an investor is currently willing to pay for the stock. It also reveals the return the company will earn on the price paid by the investor to become a part owner in the company. Therefore, the investor must ask what return do I expect for being a part owner in the company? Wipro at Rs 9,000 was trading in excess of a multiple of 850x FY00 earnings. At that price the company would be able to earn a return of 0.12% on the amount invested for acquiring part of the ownership. Is it worth it? Company Madras Cement Gujarat Ambuja Hind. Lever Market EPS PER Price (Rs) (X) (X) 4,418 333 141 184 29 5 13 5 37 Comparing the PER across industries will not give an accurate picture. One of the determinants of the ratio is the growth in earnings, which will vary across industries and consequently, the PER's will be different. However, intra-industry comparison will illustrate how pricey the stock is vis--vis its industry peers. Therefore, it will highlight the comparative valuations of companies. These are some of the key ratios one would like to look at when researching on a company. The article should help you overcome the impediments of the numbers game.

Cash flows vs income statements


While profit statements can be distorted by anomalies in the accounting policies, the cash flow statement can be considered as a gospel for investors. A cash flow in simple terms is a statement, which summarizes movement of cash (the lifeline of any business) in an entity. There are several issues on which cash flow statement scores over the income statement. While the profit and loss statement gives a summarized view on the profitability of the entity, cash flow measures the health of the business as well. Income statement ignores time value of money: Income statement does not look at the time value of money. A typical example of the same could be refinery companies. The growing deficit in the oil pool account has reflected in increased receivables in the books of oil companies. The

Equitymaster-Knowledge Centre-Intelligent Investing

10

deficit in totality is estimated in the range of Rs 100 bn. In other words, though oil companies must have booked sales (profits thereon), they have in fact only resulted in huge receivables in the books of these companies. The government has decided to issue oil bonds to oil companies in lieu of their respective oil pool account receivables. With lack of a definite period for redemption of oil bonds it would take much longer before they actually make profits. The cash flow statement on the other hand recognizes the time value of money. Probably, its the most conservative way of looking at business. Look how BPCLs growing debt burden is in fact due to burgeoning receivables. (figures in Rs m) Net Profit Current Ratio (x) Debt Debt/Equity (x) 1998 5,327 0.96 0.58 1999 7,012 1.12 0.55 2000 7,039 1.22 0.74

14,645 16,673 25,927

The above table would indicate that Oil Co-ordination Committee (OCC) receivables are putting a strain on the companys balance sheet, which can in no way be reflected through the income statement of the company. It is only when the investor looks at the cash flow position does he realize that the situation is strenuous (for no fault on the companys part). In this case, the income statement of BPCL thus ignores time value of money. Had the OCC receivables been on time, the interest cost of the company would have been considerably lower. Difference in Accounting policies: An income statement could be distorted depending on the nature of accounting policy, which the company follows. A typical example of the same could be the difference in accounting policies for right off of expenses on content creation (intangible assets). The treatment of the same ranges from company to company. A extremely conservative company may write off the entire expense on software creation in the same year while others may write it off over the useful shelf life of the content, may well be even ten years. Now, other things remaining constant the income statement of the company, which writes off expenses over a longer period, appear better. Financial Management: A cash flow statement not only provides a snapshot of the companys operational performance but also its financial management and utilization of scarce capital. While investment activities provide a birds eye view of the treasury operations of the company, financing activities provide the financing tactics adopted. i.e the movement of cash from equity and debt.

Equitymaster-Knowledge Centre-Intelligent Investing

11

Let us take example of Himachal Futuristic Communication Ltd. (figures in Rs m) Cash flow from Operations Cash flow from investing activities Cash flow from financing activities Net cash inflow/( outflow) Net profit as per income statement 1999-00 1998-99 50.6 -333.3 406.1 123.4 86.o -87.4 -6.7 99.1 5.0 36.0

The above table is self-explanatory. While net profit has grown by three digit rates year after year, cash from operations have not matched up with net profits. Secondly, inflows from financing activities (from issue of share capital) were utilized for investment activities (primarily as loans and advances). Thus a cash flow statement is a mirror of not only the companys profitability but also a reflection of the financial structure (including its liquidity and solvency) and the ability of the firm to adapt to the changing business scenario. Historical cash flow could also indicate the amount, timing and certainty of future cash flows. It therefore also offers comparability of operating performance of different enterprises because it eliminates the effects of using different accounting treatments for the same set of transactions and events.

Cash flows: The health parameter


A rupee today has more intrinsic value than a rupee tomorrow. Why is it so? If you have Rs 100 today, you can deposit this money in the bank, which fetches you interest from that day one itself. That is precisely the reason why cash flows and money management are all about attaining maximum returns. It is fine if a company earns adequate profits and commands better market share. But, if your company is not generating enough cash, which it can utilise for its expansion plans, it is losing on many fronts. From a shareholders perspective, the company could distribute a part of its free cash as dividend to the shareholders, who are entitled to every rupee that the company earns. From a companys perspective, one, this will enable them to plough back money for further expansion plans and secondly it can buy back shares, which will enhance shareholder value. Having said that, negative cash flow does not necessarily mean that the company is not doing well. Normally, for green field projects, cash flows tend to be in the negative territory as they build assets during the initial phase. There is always a lag time between investments and returns. So,

Equitymaster-Knowledge Centre-Intelligent Investing

12

cash flows from such capital expenditure would start flowing in probably after three or four years (this period is higher for capital-intensive companies like steel, cement and automobiles). But how do I calculate free cash flow? A simpler method of calculating a companys free cash flow is to add depreciation to the net profits and deduct capital expenditure and dividend. An indepth methodology would be to adjust a companys increase or decrease in net working capital (current assets less current liabilities) to the above figure. Free cash flow increases if the company manages to unlock efficiency by reducing the required working capital. Calculating FCF (Rs m) FY00 Net Profit Add: Depreciation Less: Change in NWC Capex Dividend Free cash flow (145) 300 401 765 Let us take a simple example. Assuming that a company spends Rs 100 as capital expenditure in April 2000. The company has projected cash flows or returns from such investments as follows: Rs 20 in April 2001, Rs 35 in April 2002, Rs 50 in April 2003 and Rs 70 in April 2004. Assuming a discount rate of 15%, the net present value of these future cash flows is Rs 117 (present value factor is determined by dividing 1/(1+15%) in FY01E, 0.87/(1+15%) in FY02E and so on). Multiplying actual cash flow by PV factor would give you PV of the cash flows. Effectively, this means that earning Rs 20 in FY01, Rs 35 in FY02, Rs 50 in FY03 and Rs 70 in FY04 is equivalent to Rs 117 today. Simple cash flow calculation FY00 FY01E FY02E FY03E FY04E Total 100 15.0% 1.00 0.87 17 0.76 26 0.66 33 0.57 40 117 20 35 50 70 175 973 348 Asian Paints reported a net profit of Rs 973 m in FY00. The depreciation, capital expenditure and dividend payout were Rs 348 m, 300 m and Rs 401 m respectively. The change in net working capital (NWC) was negative Rs 145. The free cash flow (FCF) is calculated as follows:

(Rs) Cash Outflow Cash Inflow Discount rate

Present Value factor PV of cash flow

The debate then arises as to what rate should one discount the cash flows. But generally, the cost of capital of the company is a widely used hurdle rate because this takes care of a companys debt and equity obligation like interest and dividend respectively. (Generally speaking, if the return on capital employed is higher than a companys cost of capital, it is apparent that the company is managing its cash flows efficiently).

Equitymaster-Knowledge Centre-Intelligent Investing

13

Let us consider a practical example: Mahanagar Telephone Nigam Limited has ventured into the cellular business for which it needed to incur capital expenditure for setting up infrastructure. The company has set this up at a cost of Rs 3,660 m through which it will be able to serve 0.8 m subscribers. As per the internal estimates, the company would net Rs 2,000 m as revenues in the first year of inception itself. But at the earnings level, the company is expected to report a loss in the first year, primarily on account of capital costs incurred in setting up the necessary infrastructure. Assuming that the companys cost of capital is 17%, when we discount the projected cash flows from the cellular business, we get the net present value, which when divided by the number of shares, we get the fair value of the share. Remember, a company is not valued for what it has achieved but for what it has planned to do in the future i.e. growth prospects. It is precisely the reason why cash flow analysis is ranked high by many of the value investors. So, the next time you plan to invest in a company, ascertain cash flows, as they are the health parameter of any company.

The dividend attraction


The stock markets in recent months have been a big disappointment for investors. Across the board selling pressure has led to erosion in capital of billions of investors. The losses have been significant. In such a scenario, does it make sense to risk investing in stocks again? Maybe. Look at it this way. Returns from a stock comprise of two components dividend and capital gains. It is the latter that generates most of the attention revolving around stocks. The first, that is the dividend, has generally been ignored. Consider this. The return on one-year government paper is under 10% (tax free). On the other hand, there are several stocks that have a dividend yield in excess of 10% (tax free). There is a case for investors to put money in such stocks. What we have attempted to do below is highlight a few such stocks, which at current prices offer attractive dividend yields. A note of caution is needed here. It is not necessary that companies paying high dividend only make investment sense. It is possible that the company prefers to invest the money in a new plant; launch of a new product line or it could be for making acquisitions of brands or companies having same synergies. The management might be doing much more to build shareholder value than it would have been doing just by passing their earnings as dividend. A prudent and efficient management would not increase the payout ratio by scarifying opportunities for reinvesting increased earnings in the business. The best example is the companies in the software sector, which have relatively low dividend payout ratio.

Equitymaster-Knowledge Centre-Intelligent Investing

14

Nevertheless, the fact remains that an increase in dividend rate is invariably looked upon as a favourable development. The following table indicates that the stocks, which have been hit by the markets, are showing high dividend yield. These stocks are not from the much talked about TMT, pharma or FMCG sectors. These stocks are trading at a significant discount to their expected performance in the coming years. Out of the 22 companies selected for the study, 8 are from the finance sector. Banking stocks are losing ground on the recent co-operative bank default and bullion trading scam. However, these banks are fundamentally sound and the only risk is to the extent their profits will be eroded (a one time write off) on account of having to make provisions for the losses. Scrips like Pentamedia Graphics has been hit due to the adverse perception of the management notwithstanding the fact that the company is the leader in animation industry. Dividend yield analysis
Companies IDBI Electrosteel Castings Madura Coats Thirumalai Chemicals Tata Chemicals Supreme Industries Pentamedia Graphics GNFC Tata Finance Chennai Petroleum Centurion Bank Bank of India Indusind Bank Oriental Bank of Commerce Global Trust Bank BPL Ltd. Trent Indo-gulf Bank of Baroda Goodlass GAIL Div/share (Rs) 4.5 1.8 4.0 5.0 7.0 10.0 2.5 4.5 3.0 1.0 1.0 1.3 3.5 2.2 6.0 6.0 2.6 4.0 6.5 3.5 Price Dividend Tax free (Rs) yield yield 26.7 12.0 28.0 39.9 57.0 83.0 21.2 38.9 29.4 10.2 10.5 13.8 40.0 25.2 69.0 71.0 35.0 56.0 94.0 51.0 16.9% 15.0% 14.6% 14.3% 12.5% 12.3% 12.0% 11.8% 11.6% 10.2% 9.8% 9.5% 9.1% 8.8% 8.7% 8.7% 8.5% 7.4% 7.1% 6.9% 6.9% 24.3% 21.6% 21.0% 20.6% 18.1% 17.7% 17.4% 17.0% 16.7% 14.7% 14.1% 13.7% 13.1% 12.6% 12.6% 12.5% 12.2% 10.7% 10.3% 10.0% 9.9%

15.0 100.0

However, while using this investment approach investors need to determine the consistency of the company in paying dividend. Lets say for example the dividend yield of a company amounts to 15% this year, but due to adverse business developments it is unable to pay dividend in the

Equitymaster-Knowledge Centre-Intelligent Investing

15

coming year. In such a scenario, of course, the investment would be a disappointment. So one needs to pick a stock where there is a high probability of a consistent payout. The dividend considerations should not be given an unduly high weightage by those desiring to select outstanding stocks over the long term. Some stocks would compensate the low dividend yield by generating higher capital appreciation. In a bottom finding market dividend yield could help investors protect their returns vis--vis debt portfolio. At the same time allowing the investor to benefit from any upswing in the markets.

Look (at the downside) before you leap


On February 28th 2001, the Finance Minster presented what was thought to be one of the most market savvy budgets of the decade. Not in his wildest dreams would the FM have thought that post budget all hell will break loose. It did. And when the carnage ended it left behind a trail of bodies. No not of the bulls or the bears, but of the small investors- as always. Not to say that the individual investors were not at fault but they could have never guessed the corruption in the exchanges and complacency of the regulators. Their undoing was greed, to make money as quickly as possible. Somehow it was imbibed into them that stocks exchanges were the quickest route to riches. There objective was simply to maximize their returns. But they forgot one fundamental principle more the risk, more the return. In other words, if there are unrealistic returns expected, the risks too are unimaginable. It is very interesting to note that there is far greater interest in the returns rather than the risk involved. If there was no risk why would any return be more than that the return to government securities? Therefore, investors must appreciate one very simple fact that if they are looking at returns, they need to look at risk. Then the question is what is risk? Risk can be explained as a quantification of the outcome not meeting expectations. To put it very simply, things going wrong. Now the problem is how do we measure risk? Let us look at a few measures of risk used and how they have evolved over time. Volatility The simplest measure of risk, which says what is the standard (average) deviation of the values (stock price) from the mean. A measure of how much the returns have missed the mark by. Greater the deviation greater the risk. As this is a statistical concept it is very difficult to interpret.

Equitymaster-Knowledge Centre-Intelligent Investing

16

The unit of measurement is percentage (%). The returns should be seen in combination with the standard deviation. Standard Deviation Mean returns Infosys HLL Sensex 3.4% 2.2% 1.8% 0.40% 0.10% 0.03%

Based on daily returns for the period from 15 Dec,1995 to 4th Apr, 2001

One of the most prolific users of standard deviation was Harry Markowitz. He came out with his portfolio theory and revolutionized the way people selected stocks. He introduced the concept of portfolio risk diversification i.e dont put your all your eggs in one basket. According to him the combined risk arising from two stocks depended not only on the risk of the individual stocks but also on the how closely their price move together (correlation). Therefore, if two stocks have almost no correlation then the combined risk of the two stocks can be lower than the lowest of both the stocks involved. The premise was that same factors would not affect the stocks and therefore, risk would be lower. Probably losses on one of the stocks would be offset by gains on the other stock. Therefore risk was broadly categorized into diversifiable and non-diversifiable risk. The diversifiable risk can be made to disappear by a combination of stocks but the non-diversifiable risk has to be borne by the investor. The lesson here is very simple. Dont put all your money into one sector. What if the sector has a de-rating? Obviously all the stocks of the sector are going to take a hit. The IT sector was recently de-rated as its largest market (the US) was facing tough economic environment and therefore, the IT spend in the US dropped. This meant lower revenue growth for the industry. William Sharpe extended Markowitz diversification principle. According to Sharpe, if there was a part of the risk that could be done away with, why would there be returns for it? Therefore, only that part of the risk that cannot be diversified would be rewarded. He decomposed risk into two components. Systematic risk (non-diversifiable) that affects all stocks and is more macro in nature and unsystematic risk (diversifiable) that comprises of the stock specific risks. Beta Beta is the measure of the non-diversifiable or market risk. It gives a measure of how much would the stock price change if the market moved by a particular amount i.e. the sensitivity of the stock to market movements. Therefore, it quantifies the extent of dependence of the stocks price on the macro or market factors. Suppose a stock has a Beta of 0.5, if the market moves by a certain

Equitymaster-Knowledge Centre-Intelligent Investing

17

amount the stock is likely to move by half the amount, as its sensitivity to the market is low. Again if a stock has a beta of 2, then the impact of market movement on the stock is likely to be magnified and be of twice the amount. Beta Both these measures do quantify risk 0.68 but what have one major flaw that is 1.04 they do not say what will be the loss in rupee terms and what is the probability

HLL Infosys

Based on daily returns for the period from 15 Dec,1995 to 4th Apr, 2001

of this happening. For example volatility tells us that Infosys is more volatile than HLL and more risky. Also Beta tells us that Infosys is more likely to be affected if the markets move as compared to HLL. But it still doesnt answer the question that what amount of money does the investor stand to lose. This answer is provided by a measure known as value at risk (VaR). Value at Risk VaR is generically defined as the maximum possible loss (in Rs terms) for given position or portfolio within a known confidence interval or a specific time interval. There are number ways to measure VaR. But basically VaR can be thought of comprising two components. a. The sensitivity of a portfolio or positions to the change in markets b. The probability distribution of the markets over the desired reporting period horizon. If we combine both the components above then we are able to say with a certain level of confidence what will be the stock price movement in a day. Confidence Level 68% 90% 95% 99% HLL (VaR) Infosys (VaR) Var Rs 10,000 2.2% 3.6% 4.3% 5.7% 3.2% 5.3% 6.3% 8.3% 320.0 528.0 627.2 825.6 Var for Rs 10,000 220.0 363.0 431.2 567.6

Based on daily returns for period from 15th Dec, 1995 to April 4, 2001

Here for 68% confidence level that can be interpreted as on 68 days out of hundred the VaR is 2.2% (1 times std deviation) of the portfolio value. For an investment of Rs 10,000, the value at risk works out to be Rs 220. Therefore on 68 days out 100 an investor will not lose more than Rs 220 in a day for an investment of Rs 10,000 on HLL.

Equitymaster-Knowledge Centre-Intelligent Investing

18

Similarly for Infosys at a confidence level of 99% can be interpreted as 99 days out of hundred the VaR is 8.3%. Therefore, in 99 days out 100 an investor will not lose more than Rs 826 in a day on an investment of Rs 10,000 on Infosys. These are just a few methods used to quantify risk. The purpose of this article was to introduce risk as a measure and stress the importance of valuing risk while investing in volatile markets. Investing in stock market is not a gamble. But again its certainly not a sure way to make money nor is it a sure way to lose it either. Investing calls for lot of research and thinking before you put in your money. Luck can sometimes help you get some easy money but in more than a few cases luck runs out. Therefore, look before you leap. And leap because you know the risk involved not because you got a hot tip. There is no easy way to make money, at least not on the stock markets; not that we know of. If you still think otherwise, best of luck to you. You are going to need tonnes of it.

Troubleshooting for retail investors


When one invests in the equity markets, one dreams of capital appreciation, regular incomes in the form of dividends, bonuses and so on. Cut to the world of reality and we find that the Indian investor community is one harried lot. Forget capital appreciation, investors sometimes are locked in heated battles with the companies they own shares in. The complaints range from non-receipt of dividends, bad deliveries, problems in share transfers, loss of share certificates, non-credit of bonuses etc. So whats the recourse for the common retail investor in such cases? We spoke to some experts who deal with investor grievances day in, day out. About 85-90% of the complaints received by the Bombay Stock Exchange (BSE) are about share non-transfer and dividend non-payments. From the conversations we had with officials at BSE, we formulated a list or thumb rules, which equip you to take a better recourse. Thumb rules Your first step should always be to write to the company and get a clarification from them as to what went wrong. Sometimes, the company does have a logical explanation to the issue concerned. For example, BSE receives a lot of complaints regarding dividend nonpayment or a lesser dividend than what was proposed at the shareholders AGM. But it has happened in many cases that the dividend has been revoked or not approved later.

Equitymaster-Knowledge Centre-Intelligent Investing

19

Incase the company doesnt reply or the companys reply doesnt satisfy you, approach the exchange on which the company is listed (i.e. BSE or NSE), the Department of Company Affairs (DCA) and the Registrar of Companies of the region where the company is registered.

Experts say that it is better to write to them all at one time. The reason being that all these institutions have a hold on the companies and can add collective pressure, which is likely to force the company to either give a reasonable explanation or to take quick remedial actions.

Added to the above, if the company or the Registrar of Companies doesnt respond after two reminders, you should write to The Securities Exchange Board of India (SEBI) about your grievance.

Do not think that all this letter writing will yield no results. It is important to remember that all these institutions maintain records on the companys investor friendliness. They actually file all these complaints against the erring company. The companys are scared of them and do not want to invite their ire. For example, the stock exchanges on which they are listed have the right to blacklist them. BSE has developed a Z category shares, under which the regular erring companies are placed on a watch, which has a negative impact on the stock prices of these companies. The exchanges also hold the right to delist the company as a last resort.

You can also sue the company and demand damages. One can either file the complaint with the Company Law Board or the consumer court. But one must weigh the pros and cons of taking the battle to court. For one, Indias legal system is slow and time consuming. Secondly, court battles are costly affairs and are neither advisable nor practicable for small retail investors.

Always keep photocopies of all your correspondence with the company and the institutions you are writing to for recourse and file it. This will act as a handy reference tool and an important proof in case the dispute gets prolonged.

At all times, please remember that as a shareholder you have the right to information, the right to your dividends, bonuses, all at the right time. Do not desist from staking a claim to your rights.

To avoid all this hassles in the first place, it is advisable to read about the companies before you invest in them. Always prefer companies with a reputed management and a good track record.

Equitymaster-Knowledge Centre-Intelligent Investing

20

Avoid fly by night operators, unless you are absolutely sure of their business propositions. Remember, prevention is always better than cure.

Equitymaster-Knowledge Centre-Intelligent Investing

21

Level 2: How to put a price to stocks Book value: Weighing on assets


In general, we can assume a companys share price to be the sum of two components. The first component is the price assuming that the company does not grow in the future. The remaining part would be derived from expectations of growth in earnings going forward, the present value of future growth opportunities. For high growth sectors, a significant component of the stock price would be a function of the future growth expectations, while for the not so rapidly growing sectors the markets would look at other options for determining the stock price. And the assets a company holds is a good place to start. Stocks that derive a large part of the price from future growth prospects are known as growth stocks. (Read more). This article is focused on the theoretical aspects of book value and how to put a price to a stock using the book value. The difference between assets and liabilities gives net worth of the company. Net worth is that part of business, which belongs to the common shareholders (the owners). Net worth per share of the company is known as book value. So what does book value tell us? Firstly, it is the value received by the shareholders on the sale of companys assets at prices mentioned in the balance sheet. Since the value is determined from accounting journals its is known as book value. Also, book is an approximate indicator of the inherent value in a stock price and can therefore be assumed to be the no growth component of the stock price. This is what makes the number so useful. For low growth industries or when a company is passing through a period of low (or negative) growth the book value can be used as an indicator of the stock price or a floor for the stock price. Industries like banking, manufacturing and automobiles are basically asset intensive in nature and therefore, looking at book value as a tool for making investment decision makes good sense. While book value is a good tool to determine stock price for such industries, there is a word of caution. Assets include land, buildings and inventory amongst other things. The valuation, as per accounting standards for these assets could be vastly different from their real market value. The real market price, of the assets, could be much higher or lower. Consider Indian Hotels Company (IHCL), the companys prime property in South Mumbai is much more valuable than that shown in the books due to the fact that building has been fully deprecated and is carried on the books for almost no value. The book value grossly understates the sell-off value of the company. On the other hand, consider the IT companies with old

Equitymaster-Knowledge Centre-Intelligent Investing

22

computers. The computers are not of much of value on resale. Here the book value overstates the sell-off value. While using book value makes sense for certain industries, for other it does not. It does not make sense to use book value for services and FMCG industries not advisable. This is due to the simple fact that stock price contains a significant proportion of growth component. Let us take a look at a few examples. Networth No of BVPS (Rs) CMP (Rs) BV/P (%) P/BV (x) (Rs m) Shares (m) L&T SBI HLL Infosys* Telco 39,599 134,615 24,882 20,803 32,538 249 526 2,201 66 256 159 256 11 314 127 181 203 3,819 138 87.9% 5.6% 8.2% 92.2% 1.1 0.9 18.0 12.2 1.1 220 116.5%

*As per FY02 balance sheet; All others numbers from FY01 balance sheet

L&Ts book value for the year-end March 2001 is Rs 159. Thus, approximately 88% of the current market price is based on the assets the company has. For SBI the book value is Rs 256 and the stock price of is Rs 220. This translates to the fact that the markets are valuing the bank lower than its book value. However, there is a catch. SBI had net NPAs (Non Performing Assets) of Rs 68 bn in FY01. NPAs are loans given out by the bank that have gone bad. Though the amount of Rs 68 bn is owed to SBI by various borrowers, and theoretically is an asset, it is unlikely that the bank will recover most of the money. Thus, if we exclude the NPAs from the banks net worth, the book value works to be Rs 125. In this case the book value supports around 57% of the current market price. Similarly, for Telco the book value supports 92% of the stock price. Let us take the case for HLL and Infosys. While HLL stock price is Rs 204, the book value works out to be only, Rs 11. Similarly in the case of Infosys, the book value works out to be Rs 314 and the stock price is Rs 3,819. Thus, the book value accounts for 5% and 8% of the stock price for HLL and Infosys respectively. This variation in the price of Infosys and HLL is due to the fact that these companies dont need to have significant amount of assets for their business. Their most valuable assets, intellectual capital and brands, are intangible in nature. Consequently, it is very difficult to put a price to these intangibles. This make valuation of the companys very subjective. Incase of an unfortunate event the price of these stocks can erode rapidly.

Equitymaster-Knowledge Centre-Intelligent Investing

23

(Rs m) L&T SBI HLL Infosys* Telco

Total Fixed Assets Assets 108,205 46,710

Sales 73,787

Sales/ Sales/ Total Assets (x) Fixed Assets (x) 0.7 0.1 1.8 1.0 0.9 1.6 11.6 8.8 4.7 1.8

2,615,050 25,933 300,212 57,345 12,035 106,038 25,397 5,577 26,036 68,036 79,766 38,236

*As per FY02 balance sheet; All others numbers from FY01 balance sheet

This is evident from the fact that Infosys and HLL have sales at 1x and 1.8x times their assets. The number is low for Infosys as it holds a significant amount in cash and investments. Considering only net fixed assets (NFAs), the sales work out to be 9x and 5x the fixed assets for Infosys and HLL respectively. The Sales/NFA for SBI works out to be very high 12x, as banking business requires low fixed assets. However, the Sales/Asset for SBI is 0.1x. This is because the business requires significant amount of advances and investments. Price/book value A very interesting ratio emerges by the comparison of the market price (market valuation) to the book value (accounting value of assets less liabilities). While one measures the earnings power the other reflects the part of price backed by assets. A market-to-book ratio of about 1.5 times is that the firm is worth 50% more than what past and present share holders have put into it. The ratio indicates what kind of a price investors are willing to pay for Rs 1 of book value of the stock. The price to book value for a stock can be calculated using, We know that price of a stock (P), D P = ---r-g

Where D = Expected value of dividends next year r = Required return on equity (Read more) g = perpetual growth rate of equities Now substituting dividends by Earnings Per Share (EPS)* Payout Ratio

Equitymaster-Knowledge Centre-Intelligent Investing

24

EPS * Payout Ratio* (1+g) P = --------------------r-g

The EPS can be written as the Book Value (BV) * ROE (Return on Equity)

BV* ROE * Payout Ratio* (1+g) P = Thus, P --- = BV ROE * Payout Ratio* (1+g) -------------------------r-g ----------------------------r-g

The bank rate (at interest rate at which SBI borrows from the RBI) is 6.5%. SBIs beta is 1.04 and market risk premium is assumed to be 7%. Therefore, the cost of equity ( r ) for the bank works out to be 13.8%. Further, SBI had a ROE of 16% in FY01, the payout ratio was 12.9% and the dividends were expected to grow at CAGR of 9% for the next five years. Thus, substituting the values in the equation we get the theoretical P/BV for SBI should be 0.6. Currently, SBI trades at 0.9x its book value. Once the P/BV is determined by using the equation, using the BV the price can be easily determined. Thus, calculating the theoretical price to book value should give an idea about the fair value of the stock. However, the investment decision cannot be made on this ratio alone. Other qualitative and quantitative factors have to been taken into consideration. The Price/Book Value is useful when evaluating banks. This is because there the difference between the market value of the loans and their book value is likely to be very less.

Equitymaster-Knowledge Centre-Intelligent Investing

25

A study of the valuation of three majors one from the automotive sector (Telco), one from the banking sector (SBI) and one company with diversified business interests (L&T) indicates that P/BV of 1x serves as a good measure of floor price of the stock price. In the period between 1994-1998 not one of the three stocks mentioned traded below a 1x its book value.

However, post 1999 many things changed. Firstly, the markets as a whole took fancy to new economy and old economy stocks like Telco, L&T and SBI were no longer in favour. Also, Telco ventured into its car project and the company posted losses. However, since third quarter of FY02, Telco car Indica started toppling the sales charts. SBI as we mentioned before has NPAs to the tune of Rs 68 bn.

Equitymaster-Knowledge Centre-Intelligent Investing

26

However, a trend that is evident for all the three stocks is that the P/BV has declined over a period of time. This can be explained on a case-to-case basis. SBI has seen a sharp decline in its payout ratio during the period. L&T on the other hand has seen the ROE decline steadily. However, the effect of the decline in ROE has been offset to some extent by an improvement in the payout ratio. While value stocks do not offer swift gains, but they are not prone to rapid erosion in value either. This makes them excellent candidates for a retail investors portfolio. Knowing how to price them will certainly help. L&T for all its value does not seem a good buy at a P/BV value of 4x.

Stocks: Measuring expectations


The most mysterious thing especially with the software stocks has been their price. The price of a security can be broadly divided into two elements viz. the intrinsic value of the stock and the speculative element. But from the point of view of making a long-term investment, and not punting, it is the intrinsic value that ultimately matters. Arriving at the intrinsic value is, however, of little help as many times the stocks are nowhere near their correct valuations and in recent times speculative element in stock price has increased considerably. The idea of this report is to help you evaluate whether market assumptions that go into pricing of the stock are realistic or not. The attempt is not to put a correct price to the stock. The price of a stock is fundamentally based on two components. The future cash flow from expected dividends and the expected capital gains on the stock. (P1-P0) As expected return (r) = Where, D1 = Divided expected P1= Price at end of year one P0= Current market price D1/P0 + -------P0

D1 + P1 Rearranging we get, P0 = --------1 + r P1 would again depend on the next years expected dividend and the stock price at the end of year two so on and so forth.

Equitymaster-Knowledge Centre-Intelligent Investing

27

D1 P0= ---(1+r)

D2 (1+r)2

D3 (1+r)3

D4 + ----(1+r)4

Dn + Pn + ........ ----------(1+r)n

+ ------ + -----

Thus, the current stock price is nothing but the present value of the dividends and the future market price at a terminal date. To arrive at a stock price we need to know the future price, the expected rate of return and the expected dividend. Estimating the required rate of return The key variable here is r, the expected return. The value of r, i.e. expected return will vary according to the risk perception regarding the company in question. More the risk more the return will be expected. To determine expected return the risk profile of the individual stock is to be measured. The benchmark against which risk for an individual stock is measured is the equities market as a whole represented by indices like DIJA (Dow Jones Industrial Average), BSE Sensex and NSE Nifty. By plotting the returns of a particular stock against the index, the sensitivity of a stock to that particular market can be measured. This measure is known as the Beta or sensitivity of the stock to the market. If the beta is less than one then the stock is less prone to factors affecting the market as a whole. If the beta is more than one the stock price is very sensitive to events in the market. The expected return can be calculated using the capital asset pricing model (CAPM). According, to the CAPM, the expected risk premium on a stock is the market risk multiplied by beta or the sensitivity. Thus, we can conclude higher the value of beta higher the sensitivity and higher the expected risk. Expected risk premium (Rp) = beta * (Rm - Rf) Where, Rm = Return on markets Rf = Risk free rate of return

Once we have estimated the risk premium, all we need to do is add the risk free rate of return to the risk premium to get the expected return on the stock. As the risky investment will provide for returns at least equal to risk free investments and additional returns, which are proportional to the risk profile of the investment.

Equitymaster-Knowledge Centre-Intelligent Investing

28

Thus, expected return r = Rf + Rp For the risk free returns Government security yields can be used. Thus, for Infosys the expected rate of return was 21.1%. Company Risk free Beta Market expected returns* premium return ( r ) Infosys Satyam 10.3% 1.5 10.3% 1.6 7.0% 9.0% 21.1% 24.9%

As per company's FY01 balance sheet.

*Yeild on Government securities dated 2021 Estimating the terminal price It has been observed that over longer period of time the dividend component of a stock price is far greater than the present value of the future price. Thus, for simplicity's sake we will assume that the stock price is a function of the dividends only and neglect the terminal price. The stock price therefore is the present value of dividends paid out by the company. Assuming constant dividends for simplicity the stock price is now the present value of a perpetuity discounted at r or the expected rate of return.

Thus,

D r

P0 = ---

If g is the assumed growth for of the dividend over a course of time, the value of the stock price changes to D P0 = ---r-g

Rearranging the previous equation would give us a very interesting interpretation of the expected rate of return.

Equitymaster-Knowledge Centre-Intelligent Investing

29

Thus, r = D + g -P0 The expected return therefore is a combination of the dividend yield and expected growth. We often use terms like growth and income stocks. The stocks, which derive a greater component of their price from dividend yield, are income stocks. While stocks that largely owe their price to growth expectations are growth stocks. Infosys is expected to pay Rs 15 in dividends this year. At the current market price of Rs 2,956, this works out to be 0.5%. Thus, remaining 20% return is expected from the growth in the business. On the other hand HLL is expected to give a dividend of Rs 4.5 in FY02. The company's cost of equity works out to be 19.7%. Consequently, the implicit growth rate is 17.6%. To estimate the expected growth rate in a stock price we have to delve a bit deeper. Assume that the company does not see any growth in the future and pays out all its earnings as dividends. In such a case DPS (dividend per share) = EPS (earnings per share). Thus, DPS P0 Rearranging we get DPS r EPS r

r = --------

P0 = ----- = -------

Infosys is expected to earn an EPS of Rs 124 in FY02. Therefore, the price of the stock assuming no growth and cost of equity as 21.0% would be Rs 589. Of the current market price Rs 2,956, Rs 589 is on assumption that the company will continue to have a constant EPS (no growth) of Rs 124 for a considerable period of time in the future. Thus, Rs 2,368 in the price is due to the present value of the growth. The company pays dividend of Rs 15 and therefore the money ploughed back into the business is Rs 109. With a return on equity of 36.4% this investment is expected to generate Rs 40. Assuming that the investment generates Rs 40 every year

Equitymaster-Knowledge Centre-Intelligent Investing

30

(40) NPV = -109 + -----0.21 = Rs 80

Returns on growth oppurtunity Div for FY02E (Rs) Money ploughed back ROE Cash in flow from investment of Rs 108 NPV of this investment 15 109 36.4% 40 80

Thus the price due to growth,

NPV PO = ----r - g

80 2,368 = ------0.21- g

Solving for g we get a growth rate of 17.3% embedded into the stock price. Of course this growth rate is for a considerable period of time. However, any deviation in growth rates from this estimated (towards the downside) in the near future would adversely impact the stock price. According to Gartner, markets for IT services are expected to grow at a CAGR (compounded annual growth rate) of 16%, from a size of US$ 749 bn in FY01 to US$ 1,174 bn in 2004.

Equitymaster-Knowledge Centre-Intelligent Investing

31

In Satyam's case assuming a cost of capital to 24.9%, and an estimated EPS of Rs 52 for FY02 the price considering no growth comes to around Rs 208. However, the stock is trading at Rs 146, as on a consolidated basis it is making losses. Before concluding we would like to make a point, i.e. companies like Infosys have shown a supernormal growth rates of 100%, which is not sustainable over a long period of time. Eventually, the growth rates fall in line with the growth in GDP and therefore, a growth rate for perpetuity is the growth rate of the global GDP. This is a single digit growth figure, which is below 5%. The decision that has to be made now is will Infosys be able to grow at 17% for the foreseeable future? And will Dr. Reddy be able to grow at 12% for a considerable period of time? This will help you determine the price of the stock is realistic or not.

Valuing super normal growth


In the previous article , we had seen how to put a measure to the growth expectations embedded in a stock price. In this article we attempt to price a stock, which is expected to show very steep earnings growth. We came across very simple formulae, for determining the price of a stock. If g is the assumed growth for of the dividend over a course of time, the value of the stock is determined by D P0 = ---r-g Where Po= expected price D = Dividend paid out at the end of the year r = Expected returns g = Perpetual growth rate of dividends being paid

However, the problems here are twofold. Firstly, the growth rate is not constant and can vary significantly year to year. For example, Infosys grew by more than 100% in FY01 but the growth for FY01 is expected to be 30%. Secondly, the value of g is more than r and therefore, the formulae cannot handle this calculation. Thus, the best method to arrive at a price is to estimate expected the dividends for every year for those years in which supernormal growth is expected and then to assume a perpetual growth rate. This is because a steep or supernormal growth cannot last forever. Eventually, the growth figure

Equitymaster-Knowledge Centre-Intelligent Investing

32

will fall in line with the GDP growth rate of the major economy in which the business operates. Otherwise eventually the business will become bigger than the economy. Thus, the value of a stock is the present value of the expected future dividends. To recall

D1 P0= ---(1+r)

D2 (1+r)2

D3 (1+r)3

D4 + ----(1+r)4

Dn + Pn + ........ ----------(1+r)n

+ ------ + -----

Here, future dividends are estimated based on the growth expectations.

D1 (1+r)

D1(1+g2) (1+r)2

D2(1+g2) (1+r)3

D3(1+g3) (1+r)4

Dn/(r-g) (1+r)n

P0= ---- + ----------- + ----------- + ---------- + ... ----------

The dividends after a foreseeable period of time are expected to grow at a constant growth rate perpetually. Estimating the required rate of return click here Thus, the variable that becomes most critical in the calculation is growth. Estimating growth rates accurately would give an accurate idea about the value of the stock. The growth rates can be assumed by looking at past data, macro economic numbers, industry growth rates, relative market share data and other qualitative aspects. Year EPS DPS FY94 FY95 FY96 FY97 FY98 1.2 2.0 3.2 5.1 9.1 Payout ratio EPS growth 64.8% 58.2% 60.1% 79.4% 28.6% 11.1% 10.0% 9.1% 25.0% 20.0% DPS growth

1.8 143.4% 2.3 111.9% 2.5 2.8 3.0 3.8 4.5 78.6% 54.0% 32.9%

FY99 20.7 FY00 43.2

18.1% 126.8% 10.4% 108.7%

FY01 94.2 10.0

10.6% 118.0% 122.2%

Equitymaster-Knowledge Centre-Intelligent Investing

33

Let us take the example of Infosys here. Infys dividends in the past 8 years have grown at a CAGR of 30.8%. However, this is due to the spike (115% growth) in FY00. The CAGR growth rate from FY94 to FY00 for dividends works out to be 13.5%. This should give a good idea about what kind of growth rates to expect from the company under normal circumstances. However, considering the fact that Infosys has established a strong brand for itself, the company is expected to beat industry growth rates and continue to grow swiftly till it reaches substantial market penetration. Infosys, in FY01, with revenues of around US$ 367 m had a 0.1% market share of the US$ 367 bn services market. IBM that has had revenues of US$ 14 bn from services in the US (10% market share) is expected to post a growth of about 7.5% in services revenues for FY01. For the next three years considering that the US economy revives, Infosys the dividends can be expected to grow at a rate of around CAGR 30%. However, for the next five years after that assuming that revenue growth starts to decline the dividend growth could be expected to taper. Then we have assumed the growth to be in the range of 15% between (FY08 to FY011). Growth after this has been taken to be 10% for the next three years. Finally, the company is expected to grow perpetually at 5% in the future. Year FY02E FY03E FY04E FY05E FY06E FY07E FY08E FY09E FY10E FY11E FY12E EPS (Rs) 124 175 254 330 413 DPS Payout EPS DPS Present (Rs) ratio growth growth value (Rs) 15.0 12.1% 31.8% 26.2 15.0% 40.5% 74.5% 44.5 17.5% 45.7% 70.0% 66.1 20.0% 30.0% 48.6% 92.9 22.5% 25.0% 40.6% 15 23 34 43 53 62 68 74 80 86 88 90 92

496 123.9 25.0% 20.0% 33.3% 570 156.8 27.5% 15.0% 26.5% 656 196.7 30.0% 15.0% 25.5% 754 245.0 32.5% 15.0% 24.6% 867 303.4 35.0% 15.0% 23.8% 954 357.6 37.5% 10.0% 17.9%

FY13E 1,049 419.6 40.0% 10.0% 17.3% FY14E 1,154 490.4 42.5% 10.0% 16.9%
(Note the expected returns have been assumed to be 15%)

At the end of FY14, the companys dividends are expected to be Rs 490. Assuming the dividends continue to grow perpetually at the rate of 3%, value of the stock based on stable growth in

Equitymaster-Knowledge Centre-Intelligent Investing

34

FY14E would be Rs 4, 083. The present value of this works out to be Rs 664. Thus the total value of the stock comes to around Rs 1,472. However, the stock currently is trading at a price of Rs 4,533 this works out to be a premium of about 208%. There are certain reasons for which the company commands higher valuations, which could be management quality and transparency. Also another factor contributing to he high price of the stock is sentiment. The markets could be expecting a recovery in the technology sector and even stronger growth rates from the company. However, the theoretical calculations could give you an idea about how low the stock price can move. Post September 11, in the free fall the company touched a low of Rs 2,156. A significant part of the price is derived from the companys stable growth rate in the future. For our calculations we have assumed a very conservative 3%. To justify the current stock price (Rs 4,533) the perpetual growth rate required (consequent to above mentioned growth rates) is 12.9%. The question is what says the company will be able to manage such a fast growth rate? The S&P 500 between 1925 and 1995 has grown at a CAGR of 10%. This growth rate suggests a price of Rs 2,467.

P/E ratios: Reality check


One of the most commonly used tools for making an investment decision is the P/E ratio. This is due to the fact that that it is very easy to compute and more so, due to its easy availability. However, using the ratio without understanding its interpretation can be very dangerous especially for the retail investors, who have limited access to information. For sectors that have a long history, use of P/E ratios is less risky. However, for sectors that do not have much of a past, like software, the P/E ratio should be used with extreme caution. Infosys, in February 2000, touched a peak of Rs 16,932. This would translate to a P/E multiple of 382x its FY00 earnings. Yet many investors bought the stock as if there was no tomorrow, only to repent later. In times of irrational exuberance, the P/E ratio can give a clue about the insanity in valuations. In this article we look at how the P/E ratio can in help you avoid making such hazardous investment decisions.

Equitymaster-Knowledge Centre-Intelligent Investing

35

Let us start with what is the P/E ratio. P/E ratio is calculated by dividing the market price of the stock by the EPS (earnings per share).

Earnings Per Share, EPS (Rs)

Profit After Tax -----------------No of shares outstanding

Price to earnings ratio, P/E (x) =

Market Price ---------------Earnings Per Share (Rs)

The P/E ratio can be looked at as a price tag how many times the earnings is the market willing to pay to be part of the companys fortunes. The reciprocal of the P/E ratio (dividing 1 by the P/E) would give the earnings yield on the stock. For example the P/E of a stock is 12, then reciprocal works out to be an 8.3% yield. Another way of looking at the P/E ratio is that if the companys earnings did not grow at all in the future, it would take company P/E number of years to get back the money invested into the company. When Infosys was trading at a P/E multiple of 382 times, assuming no growth in earnings it would have taken 382 years for the company to earn the investment back for the investor. We are looking at some really long-term investors here. And of course no one is willing to wait perpetually to get a return on his or her investments. Thus, the higher the P/E multiple investors are willing to pay, greater will be the hopes of getting the investment amount back in a shorter time horizon. Therefore, generally a high P/E would be based on expectations of higher growth in earnings. More often than not, P/E ratio is used as relative valuation tool. Different companies from the same sector are compared on the basis of this ratio. Also, many times sector averages are used as a benchmark to compare valuations of different companies.

Equitymaster-Knowledge Centre-Intelligent Investing

36

However, creating sector averages are prone to errors. We have an average P/E of 27x (for FY04) by taking six companies in a sample for the software sector. For example, if Hughes Software were to replace Wipro, the P/E could come down from 27x to 24x.
Company Market Cap PAT P/E Company Market Cap PAT P/E (Rs bn)* (Rs bn) (x) (Rs bn)* (Rs bn) (x) Wipro Infosys Satyam i-flex Geometric MphasiS Sector 341 347 97 40 3 17 844 10 33.0 Hughes 12 27.9 Infosys 6 17.5 Satyam 2 22.2 i-flex 0 11.8 Geometric 1 16.9 MphasiS 31 27.0 *All numbers for FY04. 17 347 97 40 3 17 521 1 22.0 12 27.9 6 17.5 2 22.2 0 11.8 1 16.9 22 23.9

However, the greater risk that is embedded in a relative valuation exercise that uses P/E multiple is, that there is an intrinsic assumption that the markets are valuing the firms in question correctly. This is a very brave assumption to make. This might not be the case always. While the investor has to take in to account the fact that the markets do generally tend to be correct, the same markets do end up with average P/E ratios of 27x for a sector. Therefore, to get a bearing on realistic P/E ratios investors can use two methods and thus, cross check to find a rational price for the stock. a. First method is to calculate a P/E ratio for a stock and compare it with the P/E ratios the markets are using. b. Second method is to look at the PEG ratio. That looks at the P/E ratio in light of the future growth in earnings.

In the past we have seen that stock price is a function of the expected dividends in the future. Therefore, we have
D P0 = ---r-g PO= stock price D= Dividend expected at the end of the year r= required rate of return g=perpetual growth rate expected

Equitymaster-Knowledge Centre-Intelligent Investing

37

For calculation of rate of return please follow this link Expected rate of returns Dividend can be also expressed as = EPS x Payout ratio Modifying we have PO = EPS0 x Payout ratio *(1+g) ------------------------------(r-g) Where EPS0 is the current EPS for the company Therefore, P0 ---EPS0 P0 ---EPS0 = P/E = Payout ratio*(1+g) -------------------------(r-g)

Therefore, P/E

Payout ratio*(1+g) ------------------------(r-g)

HLL that has a pay out ratio of about 90%, has seen earnings grow at a CAGR of 25% for between 1986 and 2004. Assuming a perpetual growth rate of 10% for the company and a required rate of return of 14% the P/E ratio works out to be 14x times. The stock is currently trading at a P/E multiple of about 17x. Obviously, the markets are factoring in a slightly higher growth rates. Thus, based on the same assumptions for calculating the stock price, the P/E ratio can be estimated. However, the problem with this method is that retail investors need to make assumptions about the discount rate, payout ratio and perpetual growth rates. These being not so widely available would be very difficult to approximate. And if any one was to make the effort, why not calculate the stock price? There is merit in the argument. We want to point out here is that many times P/E ratio is used because there is a misconception that while using P/E ratios the need to make assumptions about the above mentioned variables are eliminated. However, one

Equitymaster-Knowledge Centre-Intelligent Investing

38

must appreciate that this is not a number pulled out of a hat, but the ratio is determined by the same assumptions that go into determining the stock price. However for those who do not want to get involved in the complex process of valuing a stock the PEG ratio, is a tool that can help. The PEG ratio is the ratio of the P/E ratio to future growth in earnings. This is based on the thumb rule that the P/E ratio should be equal to future earnings growth for the stock. Therefore, if the stock has a P/E ratio of 35, this should be supported by earnings growth of 35% in the future. It is preferable to use a CAGR for next two to three years. The future growth rates can be determined from companys earnings guidance or research reports on the companies that give projections about future earnings. Equitymasters research reports give three-year forward projections for companies under our coverage. Thus, this helps to justify whether the EPS has future growth potential to support the P/E. In that sense this becomes an indispensable tool for the investor.

PEG =

P/E ratio (x) -------------------------Growth in earnings (%)

The number is calculated by dividing the P/E ratio by the expected growth in earnings. For example, Infosys has a P/E of 28x (based on FY04 earnings) and the CAGR growth in earnings is expected to be 22%. Theref ore, the companys PEG ratio will be 1.3 (28/22). The use of the PEG ratio is however based on a thumb rule and is not a valid financial law. The two sides of the formula have different units: you're comparing a fraction with a percent, meaning that a factor of 100 has magically appeared on one side only. Taking on from here investors should be very cautious about stocks that are trading at PEG ratios of more than 0.8.
Company *Current Market EPS P/E CAGR PEG Price (FY07E, Rs) (x) (FY02E-FY04E) Infosys Wipro Satyam 5,235 1,447 310 337 15.5 77 18.9 31 10.0 21.9% 19.9% 20.4% 0.7 0.9 0.5

* As on 3rd June 2004 close

Wipro and Infosys look highly valued based on the PEG ratio. However, this ratio does not reflect the huge amount of cash these companies are carrying on their balance sheet. Infosys has

Equitymaster-Knowledge Centre-Intelligent Investing

39

around Rs 6,000 m (US$ 125 m) balance sheet if its buys a business at a market cap to sales ratio of 1.5x spending Rs 3,000 m (US$ 62.5 m), the company can add about 8% to its topline. The thumb rule that the P/E ratio should be equal to the future growth in earrings for a stock is actually based on the time value of money. The P/E ratio is an indication how much should investors pay for a company? A company that is growing twice as fast is worth twice as much. But PEG is not suitable to value cyclical companies like semiconductors and chemical manufacturers, airlines, utilities, or financial companies like banks. It is also not useful in valuing large, well-established companies. Also, a low PEG ratio might not mean necessarily mean that the company is undervalued. There a lot of certain facts about a company that the P/E ratio does not reflect like the amount of debt in the company. There are two parts to selecting a company the first one is about finding out a viable business model and second part is about finding a correct price for the stock or put a correct value to the stock. In this article we have looked at trying to put a value to the stock but more the focus has been to a clue on how realistic valuations are. All these tools can only aid. All these tools can also be used against you to justify things like the information technology revolution, which ultimately turned out to be an evolution. They are no substitute for rational thinking and patience. For high growth stocks like Infosys a two-stage model has to be used. A growth rate and payout ratio is assumed for the super normal growth period. A lower growth rate and higher payout ratio is assumed for subsequent period of time.

EVA Another barometer for corporate performance


The liberalisation of the Indian economy has led to a paradigm shift in the corporate goals of public and private companies. The focus is now being primarily on enhancing the shareholder value in a company. It was Stern Stewart & Co. who devised an accounting method called Economic Value Added (EVA) which measures whether the company is generating adequate profits to reward its shareholders. EVA is the registered trademark of Stern Stewart & Co. It is the financial performance measure that captures the true economic profit of an enterprise. It is also one of the measure most directly linked to the creation of shareholder wealth over time. So how do you define EVA? To put in a simple terms EVA is the profits generated by any economic entity over its cost of

Equitymaster-Knowledge Centre-Intelligent Investing

40

capital employed. The entity can be a company, country or the entire human civilization. If the difference between the above two parameters is positive than the entity is said to be creating wealth for its stakeholders. A negative EVA on the other hand indicates the company is a destroyer of value. So now the next question arises how do I go about in calculating EVA. EVA = Net Operating Profit After Tax (NOPAT) Cost of Capital Where NOPAT = Profit Before Tax + Interest Tax + Tax shield on interest In other words NOPAT is the profits generated from the core operation of the company. Cost of Capital: It is the weighted average cost of borrowings and equity as on the balance sheet date. Cost of borrowings: The cost of borrowing depends on the rate of interest on borrowings. Cost of equity: To define the term in a simple term it is

Risk free cost of bank lending rate + Market premium on the risk free equity investment * Beta variant (R + B * M).Where Beta is the relative price movement of the stock vis a vis the market. In simple terms the greater the volatility, the more risky the share and the higher the Beta. Lets take a simple example, a company having a Beta of 1.5 times implies that if stock market increases by 10%, the companys share price will increase by 15% and vice versa. For example an investment of Rs 1,000 in a soaps and detergent shop produces 7% return, while the similar amount invested elsewhere earns returns of 15%. EVA can be defined as a spread between a companys return on capital employed and cost of capital (similar to the opportunity cost of investing elsewhere) multiplied by the invested capital. The EVA from this case would be EVA = (7%-15%) * Rs 1,000 = (Rs 80) An accountant measures the profit earned while an economist looks at what could have been earned. Although the accounting profit in this example is Rs 70 (7% * Rs 1,000), there was an opportunity to earn Rs 150 (15% * Rs 1,000). So in this case the company can be called as a destroyer of wealth. Thus, the litmus test behind any decision to raise, invest, or retain a Rupee must be to create more value than the investor might have achieved with an otherwise alternative investment opportunity of similar risk.

Equitymaster-Knowledge Centre-Intelligent Investing

41

Now consider this example based on the formula explained above. You can put different balance sheet and profit figures to know your own EVA. Particulars Equity Capital Reserves Net worth 12.5% debentures Capital employed Weight of equity Weight of debt NOPAT (as per defination) Return on tax free government bonds * Beta * Market premium * Corporate tax rate * Cost of borrowings * Cost of equity Cost of debt WACC NOPAT as a % of capital employed Cost of Capital EVA
* Assumptions

(Rs m) 500 7,500 8,000 2,000 10,000 0.8 0.2 1,500.0 11.0% 1.1 15.0% 33.0% 12.5% 15.4% 8.4% 14.0% 15.0% 1,400 100

As calculated in the above example the company has generated EVA of Rs 101 m. That means maintenance of shareholder value will require the company to earn NOPAT over Rs 1,400 m. In other words the % of NOPAT to capital employed should be greater or atleast equal to the % of WACC. Where do I use the concept In the present market scenario every second company is making an attempt to impress the investors, with their excellent financial performance showing the high growth rate. With the limited resources available the investor is confused as to who is better and why? Here comes the concept of EVA, which helps the investors in simplifying investment decision making. Apart from

Equitymaster-Knowledge Centre-Intelligent Investing

42

looking at only P/E or EPS of the company, EVA helps the investors to see whether the valuation of the company really justifies the high or low P/E. EVA & P/E EVA is the measure and reflection of a good management. A good management is one which can Create value, Give value and Get value. To achieve this the management of the company has to deploy more and more capital to those activities wherein the amount of NOPAT generated by the activities is greater than the amount of WACC. Then only they will be able to generate real wealth for their stakeholders. So who are these stakeholders they are our mutual funds, pension plans, life insurance policies, and many small investors, which represent the vast majority of stock ownership. Our largest institutional investors represent the savings of everyday citizens. Investors invest their savings and bear risk, in the hopes of the best return possible. There are very few companies in India, which are successful in generating EVA. As a reason these companies have been given premium valuation on the bourses. HLL, Infosys and Dr. Reddys have been given the premium valuations by the market not only based on their EPS performance but also on the basis of their ability to consistently increase shareholders wealth. The graph hereunder presents the growth pattern of EVA of Infosys and HLL, two companies that have been successful in generating wealth and this is also reflected in their market cap.

The corporates, which were paying lowest preference to the shareholders interest, are now giving the highest preference to it to generate value for shareholders. The true example of this is the software viral, which affected investors in the past few months. Even though in short term these software companies might provide a good return to investors, in the long term only those companies will be able to survive which are actually generating the returns. EVA is too sophisticated a tool for lay investors to use. They may not indulge in the exercise of computing it but must try to understand from the numbers reported by the company whether it is

Equitymaster-Knowledge Centre-Intelligent Investing

43

generating a positive or negative EVA. Investors should be cautious enough in selecting companies, which have high EPS but low EVA and consequently lower ROCE and RONW. So only those companies can be called as Real Wealth Creators, which know the above principals. As it is rightly said by someone You only get richer if you in vest money at a higher return than the cost of that money to you. Everyone knows that but many seem to forget it

Perception vs Valuation: Directly proportionate?


Revered investment analysts the world over have constantly drilled into our minds that it pays to be invested in companies whose managements are perceived to be focused and proactive. A good management always commands premium valuations for the stock. The logic is justified given the fact that the managements attitude towards the company determines the growth curve it takes. Lets test this reasoning and see whether the logic really holds good for Indian companies. For the study we took some companies known for their reputed managements. The sample includes the likes of Infosys, HDFC, HDFC Bank, HLL, Hero Honda, Punjab Tractors and Dr. Reddy's. HLL vs contemporaries FMCG major, Hindustan Lever (HLL) is a prime example of what management perception can do to the valuations of the stock. HLL has always commanded premium valuations not only because of its size, but its consistent good performance. Though another FMCG company, Nirma, too has put in good performance year after year, it still lags behind when it comes to valuations. Though Nirmas management is considered to be very focused on its business, it is HLLs management that is considered to be more pro-active between the two. HLLs management has continually expanded its topline by adding more products and businesses, either organically or inorganically. It spreads the companys risk. Mkt. Cap. (Rs m) ROE (%) P/e (X) HLL Nirma Godrej Soaps 445,727 21,687 4,260 50.9 27.3 20.2 41.7 9.3 7.0

Equitymaster-Knowledge Centre-Intelligent Investing

44

If you look at the valuation table, it looks as if Godrej Soaps is back with a bang. But this revival in fortunes of Godrej Soaps can also be attributed to a large extent on the right moves the companys management has been making in the last one year. The management has broken the company into two, to lend more focus to its FMCG business. The company has been repaying its debts in a bid to improve its profitability. All this has not gone unnoticed by the bourses. The valuations of the company have started to improve in the past couple of months, as the markets perceive the management to be on the right track. HDFC vs contemporaries Indias leading housing finance company, Housing Development Finance Corporation Limited (HDFC) is another fine example. HDFC is a pioneer in housing finance in India. The company controls 70% of this market. Its consistent performance, both financial as well as in customer satisfaction has helped it retain its market share in this business. Despite new entrants in the business in the recent years, it continues to be the leader. Because of its carefully laid out huge branch network it is able to service its consumers efficiently. HDFCs management is rated very highly for its focused approach to its business. In contrast aggressive entrants like ICICI have historically taken on more NPAs. Mkt. Cap. (Rs m) ROE (%) P/e (X) HDFC LICHF ICICI 66,702 2,586 76,332 19.2 19.3 15.7 16.6 2.4 6.3

While the competition plays catch up with HDFC, the company has branched out into banking, insurance, mutual funds and retail loans. Its subsidiary, HDFC Bank, is already the fastest growing private bank in India. Even this subsidiary, is valued highly because of the management feel good factor. Mkt. Cap. (Rs m) ROE (%) P/e (X) HDFC Bank ICICI Bank SBI UTI Bank Infosys vs contemporaries Lets take a look at one company, which has now become synonymous with the Indian software revolution, Infosys. The company not only has been turning in good performances quarter on quarter, but is also at the forefront of management reporting. Infact, Infosys annual report was 61,331 33,656 124,733 5,447 16 9.2 16.9 21.3 51.1 31.8 6.1 10.7

Equitymaster-Knowledge Centre-Intelligent Investing

45

one of the first in its kind in India that gave complete disclosure on the companys operations to its investors. This small act must have added tons of goodwill to its valuations. Since then, disclosures by companies in their annual reports and measures to improve relations with investors have touched new levels in Corporate India. This proactivity and foresight has helped Infosys become one of the most valuable companies in the country, adding to shareholder wealth year after year. Mkt. Cap. (Rs m) ROE (%) P/e (X) Infosys Satyam Visualsoft Silverline Hero Honda vs contemporaries In the two-wheeler segment, it is not for nothing that the Munjal family is revered. The familys motorcycle joint venture with Honda Inc, Japan, Hero Honda, redefined the shape of the twowheeler industry in India. At a time when Bajaj Auto was the uncrowned king of this segment (read scooters), the Munjals had foresight to gauge a shift in consumer preferences towards motorcycles. For this, they were amply rewarded. Not only the company, Hero Honda, became the undisputed king of the two-wheeler segment but in the process created a lot of wealth for its investors. Till today, the companys distribution muscle coupled with its top of the line bikes, command the consumers as well the investors loyalty. Mkt. Cap. (Rs m) ROE (%) P/e (X) Hero Honda Bajaj Auto TVS Suzuki Punjab Tractors vs contemporaries The management of Punjab Tractors, part of the Swaraj Group, is not as high profile as some of the leading business houses in India. But the companys silence is more than made up by the consistent performance of the company. The company is focused on the tractor segment, unlike market leader Mahindra & Mahindra. It is this focus that has paid it rich dividends in terms of shareholder value. Whenever, the agriculture sector in India is on an upturn, Punjab Tractors is the first one to reap the dividends. On the other hand, whenever a bad crop comes by, Punjab Tractors focus helps it tide through the difficult situations smoothly as compared to its rivals. The companys prudent financing policies and working capital management has kept it at the forefront of providing the maximum return to investors. 33,749 22,386 4,331 43.3 19.1 27.4 17.6 3.7 5.0 428,255 107,682 15,720 15,738 34.3 149.8 38.5 31.9 15.3 79.8 55.9 22.3

Equitymaster-Knowledge Centre-Intelligent Investing

46

Mkt. Cap. (Rs m) ROE (%) P/e (X) Punjab Tractors M&M Escorts Dr. Reddys vs contemporaries In the last few years, the domestic Indian companies have seen a big re-rating in their valuations. This has come in the wake of the advances made in the field of Research and Development (R&D). The company that spearheaded the Indian R&D effort was Hyderabad-based Dr. Reddys Laboratories. The companys pioneering efforts to discover new molecules, ahead of the much dreaded product patent regime post 2005, tilted the balance in favour of homegrown pharmaceutical companies. This encouraged many other domestic companies to have faith in their R&D effort and increased investments in this area. Its no wonder then that Dr. Reddys sits at the top of heap in terms of valuations, even ahead of the MNC pharmaceutical companies in India. Mkt. Cap. (Rs m) ROE (%) P/e (X) Dr. Reddy's Ranbaxy Sun Pharma Cipla 34,516 79,223 9,311 70,165 15.8 13.8 28.7 23.1 57.2 40.7 10.3 52.7 12,663 18,782 8,841 35.8 14.7 11.9 9.5 6.8 7.9

These are just a few examples, but are enough to conclude that the goodwill the management generates reflects on the valuations of the companies. Whether the goodwill comes due to management focus, foresight or proactivity, it adds to the shareholder wealth. But it must be added here, that a good perception of the management is borne by years of solid performance and doesnt build overnight. No short cuts to this.

Dow Theory: An insight


Technical Analysis, a branch of stock market analysis, is built on the premise of studying past data to arrive at some meaningful interpretation (trends) to help forecast future stock price behaviour. The branch is at loggerheads with fundamental analysis that studies the business prospects of a company. It attempts to arrive at the future earnings, which may or may not be reflected in the current market price. Technical analysis or charting is also not very popular with believers in the

Equitymaster-Knowledge Centre-Intelligent Investing

47

random walk, which states that future prices are independent of past price behaviour. Further, if price movements are random then there are no trends. Despite a strong lobby against the study, technical analysis has held its fort and is an integral part of any stock market analysis. The Dow Theory, is one of the earliest studies based on technicals or charting. As per the theory, movements in stock market aggregates or individual stock prices can be expressed in three types of ways. Primary, Secondary and Minor moves. Primary Moves These are major moves of the aggregates or individual prices, which can either be bullish or bearish.

Secondary Moves A secondary move is an important decline in a bull rally or an advance in a bear market. These movements are considered to add further strength to the underlying primary move. The secondary move generally last for 3 weeks to several months during which time the move retraces between 33% to 66% of the primary move since the last secondary.

Equitymaster-Knowledge Centre-Intelligent Investing

48

Minor Move These are the daily fluctuations in the market and last for a maximum of 3 weeks. They do not imply or impact the current trend. Other Signals In the case of market aggregates or stock prices trading within a band. The theory hypothecates that such movements could indicate one of the two cases. Accumulation: Stocks flowing into the hands of the knowledgeable investor, which is a positive sign. Distribution: Stock flowing into weak hands, which is not a healthy sign for the markets or the stock. Indication of a new trend is established when the line (market aggregate or stock price) breaks the floor or ceiling of the band. If the line has broken the floor then it signals a bearish trend. While a move above the ceiling denotes a bullish signal. Price - Volume Relationship The normal relationship between market aggregates or stock price and volumes is direct. Volumes should expand on rallies and contract on declines. Rallies on low volumes or vice versa are not a healthy trend and one can expect a reversal. Further, a bull signal is indicated if every primary peak surpasses the previous peak and every subsequent decline is above the previous secondary. A bear signal is when every decline surpasses the previous bottom and intervening advances are lower than the previous one. Bull & Bear Markets - The theory also defines a bull and bear market and the stages involved.

Bear Market: A long decline interrupted by important advances. It starts with participants abandoning expectations on which the stocks were first purchased. This is followed by

Equitymaster-Knowledge Centre-Intelligent Investing

49

companies failing to meet their earning targets, which leads to another round of sell off. Finally, there is complete gloom, as selling prevails irrespective of the inherent value. This could be due to depressed conditions or forced liquidations, which occur as a result of stop loss or for meeting margin calls. Feels like dj vu.

Bull Market: A long advance interrupted by important declines. The rally starts with market aggregates or stock prices reflecting the worst possible scenario and outlook on the future begins to revive. This followed by companies surpassing the expectations of investors leading to further optimism in equities. The last stage is when there is excessive optimism, which leads to speculation and market aggregates and stock prices reflect the best possible or impossible (bubbles) future scenario. Technical analysis is not concerned with the state of the economy or the future earnings capacity of a company. Therefore, it is not concerned with the true value of a stock or a market aggregate and is not a tool for determining the same. However, technical analysis could facilitate in identifying short-term trends, which can assist the investor in timing his equity transaction.

Net asset value: unlocks hidden potential


How do we value companies? This is a question which often comes up in the mind of investors. Well the basic valuation techniques hold good for most companies across sectors. Some of these are earnings, revenue, cash flows, net asset and brand valuations. The purpose of this article is to familiarise investors with the methodology of calculating Net Asset Value (NAV). This valuation technique unlike most others is not available in finance books, but is essential in valuing certain type of companies, especially those which have a large asset base.

Equitymaster-Knowledge Centre-Intelligent Investing

50

Net Asset Value Net Asset Value (NAV) is popularly used as a valuation parameter around the world for valuing real estate, shipping and hotel companies. This technique is important when an investor wants to invest in a company which has a large asset base and the usage of assets are critical to the company's earnings capacity. It attempts to reflect the true market value of the company to its shareholders. Let's take a simple example like that of a hotel property. For example if the "Taj Mahal hotel" in Mumbai were to be bought by an investor (to be used in future as a hotel or for some other purpose), what would be the value that the investor is willing to pay for the same. If here we say that in future it would be continued to be used as a hotel, then the average industry replacement cost benchmark has been pegged at Rs 5 m per room for a five star deluxe hotel, excluding the cost of land. This is basically what the market is willing to pay for the hotel, based on returns it expects if the property were to be used a hotel. The property valuation will be done taking into account the cost per room of a five star hotel and the land valuation. Or incase the particular investor plans to start a new hotel property in South Mumbai to compete with this existing hotel, what would be the kind of investment he would have to make at current market prices for land and construction. In large asset base companies like real estate, shipping and hotel companies where usually the historical cost of assets purchased is not comparable to its current market value this parameter is widely used. The net asset value is basically the price that an investor maybe willing to pay based on expected future cash flows the market expects from that particular asset. There are two basic methods used for calculating NAV, one is the replacement cost method and the other is the future cash flows method. Of these the former is more widely used as it takes into account the replacement cost of assets at current prices, and is hence more realistic and widely used by equity analysts. The future cash flow method takes into account a longer time frame and is more theoretical, hence is more uncertain from that angle. However it is a useful technique when making an acquisition or taking an equity stake in a company, as the investor will be interested in the future cash flows expectations of the particular investment it plans to make. Practically though NAV has been rarely used for valuing Indian hotel companies as hotel assets in India have never really been traded. However this concept is interesting from an investor's perspective when valuing these kind of companies. It attempts in unlocking the true value of a company's properties and brands. It is a useful valuation technique to be used in times of a takeover, acquisition or investment. Besides using the usual valuation principles of earnings or revenues, it helps in understanding that for particular type of companies their assets are the key to valuations.

Equitymaster-Knowledge Centre-Intelligent Investing

51

Net asset value on replacement cost basis To take a very simple example of replacement cost of assets, we have calculated the replacement value of the Oberoi Hotels, Mumbai. As the per the industry estimates the construction cost per hotel room works out Rs 5 m for a five star deluxe property. The Oberoi hotels has 912 rooms, hence its cost of construction works out to Rs 4.6 bn. Besides this we have to take into account the cost of land, on which the hotel is built. To take a comparison of a sale of a similar property, ITC Ltd paid approximately Rs 2 bn for a four acre plot in North Mumbai to build a hotel. Hence the price per square foot works out to approximately Rs 11,400. This sale however took place three-four years ago at peak land rates. Assuming that prices have fallen by 40%-50% since then, and keeping in mind that South Mumbai commands a premium as compared to North Mumbai, we assume that to buy land for a hotel (with FSI) in South Mumbai today would cost around Rs 7,500 on a very conservative basis. The Oberoi hotels is built on a 3.4 acre plot of land and hence the replacement cost of land works out close to Rs 1.1 bn. The total replacement value of Oberoi, works out to Rs 5.7 bn. We have attempted to calculate the net asset value of two of India's largest hotel chains, Indian Hotels Company Ltd and EIH using this method. As both of them have prime properties, widespread hotel network and capital cost advantage it would be interesting to know their replacement cost values on current market prices. Indian Hotels (IHCL) owns 17 hotels and has an equity interest and manages around 30 more. EIH on the other hand owns 10 hotels and manages 4 hotels across the country. EIH's and IHCL's NAV using the replacement cost method Net asset value on replacement cost for EIH 1 Valuation of owned and leased land = Total area in sq ft X price per sq. ft = 4,457, 625 area in sq. ft x Rs 2,001 per sq. ft Total value = Rs 8,917 m 2 Valuation of hotels = Number of rooms * average cost (Replacement cost excluding cost of land) Value of hotels 3 Add other cash and non cash assets 4 Less all external liabilities Net asset value = 1 + 2 + 3 - 4 No. of shares o/s (m) Net asset value per share = Total 1,828 rooms x Rs 4.9 m construction cost per room = Rs 8,896 m Rs 3,839 m as at 30th March'2000 Rs 3,167 m as at 30th March'2000 = Rs 18, 485 m = 52.3 = Rs 353

Equitymaster-Knowledge Centre-Intelligent Investing

52

Net asset value on replacement cost for Indian Hotels 1 Valuation of owned and leased land =Total area in sq ft X price per sq. ft = 3,364,682 area in sq. ft x Rs 1,737 per sq. ft Total value = Rs 5,846 m 2 Valuation of hotels = Number of rooms * average cost (Replacement cost excluding cost of land) Value of hotels 3 Flight catering Flight catering 4 Add other cash and non cash assets 5 Less all external liabilities Net asset value = 1 + 2 + 3 + 4 - 5 No. of shares o/s (m) Net asset value per share =Total 3,001 rooms x Rs 4.4 m construction cost per room = Rs 13,354 m = 2x sales = Rs 850 m x 2= Rs 1,700 m Rs 7,829 m as at 30th March'2000 Rs 4,323 m as at 30th March'2000 = Rs 24,406 m = 45.1 = Rs 541

The above figures do not include the brand values of Indian Hotels' 'Taj' brand and EIH's 'Oberoi' brands. They also do not include the market value of assets of the company's investments in affiliate companies, as we have taken into account investments of the company as stated in the books. Hence our net asset valuation is more on the conservative side. EIH has 10 hotels with a total room base of 1,828 rooms, and considering that 89% of the room base is contributed by its five star hotels, the replacement construction cost per room works out to Rs 4.9 m per room. EIH has a total land bank (owned and leased land) of 4,457,625 square feet and the average price per square feet for all its properties in Mumbai, Delhi, Bangalore, Calcutta and others works out to Rs 2,000 per square foot. In our calculation for replacement cost the lease properties are taken into account as majority of these are for long periods of time, like 99 years and hence in that sense are as good as owned. On a replacement cost basis if a new company was to enter these cities, we have to take into account the lease properties in our calculation as the scarcity of land may not allow new players to lease out such properties but actually take them on ownership basis. Indian Hotels has 17 hotels with a total room base of 3,001 rooms. The replacement construction cost per room in the case of IHCL works out to Rs 4.4 m per room, as 67% of total room base is in the five star category. IHCL has a land bank of approximately 3,364,682 square feet and average price of this works out to Rs 1,737 per square foot.

Equitymaster-Knowledge Centre-Intelligent Investing

53

(Rs) Indian Hotels Co. Ltd EIH Ltd

Current share price NAV per share Share price disc. / prem. to net asset value 226 153 541 353 -58.2% -56.8%

If the current market price of the company trades at a huge discount to its net asset value per share, it implies upside to its share price on the basis of this technique and vice versa. In India investors still continue to largely focus on traditional valuation techniques to value hotel companies. However this tool will be of use in future with the entry of foreign hotel chains and for acquisitions and takeovers by foreign hotel chains in the country. This technique will be useful to shareholders and hotel companies in unlocking their true potential and value.

Equitymaster-Knowledge Centre-Intelligent Investing

54

Level 3: How to create your own portfolio Equitymaster Portfolio: Revisited


The Oxford Dictionarys definition of investment is the act or process of investing. Now, what is investing? To understand what is Investing the definition states that (a) apply or use of money, esp. for profit (b) provide, endue or attribute. There are two vital points to observe from the definitions. Firstly, investing is application of money that is hard earned for a profit (not to lose principal) and it encompasses providing or attributing money (in this context it is time frame). After having understood the meaning of Investing, one of the first questions that arise in the mind of retail investors is Where should I invest my money? In this context there are various avenues ranging from National Savings Certificates to bank deposits. But since returns from such investments do not earn much over a longer term, especially when interest rates are falling, the most-favored and misunderstood investment avenue is equities. After having identified equities as a better investment alternative, the next question in a persons mind is Which stock should I invest in? Unfortunately the answer to this question is not quite simple and depends on a number of factors that includes risk appetite of the investor (i.e. Am I willing to forego my principal for higher returns?). We at Equitymaster devised a portfolio in 2000 to show the power of prudent investing and a clear diversification strategy. Our portfolio has been divided into three categories. CORE: These have been defined as stocks that can be held by investors across most age brackets and status. These stocks represent companies with very good management and strong financial performance over the years. One criterion that we applied to these stocks was how they fared in the recent downturn in economic activity. Other issues considered included - position in sector, prospects for the sector itself. STARS: Companies that have good managements, sound financial track record and good prospects but not without risks. These companies, to put it in a way, are not in the core list because there are certain issues that have made them more 'risky' than the core stocks that have been identified. FLYERS: This group represents stocks that have high risks associated with them. Nevertheless, they are in

Equitymaster-Knowledge Centre-Intelligent Investing

55

a situation where they can leverage on their present position (Zee for instance) to generate returns much in excess of their peers. PORTFOLIO: The number of companies in our portfolio comprising core, star and flyers are 44. Of this, there are 9 companies in our Core list, 17 stocks in the Stars category and 18 in Flyers. We allocated Rs 1,000,000 to each stock for equal weightage. Our basic approach towards selecting companies for our portfolio was a bottom-up approach because there are sectors like housing that continue to grow at a brisk rate despite a slowdown in the economy. We had deliberately entered the buy price of all stocks as of January 1, 2000, the peak times during the tech rally to prove investors that even if one invests at high prices, investing in good companies with a long-term perspective can be fruitful. To put things in perspective, the buy price of Infosys as on that date was Rs 7,839 (Core), Aventis Pharma Rs 1,119 (Stars) and Telco Rs 217 (Flyers). The next crucial question is, How has the portfolio performed when stocks markets have exhibited extreme volatility in the last three years? The performance chart (% gain/loss) 1-month 3-months 6-months 12-months Since Jan`00 CATEGORY Core Stars Flyers Portfolio BSE Sensex CNX Nifty Nasdaq Dow -2.6% -4.5% -6.5% -4.7% -4.6% -4.8% 7.9% 12.9% -2.0% -3.2% -2.9% -2.9% -3.3% -6.0% -14.5% -10.4% -6.6% -6.5% -6.8% -6.6% -13.7% -14.3% -17.1% -7.9% 18.6% 10.9% 1.2% 9.5% -6.6% 15.5% -24.4% -12.3% 3.8% -21.9% -27.4% -19.8% -41.6% -38.1% -63.9% -17.2%

INDICES

Consider the performance of all the major indices like BSE Sensex, NSE Nifty, NASDAQ and Dow Jones since January 2000. While NASDAQ has fallen by as much as 64%, Sensex and Nifty are lower by 42% and 38% respectively. Dow Jones, on the other hand, has declined by 17%. Given this backdrop, we analyse the performance of each category. CORE: This is obviously an elite category that has proven track record, a creditable management and

Equitymaster-Knowledge Centre-Intelligent Investing

56

generate wealth for the investors. Commodity and FMCG stocks account for 13% and 31% of market value of core portfolio respectively. The rest is spread between financial institutions, energy and software sectors. Infosys is the only software stock in the Core portfolio. Coming to the performance, of the nine stocks in this list, there are only four gainers viz. Asian Paints, BPCL, HDFC and Nestle. Buoyancy in housing demand and favorable interest rates has benefited both Asian Paints and HDFC over the years. While HDFC is up 94% since January 2000, Asian Paints has added 49% wealth to the shareholders. BPCL has gained significantly over the last two years on the back of disinvestment expectation. Nestle, despite a slowdown in the economy, has managed to outperform its peers. Since January 2000, the value of Core portfolio has appreciated by only 4%. While returns may not be encouraging, one has to apply relativity theory to stock markets and gauge a trend. Also one has to keep in mind the buy prices. On the other hand, if one were to consider the performance in the last 12 months, the Core portfolio has appreciated by 19%, which is commendable by any yardstick. We have also compared our portfolios performance with three top mutual funds in the country. Barring Zurich Indias Growth Fund, the portfolio has outperformed all other funds. This goes to show that prudent and diversified investment strategy does create wealth in the long run. Comparison with Mutual Funds 1-month 3-months 6-months 12-months -2.6% -4.5% -6.5% -4.7% -0.8% -3.4% -1.2% -2.0% -3.2% -2.9% -2.9% 3.5% 1.5% 2.2% -6.6% -6.5% -6.8% -6.6% -5.3% -6.3% 1.4% 18.6% 10.9% 1.2% 9.5% 16.3% 12.2% 33.5%

(% gain/loss) Core Stars Flyers Portfolio

Pioneer ITI Bluechip (Growth) Fund Templeton India Growth Fund Zurich India Growth Fund STARS

This is a highly diversified portfolio comprising 17 stocks across the board. Auto, energy and pharmaceutical sectors account for 20%, 24% and 12% of market value of this bunch. Stocks like ACC, Aventis, Cipla, Colgate and Hero Honda find place in the Star category because of some risk element. While Colgate is a single product company, Hero Hondas agreement with Honda is expiring in FY05. Reliance also falls into this category because of management issues.

Equitymaster-Knowledge Centre-Intelligent Investing

57

Of the 17 stocks, there are only six gainers since Jan 2000 that includes ABB, BSES, GAIL, HDFC Bank, Hero Honda and HPCL. Hero Honda clearly is the top performer. The stock is up 135% since Jan 2000, which goes to show how a strong and visionary management can add value to the shareholders. Overall, given the medium-risk-medium-return profile of the stocks, the portfolio has been volatile since Jan 2000. However, it has managed to outperform all indices. Looking at the past one-year performance, the portfolio has gained 11%. FLYERS This is a high-risk-high-return portfolio. But as we have specified above, they are in a situation where they can leverage on their present position to generate returns much in excess of their peers. Select Tata Group companies like Tata Power and Telco find place in this group. Ranbaxy, MTNL, Grasim, HCL Tech, L&T, Pfizer and SBI are the other prominent companies in this list. Of the 18 stocks, there are only three gainers since January 2000 viz. EIH, ICICI Bank and Tata Power. While ICICI Bank is the star performer of the group (up 79%), Tata Power is higher by 36%. Overall, the portfolio has lived upto its name with extreme volatility. The portfolio is lower by 27%. A re-look at our portfolio Even though we believe in long-term investing, it is important to review ones portfolio once in a year to analyse whether they have performed to their mark. If not so, what is the reason for the same? Not because they are not the flavour of the season anymore, but because of the fact that the companys management has failed to deliver, when si tuation demanded their best. Downgrades HDFC was the only downgrade this time. The stock has been shifted from Core to Stars. The housing finance major, despite its expertise and leadership in the sector, faces severe pressure on spreads in the near future. With PSU majors like SBI going overboard on increasing contribution from the housing loan division, HDFC market leadership is being threatened. The companys diversifications like insurance are long gestation businesses and returns may not live up to expectations. Keeping this in mind, atleast for the next two years, HDFCs profitability could be affected. Upgrades Dr. Reddys and SBI are the two upgrades. While Dr. Reddys has been upgraded from Stars to Core, SBI is promoted from Flyers to Stars. Strong performance in the generics business and the agility displayed by Dr. Reddys management to move up the value chain is quite impressive. The

Equitymaster-Knowledge Centre-Intelligent Investing

58

company is fast emerging as a speciality pharma company. The company's research pipeline holds potential and there is better visibility emerging in the ANDA (Abbreviated new drug application) pipeline. Meanwhile, SBI is revamping its business strategies, which is reflected from its speedy efforts in implementing technology and retail focus. It has also restructured its business and as a result productivity ratios have improved. Exit from select non-core businesses like mutual funds is also on the anvil. The new ones Gujarat Gas and IDBI Bank are the new inclusions. Both stocks were added to the Flyers category as IDBIs stake in the bank is the big negative and Gujarat Gas has limited supply constraints. Conclusion While making an equity investment decision, keep in mind that one is buying the business of the company and not its EPS alone. Warren Buffet in his annual shareholders letter 1998 wrote and we quote: Our policy is to concentrate holdings. We try to avoid buying a little of this or that when we are only lukewarm about the business or its price. When we are convinced as to the attractiveness, we believe in buying worthwhile amounts. Bottomline, be convinced and dont lose focus amidst the noise around you.

Equitymaster portfolio A review


"Disinvestors lose as market falls -- but investors gain" Warren Buffet in his annual shareholders letter 1997. Before making investment decisions, the importance of asset allocation cannot be understated. Investment avenues, on a broader basis, can be classified as equities, real estate, bonds, mutual funds, gold and fixed deposits. Depending on the risk profile of an investor, i.e. age profile and expected returns, proportion of each category of the total investment would vary. For instance, the risk appetite of a 25 old person would be higher when compared to a 40-year-old working executive. For the former, the equity component is likely to be on the higher side and for the later, the real estate, fixed deposits and cash component would be proportionately higher. Click here for Your Asset Allocation Review

Equitymaster-Knowledge Centre-Intelligent Investing

59

Now, if a retail investor, after determining the asset allocation component, decides to invest in equities, the next question would be, where and which companies should I invest? Returns from equities, broadly speaking, are comparatively higher than all other investment avenues. And so are risks of investing in equities. Equities are generally subject to various risks like market risk, business risk, interest rate risks and so on. So depending on the risk profile, we have clubbed companies under three broad sub-divisions. CORE: These have been defined as stocks that can be held by investors across most age brackets and status. These stocks represent companies with very good management and strong financial performance over the years. One criterion that we applied to these stocks was how they fared in the recent downturn in economic activity. Other issues considered included - position in sector, prospects for the sector itself. STARS: Companies that have good managements, sound financial track record and good prospects but not without risks. These companies, to put it in a way, are not in the core list because there are certain issues that have made them more 'risky' than the core stocks that have been identified. FLYERS: This group represents stocks that have high risks associated with them. Nevertheless, they are in a situation where they can leverage on their present position (like national presence for ACC) to generate returns much in excess of their peers. The performance chart (% gain/loss) 1-week 1-month 3-months 6-months 12-months Since Jan`00 Core Stars Flyers Portfolio BSE-30 CNX Nifty Nasdaq Dow 4.5% 1.1% 2.3% 2.4% 5.1% 4.7% 4.6% 1.6% 8.9% 1.3% 6.7% 5.1% 11.8% 11.1% 8.9% 3.3% 6.4% -3.1% 10.6% 3.9% 8.1% 7.9% 17.5% 3.3% 4.3% -3.6% -10.1% -4.0% -1.5% -1.0% -10.1% -9.6% 4.3% -8.4% -16.3% -8.3% -17.2% -15.1% -31.7% -7.4% -5.4% -15.2% -27.4% -17.6% -34.7% -30.0% -49.4% -9.3%

We had deliberately entered the buy price as of January 1, 2000, the peak times during the tech rally to prove investors that even if one invests at high prices, investing in good companies with a long-term perspective can be fruitful. To put things in perspective, the buy price of Infosys as on

Equitymaster-Knowledge Centre-Intelligent Investing

60

that date was Rs 7,839 (Core), NIIT was trading at Rs 3,581 (Stars) and Zee was at Rs 1,180 levels. PORTFOLIO: The number of companies in our portfolio comprising core, star and flyers are 48. Of this, there are 11 companies in our core list, 17 stocks in the stars category and 18 in flyers. We allocated Rs 1,000,000 in each stock thus resulting in equal weightage. Our basic approach towards selecting companies in our portfolio was a bottom-up approach because there are sectors like housing that continue to grow at a brisk rate despite a slowdown in the economy. The number of TMT companies in our portfolio are just 5 (Infosys, NIIT, VSNL, MTNL and Zee). The rest is spread between services (banking and financial institutions) and old economy companies from a bunch of sectors that includes FMCG, auto, commodities, hotels, energy and power. Before going any further, we look at the performance of the each category of our portfolio. Core This set is highly diversified with companies from both high growth areas like software and pharma to relatively stable performers from FMCG sector. Given the state of infrastructure in India, exposure to commodities also makes sense. If one were look at the sector-wise weightage, FMCG sector accounts for 27% value of investment. Cement and aluminium sector account for another 18%. Of the 11 companies in our core list, there are only four gainers (once again we would like to remind you that we are comparing with prices as on January 1, 2000). Asian Paints, BPCL, HDFC and Nestle are the ones that have outperformed every benchmark. The clear out performer in our core list is the housing finance major, HDFC. While all the global and domestic indices are down 35%, the stock has gained 124%. But all is not rosy in our core list of companies. HLL, Indian Hotels, Infosys and Gujarat Ambuja have fallen significantly in the last one-year. While Glaxo has come for criticism for not introducing new products in the Indian market, unfavorable economic environment and weaker sentiment affected valuations of the other companies. After all long-term investing is not just about a year. HLLs understanding of the Indian market, Gujarat Ambujas low-cost competitive edge, Indian Hotels unmatchable asset profile and Infosyss management cannot be doubted. In the long run, one can expect these companies to outperform the industry and its peers.

Equitymaster-Knowledge Centre-Intelligent Investing

61

(% gain/loss) Core Stars Flyers Portfolio

Comparison with Mutual Funds 1-week 1-month 3-months 6-months 12-months 4.5% 1.1% 2.3% 2.4% 3.6% 1.8% 0.9% 8.9% 1.3% 6.7% 5.1% 9.4% 10.1% 11.8% 6.4% -3.1% 10.6% 3.9% 15.2% 15.8% 23.9% 4.3% -3.6% -10.1% -4.0% -3.7% 3.3% 12.1% 4.3% -8.4% -16.3% -8.3% -17.9% -5.4% -3.2%

Pioneer ITI Bluechip (Growth) Templeton India Growth Zurich India (Growth)

Star Though this is a diversified portfolio, the proportion of pharma and auto companies is one on the higher side because of growth prospects. First lets look at the selection process. Domestic pharma majors like Dr. Reddys, Cipla and Ranbaxy are in this category because they are relatively new to R&D and clinical trials. Though the growth prospects are promising, much depends on R&D efforts taken by these companies and so, to that extent the risk profile increases. Colgate, despite being investor friendly and having a committed parent company to boot, is largely a single product company. Similarly, Hero Honda faces the challenge of Hondas exit from the joint venture. Out of the 18 Star companies, just 4 companies are on the positive side. This includes BSES, EIH, Hero Honda and HDFC Bank. Hero Honda and HDFC Bank are up 106% and 29% respectively since January 2000. If you look at the performance of this lot in the last twelve months, the returns are mid-way between core and flyers category. This, in itself, puts forth the nature of the portfolio. Flyers This is a high risk-high return portfolio. Of the 17 companies in this list, there are only three gainers namely Tata Power, ICICI Bank and Reliance. Though ICICI Bank is aggressive on the retail front, its investments in various subsidiaries and technology ventures are one worrying aspect. Besides, the proposed reverse merger with the parent company (ICICI) is also a cause for concern. Similarly ITCs investment in hotels and greeting cards would have a negative impact on profits in the long run. If one were to look at the performance of this lot in the last 3 to 12 months horizon, there has been a sharp fall, as well as a sharp recovery in returns. While returns from this category are 16.3% in the last twelve months, when the markets recover, they are first ones to turn around (10.6% in the last three months).

Equitymaster-Knowledge Centre-Intelligent Investing

62

A re-look at our portfolio After more than a year and a half, we reviewed our companies recently and some changes were required. Not because they are not the flavour of the season anymore, but because of the fact that the companys management has failed to deliver, when situation demanded their best. Downgrades Glaxo Smithkline and Indian Hotels, for instance, have been shifted from the core to the stars category. Glaxos management is averse of introducing new drugs in India in absence of proper patent rights. Though they have a valid reason to do this, investors have lost almost 58% since January 2000. If Aventis Pharma (formerly Hoechst), operating in similar environment, has managed to introduce new drugs and managed to grow, so can Glaxo. Indian Hotels management has failed to stem the slide in profits and at times displays lack of focus. Also competition has increased and the industry is reeling under pressure due to excess capacity in key markets. EIH, NIIT, Ranbaxy and VSNL also have been downgraded from stars to flyers. Ranbaxys investments in stock markets have raised apprehensions about the focus of the company. NIIT, though a market leader in the software education business, has group companies competing in similar areas (HCL Technologies and HCL Infosys). This has forced us to rethink its risk profile. VSNL faces a double whammy. While on one front the government is preparing the ground for its divestment, on the other, opening up of the international long distance telephony has posed new challenges to the company. Thus the company is now showing stagnation in revenues and falling profits. But VSNL is now categorized as a Flyer on the hopes that disinvestment may bring in new growth avenues for the company. Upgrades Reliance and ACC have been shifted from flyers to stars category. ACC initially was there in the flyers list because it was a tentative turnaround story (it may or might not happen). Now with Gujarat Ambuja raising its stake in the company, one can expect a consistent performance from the company in the coming years. We had included Reliance in the flyers category because of concerns about financial reporting standards. Though the concern still remains, the sheer scale of operations coupled with its project execution skills cannot be understated. Its global efficiency standards also have to be reckoned with. The also ran (Deletions) We have removed Novartis and TVS Motor Company (formerly TVS Suzuki) from our portfolio. Though TVS is backed by a management with high level of integrity, its product profile and lack of

Equitymaster-Knowledge Centre-Intelligent Investing

63

aggressiveness are expected to slow profit growth in the coming years. Novartis lacks a competitive edge in the otherwise highly competitive pharma sector. And there have been no positive developments to kick start growth also. The new ones We have included Wipro (Stars), GAIL (Stars) and HCL Tech (Flyers). The reason why Wipro was included in the Stars category and not in the Core portfolio is because the promoter holds 85% stake in the company and the management is yet to announce any succession plans. But the management team can be rated at par with that of Infosys (after all, Wipro has created more than 65 entrepreneurs). Gas Authority of India (GAIL) is the clear market leader in the gas transportation segment. The cross-country pipeline traverses a distance of 1,700 kilometers and with extensions measures up to 2,300 kilometers. But sales growth of the company continues to be dependent on gas availability. Therefore, GAIL does face a supply risk. Conclusion Our policy is to concentrate holdings. We try to avoid buying a little of this or that when we are only lukewarm about the business or its price. When we are convinced as to the attractiveness, we believe in buying worthwhile amounts. Warren Buffet in his annual shareholders letter 1998 In line with the Berkshire Hathway philosophy, we keep trying to pick the very best available on the Indian stock markets. We must admit that its a constant learning process. Every now and then markets make a fool of everybody and we have been no exceptions. But in the long run, we are confident that it is not the flavour of the month or even the year that counts. What count is fundamentals, and thats what we bank on.

The Core, Stars and Flyers


The Nasdaq has fallen by almost 46% in the last one year. The benchmark BSE-30 has also fallen by 35% in the same period. The valuations of key software scrips have been found wanting at the current levels (despite a short recovery) after having been battered due to concerns of the slowing US economy. Apart from this, the recent stock market scam and the subsequent erosion of wealth did not augur well for the retail investor. But at the same time, this has provided an opportunity for the investors to understand that All that glitters is not gold. Given this backdrop, what is an ideal portfolio for an investor? We had created a model portfolio in the equity component of the Asset Allocator last year. Depending upon the risk profile (i.e. aggressive, balanced and defensive), the Asset Allocator,

Equitymaster-Knowledge Centre-Intelligent Investing

64

helps a user establish the avenues for investments available. These include a mix of equity, debt and real estate. In this article, we compare the performance our equity portfolio with that of various other benchmarks in the last one-year. We had bifurcated the equity component into three portfolio namely core, stars and flyers. We had invested Rs 100,000 in each of the scrips as on 1st January 2000, when the benchmark BSE-30 was at 5,400 levels. Before proceeding any further, let us understand what are core, stars and flyers. CORE: These have been defined as stocks that can be held by investors across most age brackets and status. These stocks represent companies with very good management and strong financial performance over the years. One criterion that we applied to these stocks was how they fared in the recent downturn in economic activity. Other issues considered included - position in sector, prospects for the sector itself. Click to see our stocks STARS: Companies that have good managements, sound financial track record and good prospects but not without risks. These companies, to put it in a way, are not in the core list because there are certain issues that have made them more 'risky' than the core stocks that have been identified. FLYERS: This group represents stocks that have high risks associated with them. Nevertheless, they are in a situation where they can leverage on their present position (like national presence for ACC) to generate returns much in excess of their peers. A comparative performance
1-WEEK 1-MONTH 3-MONTHS 6-MONTHS 12-MONTHS SINCE 1st Jan 2000 Core Stars Flyers BSE-30 S&P CNX Nifty Nasdaq Dow -7.0% -19.7% -14.6% 2.7% 2.6% 5.6% 1.3% -11.0% -22.8% -21.6% -1.0% -0.5% 15.0% 8.7% -6.4% -13.1% -9.9% -20.3% -18.6% -1.7% 2.3% -13.8% -22.9% -25.0% -3.6% -2.0% -18.5% 3.1% -16.3% -18.9% -14.1% -25.9% -18.4% -37.8% 2.0% -7.1% -18.5% -18.3% -34.5% -29.3% -46.3% -1.9%

The performance of these scrips is compared with their price as on 1st January 2000 (we had deliberately entered the price as on 1st January to analyse the worst case scenario). Let us analyse the performance of each of the groups respectively. To start with: CORE: Though the recent month performances of our core portfolio is not encouraging, it has

Equitymaster-Knowledge Centre-Intelligent Investing

65

outperformed almost all other benchmarks, except for Dow, since 1st January 2000. Despite Sensex declining by 35%, the value of our core portfolio has declined only by 7% since January 2000. This is indicative of the inherent strength of these companies in terms of commendable market share, sound business model and a management, which has delivered during rough periods. The major losers in our core portfolio are Glaxo (down 53%), Infosys (down 50%), Gujarat Ambuja (down 48%) and Indian Hotels (down 28%). We believe that the some of these scrips have declined primarily on account of temporary concerns. For example, Gujarat Ambuja is one of the most cost efficient producers of cement in India with economies of scale unmatched by its peers. But the scrip has fallen by more than 48% primarily on account of subdued cement demand as well as the incremental debt it took to fund its acquisition of ACC. This is true across our portfolio. Take Infosys. Despite reporting more than 100% growth in net profits, the share price dropped significantly in the current year in light of a slow down in the US economy. Besides, the company lowered its earnings forecast for FY02, which added to the downfall. But, as we had said earlier, these companies have been consistently growing above the industry growth rate and one can expect the same in the long run also. Having said that, there are also clear winners like HDFC (up 90%), Nestle (up 24%), Asian Paints (up 15%) and BPCL (up 2%). In fact, average rate of return from HDFC and Asian Paints have been in the positive territory since 1st January 2000. The TMT's performance Category Core Stars No. of TMT scrips Total scrips TMT (% of portfolio)* 1 11 2 17

Flyers 2 18

64.7% 32.3% 19.3%

Performance of TMT** -50.2% -81.5% -81.7%


* As on 1st January 2000 **Since 1st January 2000

STARS: Even our stars have outperformed the BSE-30, NSE Nifty and the Nasdaq since 1st January 2000. While our star portfolio has declined by 18.5%, the indices have declined by 34.5%, 29.3% and 46% respectively. The basic characteristic of this portfolio is that the stocks are fall under the medium risk and medium return category. The number of scrips from the TMT sector is just two, namely NIIT and VSNL.

Equitymaster-Knowledge Centre-Intelligent Investing

66

The major losers are NIIT (down 89%), Punjab Tractors (down 48%), Smithkline Consumers (down 30%) and Colgate (down 23%). While NIIT fell due to slow down in the US economy, other old economy scrips have fallen because of subdued demand primarily account of less than average monsoons. But, if one were to exclude the only software scrip in this category i.e. NIIT, the overall returns have declined just by 14.1%, which means in the long-run, even our stars portfolio has outperformed almost all the benchmarks. The winners are VSNL (35%), HDFC Bank (33%), Hero Honda (16%) and EIH (9%). FLYERS: Interestingly, our flyers portfolio has outperformed BSE-30, Nifty, Nasdaq and even the stars since January 2000. Understandably so, because the basic characteristic of this portfolio is high risk and high return. These are typically dark horses. If there is a slight change in the business environment, these are some of the companies that would rise to the occasion. But they are in the flyers category (read high risk) either because they have a less dynamic management or due to inadequate corporate governance practices. Example Pfizer, which has a wholly owned subsidiary and works against the interest of investors. Other like Telco and ITC find place in the flyers due to their diversification concerns. Take a closer look. Over the one-year horizons, the flyers have outperformed almost all the benchmarks. First lets talk of the key gainers. Leading the group is ICICI Bank (up 114%) followed by Tata Power (up 57%), Reliance (up 36%), ITC (up 17%) and Pfizer (up 2%). Zee is one of the top losers. The scrip is down 91%. The other prominent losers, which brought down the overall returns, are TVS Suzuki (down 84%), L&T (62%) and Novartis (down 60%). While TVS Suzuki declined due to a slow down in two-wheeler sales, L&T was also battered due to the delay in the cement demerger. To conclude, where should an investor invest? Given the attractive valuations of some of the old as well as the new economy scrips at the current levels, is this the right time for a common investor to enter the markets? If so, which sectors should an investor invest? As per the recent budgetary estimates, services contributed to more than 50% of the Gross Domestic Product (GDP) of the country. By services, we mean, software, banking and pharmaceuticals. Indias basic strength, when compared with other developing countries is its enormous intellectual wealth, which are key for both the software and the pharmaceutical sector. The current slow down in these sectors are typically short-term in nature and in the long run, dont be surprised if Infosys makes it into the Fortune 500 lists. Infact, Infosys at the Rs 4,000 levels is cheaper in terms of forward earnings perspective than Hindustan Lever Limited (HLL)! Apart from

Equitymaster-Knowledge Centre-Intelligent Investing

67

this, given the current low per capita consumption levels, the FMCG segment, led by none other than HLL, could also be a safe bet as well.

Equitymaster-Knowledge Centre-Intelligent Investing

68

Other Investment Avenues Gold is GOLD


Gold. This magical word has always inspired the worlds imagination, but even more so for India. Indians are after all one of the largest consumers of the yellow metal. Gold has always signified solidity and safety in ones investments. Over the years as numerous others options for investments have become available, like the stock markets, debt markets, real estate, currencies and art works, the aura of gold has somewhat dimmed. This is not surprising considering the returns on investment in gold are lower as compared to the stock markets or even the dollar. If you had invested Rs 1,000 in the BSE Sensex in March 1991, it would be worth Rs 3,086 exactly a decade later (a CAGR growth of 11.9% per annum). If you had invested the same amount in buying US dollars in March 1991, it would be worth almost Rs 2,391 as the end of March 2001 (a CAGR growth of 9.1%). However, buying US dollars is just an example, as currently the Indian government does not allow it. BSE Sensex Rupee $ Gold (Rs) Mar-91 Mar-01 CAGR growth 1,168.0 3,577.0 11.8% 19.6 46.8 9.1% 3,466.0 4,260.0 2.1%

But if you had invested the same Rs 1,000 in buying gold, it would be worth only Rs 1,229 a decade later (a measly CAGR growth of 2%). Even an investment in Indira Vikas Patra or buying a National Saving Certificate (NSC) would have more than tripled your returns. But the question is why is gold giving lesser returns? Currently, the global annual demand for gold is estimated to be around 4,000 tonnes per year. However, gold miners around the globe only produce about 2,500 tonnes of gold per year. That means there is supply deficit of nearly 1,500 tonnes per year. So, if the demand exceeds supply, shouldnt the price of gold strengthen? But in reality, it doesnt. To understand this anomaly let us look into the factors that have a bearing on the value of gold. 1. Relation of gold and inflation 2. Central bank role

Equitymaster-Knowledge Centre-Intelligent Investing

69

Gold and inflation In simple economic terms, gold moves up in tandem with inflation. In other words, gold is a natural hedge against rising inflation. It is known fact that gold prices hit the roof during the second oil shock in the late seventies. Infact from around US$ 39 in 1970, the spot gold price rocketed to US$ 139 in 1975 and then to US$ 594 in 1980.

However, in the last three decades inflation across the developed world has been on a decline. Therefore gold value has also been on stagnant ground. The fact that the dollar is now the leading measure of valuation, it has led the gold valuation to be measured in terms of dollars. In hindsight this is one of the reasons for the subdued growth in the value of gold. This is because in the US inflation has been on a decline post the second oil shock in the late seventies. As such the dollar has strengthened against other currencies. On the other hand, declining inflation has subdued golds valuations. In a way relating the value of gold to a US dollar is not an accurate measure for valuing gold. This is because currencies have gained importance only in the later half of this century. But before these currencies gained importance, for centuries gold has been the unequivocal standard by which every other commodity were valued. The central bank role As gold lost its lucre against declining inflation, central banks around the world consciously decided to reduce their holdings in gold to re-invest in other investment avenues. As a result, gold holdings as a percentage of the bank reserves have been on a constant decline. In 1970 gold amounted to 43% of the global financial reserves. In October 2000 the figure stood at 12.7%.

Equitymaster-Knowledge Centre-Intelligent Investing

70

The central banks around the world reduced their holdings in two ways. One, they lent it to their respective bullion banks at a nominal interest (around 2%). These bullion banks then sold this gold at market prices and employed the capital generated in other more rewarding avenues like the stock markets etc. These banks foresaw that inflation rates are only going downhill and so it made sense for them to unlock the value of gold and invest in more lucrative instruments. The second method which the central banks employ to reduce their gold holding is an outright auction of their gold reserves. The unloading of their gold reserves is largely responsible for filling in the crucial 1,500 tonnes per annum gold supply gap. As a result, gold prices have stayed where they are. The auction of gold by western countries like UK is becoming more frequent. As a result, the supply is likely to keep pace with demand. Moreover, inflation around the world continues to be under control. In such a scenario gold will continue to figure in our country as more of an ornament rather than an investible avenue. About 75% of the gold produced in the world's mines goes to jewelry production. Indians have traditionally bought gold more as ornaments and less as an investible alternative. But before we write off gold, there are a few things one needs to analyse. For one, gold has stood the test of time as a natural hedge against inflation. No doubt that inflation levels are falling. However, some economists are of the view that inflation levels are unlikely to go any lower. In other words, there is a higher probability of inflation levels rising. Secondly, in September 1999 European central bankers signed what is known as the Washington Gold Agreement. The object of this agreement is to bring the selling and lending of gold under control. If the central banks do observe restraint in selling and lending gold, this yellow metal is in for good times. There is another reason that should find favour with gold buyers. Gold is not only a good hedge against inflation but has also proved its worth when the reverse happens i.e. depression. The

Equitymaster-Knowledge Centre-Intelligent Investing

71

best example of this is the Great Depression in the US during 1930s. During that time, fearing that the government would devalue the US dollar against the gold to make exports more competitive, many holders of US dollar converted to gold. In terms of purchasing power gold had risen almost 100% during the biggest deflation in Americas history. In effect, gold may not seem an interesting investment avenue in the current scenario, but look back at history and it is the only investment that has really counted in a crisis. Not cash, not real estate and not even stocks. Gold is ultimately GOLD.

As good as gold!
India is the single largest consumer of gold in the world. This fact is not surprising given our penchant for gold - not only as store of value but also for ornamental purposes. The strong demand for the yellow metal did not wane even as Indians incurred notional losses on their gold holdings during the recent crash in prices. While investors the world over reworked the returns on gold, the Indians continued to lap it up in large quantities. And now it is time to get rewarded. Gold prices in the international and local markets had been languishing for some time now. The reason for this was the potential increase in supply in world markets following the decision taken by a number of central banks and the International Monetary Fund (IMF) to liquidate their gold holdings. This gave rise to fears of a supply glut, and consequently prices began to be marked down. However, over the last fortnight the situation seems to have turned around dramatically. Things began to look up when the Bank of England (BoE) evoked an extraordinarily large response (8 times) for 25 tonnes of gold, which it had put up for auction. The auction achieved a price of US$ 255.75/oz. The high bids indicated that there was a robust demand for the metal in the market. As a reaction to the favourable response to the auction, gold prices escalated sharply to US$ 260/oz. For the rest of the week, the prices continued to move up, slowly but steadily.

Equitymaster-Knowledge Centre-Intelligent Investing

72

The big news came over the weekend. Central Banks of 15 leading industrial countries (accounting for 50% of all official gold holdings) announced their decision to limit gold sales to 400 tonnes per annum over the next five years. They also decided that they would not increase gold lending above existing levels. This news set the markets on fire. Gold prices shot up to an intra day high of US$ 283/oz, an increase of 6.4%. Since then, there has been no looking back. Now, let's see the impact of all this on Indian markets. The period commencing approximately a fortnight from now, and lasting upto the middle of March, comprises the Diwali (festive) and marriage season. It is during this season that demand for gold is at its peak in the subcontinent. With the supply being restricted, and demand likely to surge over the next few months, where gold prices are headed is anybody's guess! Gold as an investment Gold finds a place in the portfolios of many investors. This can be attributed to the following reasons: Gold has historically proved to be a good hedge against inflation It is highly liquid It has ornamental value (more so for Indians) Also, it enjoys a high degree of moneyness, meaning that it can easily be sub-divided or interchanged, serve as a store of value and also be easily authenticated On the other hand, investment in gold also has its disadvantages: It does not provide regular current income e.g. interest on a debenture It does not offer any tax advantages e.g. investment in a infrastructure bond entitles one to certain tax advantages There is a possibility of being cheated with respect to the purity of the metal There is a storage cost involved in preserving gold.

Equitymaster-Knowledge Centre-Intelligent Investing

73

Understanding Debt Markets Debt markets: The other alternative


Introduction When a nation has capital, it can utilize it in two ways: either consume the capital i.e. spend it on things that will not give any future benefit or invest the capital into capacity building that will help the economy to grow. Sustainable economic growth is dependent on the level of investment activity. Therefore, industries and the government need money to grow. Household savings that accounted for 18.5% of the GDP (1999) is one of the key supply avenues. And the job of financial markets is to channelize this money into the industrial sector. In 1999, 10.9% of household savings was in the form of financial assets. However, a majority of this comprised of fixed deposits with the banks. Though the fixed deposits are undoubtedly the safest form of investments, they inherently have two disadvantages that work against the investor. Firstly, the amount available to the investor on the upside is always fixed. In a scenario where the interest rates are decreased by the central bank, the investor is the loser. However, if the same investor would hold a bond that had fixed returns, the bond would become valuable in a scenario where interest rates declined. The retail investor in India did not have much of a choice. Either he was at the mercy of the banks for fixed deposits or at the mercy of the securities and the real estate market. Equities and real estates are risky. The numerous scams have time and again highlighted the so-called credibility of the equities markets in the country. Also, due to the inherent uncertainty in returns, these markets did not suit the risk appetite of many investors. Therefore, the need of the hour was to have a market in which the price discovery was far more realistic, market determined and more in favour of the investor. Also, important was liquidity. The answer to this was debt markets, where instruments with fixed returns could be traded. The development of these markets started in 1992, the year of glasnost (openness) and perestroika (restructuring) for India. The financial systems underwent changes as the country began its journey from a regulated to a free market economy. There were steps taken to deregulate Indias financial system and as a result interest rates would be increasingly determined by the market forces and decreasingly the reserve bank. The government began to borrow from the markets at rates determined by the market forces by a system of auctions. Previously this was being done at pre-announced rates. Other reforms instituted by the RBI, in close coordination with Government of India included, introduction of new instruments such as zero

Equitymaster-Knowledge Centre-Intelligent Investing

74

coupon bonds, floating rate bonds and capital index bonds, introduction of Treasury Bills of varying maturities, conversion of Treasury Bills into dated securities. And setting up system so that trading in debt instruments could be facilitated. This included the establishment of specialised institutions such as DFHI (Discount and Finance House of India) and STCI (Securities Trading corporation of India) as primary dealers in government securities. When the government auctions the debt instruments through the RBI, primary dealers are allowed to bid. However, as long as automatic monetisation (RBI would take up all of the Centres debt and print currency in exchange for it) existed, it was difficult to assure a framework for government securities market in terms of matching demand and supply through a price mechanism. Hence, the most significant development during 1997-98 has been the elimination of the practice of automatic monetisation of the Central Government budget deficit through ad hoc Treasury Bills with effect from April 1, 1997 and the introduction of a new scheme of Ways and Means Advances (WMA). WMA is the short-term credit from the central bank to the government, which allows the government to meet its immediate requirements. For FY01 the RBI set the government's WMA limits at Rs 100 bn for the first half and Rs 60 bn for the second half. WMA is comparable to an overdraft facility. If the government wants money above this it will have to borrow by issuing bonds, which are auctioned by the RBI. The debt markets Debt market as the name suggests is where debt instruments or bonds are traded. The most distinguishing feature of these instruments is that the return is fixed i.e. they are as close to being risk free as possible, if not totally risk free. The fixed return on the bond is known as the interest rate or the coupon rate. Thus, the buyer of a bond gives the seller a loan at a fixed rate, which is equal to the coupon rate. The debt market in India can be divided into two categories, firstly the government securities market or the G-Sec markets consisting of central government and state government securities (therefore loans being taken by the central and state governments); and bond market consisting of FI (financial institutions) bonds, PSU (public sector units) bonds and corporate bonds/debentures. The government securities segment is the most dominant category in the debt market. The money market also deals in fixed income instruments. However, difference between money and bond markets is that the instruments in the bond markets have a larger time to maturity (more than one year). The money market on the other hand deals with instruments that have a lifetime of less than one year.

Equitymaster-Knowledge Centre-Intelligent Investing

75

The government to finance its fiscal deficit floats the fixed income instruments. It borrows by issuing G-Secs that are sovereign securities and are issued by the Reserve Bank of India (RBI) on behalf of Government of India, in lieu of the Central Government's market borrowing programme.
(Rs bn) Year 1991-92 1992-93 1993-94 1994-95 1995-96 1996-97 1997-98 1998-99 1999-00 (RE) 2000-01(BE) Internal Finance Gross Fiscal Market Other borrowings 91 day Deficit borrowings* and liabilities # Treasury bills $ 363 402 603 577 602 602 889 1,133 1,089 1,113 75 37 289 203 331 200 325 690 771 764 165 189 153 328 170 306 563 427 349 349 69 123 110 10 98 132 (9) (2) 35 54 53 51 36 3 30 11 19 9 (0) External Finance

* Incl ZCB, lans in conv. of T-Bills, 364-Day TB etc. since 193-94 # Small savings, PF, specal deposit etc. W.e.f. 1999-00 small savings & PPF excl. $ Variation in 91-day T- bills issued net of changes in cash balances with RBI up to March 31, 1997. Since April 1, 1997 these figures represent draw down of chas balances Source : Central government budget doucments and Reserve Bank records

On the other hand FIs, PSU and corporates issue bonds to meet financial requirements at a fixed cost, thereby removing uncertainty in financial costs.
FY98 (Rs bn) Debentures Prospects Rights Convertible Prospects Rights Non-convertible Prospects Rights FY99 FY00

No of issue Amount No of issue Amount No of issue Amount 12.0 6.0 6.0 10.0 4.0 6.0 2.0 2.0 19.7 10.2 9.4 14.7 5.2 9.4 5.0 5.0 12.0 9.0 3.0 5.0 2.0 3.0 7.0 7.0 23.9 22.6 1.2 1.9 0.6 1.2 22.0 22.0 10.0 9.0 1.0 2.0 1.0 1.0 8.0 8.0 24.0 23.7 0.3 0.5 0.2 0.3 23.5 23.5

The advantages The most compelling reason for investing in the debt market is that the returns debt markets offer are as close to being risk free as possible, especially in the government securities. In the other debt instruments issued by corporates, FIs and PSUs, certain element of risk is associated with

Equitymaster-Knowledge Centre-Intelligent Investing

76

them and therefore, they are rated by credit rating agencies. Depending on the rating, which is a comment on the risk return profile of the instrument, the interest in the instrument varies. Of course, other benefits associated with the debt markets are that the liquidity is very high and loans are easily available from banks against government securities. The downside The returns being risk free are certainly not as high as the equities market. Also, the retail participation is very less, though it has increased considerably in the immediate past. These investments are through gilt funds. A retail debt market is not very well developed. Therefore, there are issues of liquidity and price discovery. Types Of Government Securities Dated securities These instruments are of the face value of Rs 100, which the buyer has to pay upfront. The return is pre-decided. This is known as the coupon rate or the interest rate. The interest rate indicates the amount that will be paid out by the government every year till maturity. The time to maturity is also fixed. For example, 12% GOI 2005 is a bond that matures on in the year 2005 and has an interest rate of 12%. The buyer will have to pay Rs 100 to buy the instrument and will get Rs 12 every year as interest. And when the security matures the face value will be returned to the holder. As the interest rate is fixed the price of this instrument will fluctuate depending on the lending rates that are offered by the central bank. If the RBI lowers interest rates this instrument will become more expensive and if RBI hikes interest rates then the instrument will become cheaper. Zero Coupon bonds (ZCBs) ZCBs are available at a discount to their face value. There is no interest paid on these instruments but on maturity the face value is redeemed from the RBI. A bond of face value 100 will be available at a discount say at Rs 80 and the date of maturity is after two year in 2003. This implies an interest rate on the instrument. When the bonds are redeemed Rs 100 will be paid. The securities do no carry any coupon or interest rate i.e. unlike dated securities no interest is paid out every year. When the bond matures the face value is returned. The difference between the issue price (discounted price) and face value is the return on this security. Capital indexed Bonds Capital indexed bonds have interest rates as fixed percentage over the wholesale price index.

Equitymaster-Knowledge Centre-Intelligent Investing

77

The purpose is to provide investors with an effective hedge against inflation. The principal redemption is linked to the Wholesale Price Index (WPI). They are issued at face value. The coupon is fixed as a percentage over the WPI. The other instruments that have been issued by the government include Floating Rate Bonds (FRBs) and Partly Paid Stocks. Fixed income instruments issued by corporates The companies issue debentures, which have a face value and a fixed coupon rate. Debentures can be converted into shares depending on the type of the instruments. Those that cannot be converted are known as NCD (non-convertible debentures). Some of the debentures can be partly converted to stocks. These are known as PCDs (partly convertible debentures). Those debentures that can be fully converted into stocks are known as FCDs (fully convertible debentures).
FY98 FY99 FY00 Weighted average years to maturity Weighted average yield % Yield % Minimum Maximum Average Yield ( years to maturitywise) % Less than 10 years Minimum Maximum Average Yield ( years to maturitywise) % 10 years Minimum Maximum Average Yield ( Years to maturitywise)% Above 10 years Minimum Maximum Average 12.25 10.76 12.60 12.45 12.41 11.92 12.15 11.70 11.48 13.05 12.25 11.99 12.75 12.14 11.96 10.85 11.10 10.72 12.69 11.98 11.74 11.84 11.63 11.30 10.85 11.10 10.72 13.05 12.60 12.45 12.07 11.94 11.75 6.59 7.71 12.64

11.82 11.86 11.77

The development of the debt market has been hindered by the lack of awareness amongst the retail investors. The investors have to be made aware that there is an avenue other an equities market where instruments can be traded just like equities. The interesting thing is that the amount of risk associated is far lower in the case of bonds/debentures as compared to equities. Also, the returns are better than those offered by fixed deposits in banks. These instruments also have high liquidity.

Equitymaster-Knowledge Centre-Intelligent Investing

78

The other factors that have affected the growth of the debt market are the lack of infrastructure for price discovery and price information dissemination. The retail investors do not understand the mechanics of these markets as regards to pricing of the instruments. Once the retail participation comes in it would deepen the markets and improve the liquidity. Therefore, the areas that need attention are investor education and creating a robust system that will allow this market to develop. To read on how to measure returns on debt instruments please click here.

The different measures of debt.


In the previous article we had introduced debt market instruments, the purpose of this article is to give an insight into the different measures used to value debt instruments. First of all let us start with a few terms that will be used. Face value refers to the value of the instrument. Market price refers to the current price the instrument is quoting at in a debt market. A 12% GOI-2008, has a face value of Rs 100 but it may be quoting Rs 103 in the secondary market, which is known as the market price. The return on the debt market instrument is known as yield. There are different ways of looking at return. There will always be the fixed return on the instrument that is known as the coupon rate. For example a 12% GOI-2008, G-SEC, give 12% interest per annum paid bi yearly. This return is based on the face value and not on the market value. This rate of interest is also known as the coupon rate. The coupon rate is fixed and it does not vary with the life of the instrument and this is exactly the reason what makes the government securities attractive (or unattractive). Therefore, irrespective of what price the person buys a security the coupon rate will always be fixed (12% in the example). The other low risk investment avenue is fixed deposits. Firstly, fixed returns are not as high as the interest rate offered in bonds. And secondly the return on the fixed deposits is always fixed. Therefore, in any scenario there is no opportunity for a price appreciation or depreciation. Depending on the macro environment the government cuts or hikes interest rates (lending rates). This causes the bank to adjust their borrowing and lending rate. A bank has to always lend at a rate greater than it borrows at. This is known as the spread and this is a major source of the banks income. For example if money is available to the bank at 10% it may it lend at 11%. In case the lending rates decline then most likely the banks pass on the advantage to the borrowers (assuming strong competitive forces) and vice-versa for a hike in borrowing rates. In this scenario the G-SEC become attractive as they continue to offer 12% returns. The problem with the coupon is that it is not based on the market price. But for someone who buys the fixed income instrument from the market it does not give a realistic picture. Suppose the

Equitymaster-Knowledge Centre-Intelligent Investing

79

bond was bought at a market price greater than the face value, then the coupon rate though constant will mean lower returns for the investor. For example if a G-Sec with 12% coupon was bought at a market price of Rs 104, the return or the current yield will be much lower.

Coupon Rate Current Yield = -------------- * 100 Purchase Price

Suppose Ramesh buys 12% GOI-2008 at Rs 102 and Suresh buys the same instrument at Rs 104 then be current yield for Ramesh 11.76% is and that for Suresh is 11.53%. Yield to maturity (YTM) measures the effective return on a bond that is bought at market price. For a given bond we know the market price, the face value and coupon rate therefore, we determine what rate of discount will bring the future cash flows to the present market value and this is the actual return on the instrument. YTM is discount rate that equates present value of the all the cash inflows to the cost price of the government security (market price), which is actually the Internal Rate of Return of the government security. The concept of Yield to Maturity assumes that the future cash flows are reinvested at the same rate at which the original investment was made. The Net Present Value (NPV) can be calculated as follows:

I/2 Market price = ---(1+r) +

I/2 ---(1+r)
2

I/2 + ---(1+r)
3

I/2+FV ........... -----(1+r)n

where I/2 = annual interest rate payable half yearly r = discount rate or YTM n = number of half years remaining to maturity The approximate Yield to Maturity (YTM) can be computed as per the formula given below: YTM* ---------*(Approx.) I+(F-M)/N = --------(F+M)/2

Equitymaster-Knowledge Centre-Intelligent Investing

80

where I = Annual interest Rate F = Face value of bond M = Market price of the bond N = Number of years to maturity Suppose Ramesh buys 12% GOI-2008 at Rs 102 and Suresh buys the same instrument at Rs 104 then the yield to maturity using approximation is For Ramesh,

12+(100-102)/7 YTM = --------------- = 11.59% (100+102)/2 For Suresh, 12+(100-104)/7 YTM = -------------(100+104)/2
Maturity Date Coupon Last traded Last traded Coupon Current Years to Yield To rate (%) quantity (Nos) price (Rs) (%) yield (%) Maturity Maturity (%) 1-Sep-02 23-Mar-04 22-Apr-05 10-Apr-06 28-May-07 31-Aug-08 7-Apr-09 28-Jul-10 29-Jan-11 11.15 12.50 9.90 11.68 11.90 11.40 11.99 11.30 12.32 3,000 500 1,000 500 500 500 500 1,000 500 103.52 110.41 105.31 112.55 114.38 112.65 114.20 111.95 114.90 11.15 12.50 9.90 11.68 11.90 11.40 11.99 11.30 12.32 10.77 11.32 9.40 10.38 10.40 10.12 10.50 10.09 10.72 1.5 3.0 4.0 5.0 6.0 7.0 8.0 9.0 10.5 8.65 8.53 8.35 8.62 8.86 9.02 9.53 9.41 10.14

11.20%

Source NSE website

Price Interest rate relationship: The price of a government security is inversely related to the market interest rate. As the interest rate increases price decreases and therefore, the yield increases. However, if the interest rates fall the G-Sec become expensive and therefore, the yield falls.

Equitymaster-Knowledge Centre-Intelligent Investing

81

Therefore, if the market price is equal to face value of the government security, then the current yield, coupon yield and Yield to maturity will all be equal to the coupon rate or interest payable on government security. Coupon rate = Yield to maturity if, Market price = Face value If Market Price is less than the face value of the government security the current yield and yield to maturity will be higher than the coupon yield than the coupon rate. Coupon rate < Yield to maturity if, Market price < Face value - In cases where the market price of the government security/bond is more than its face value the current yield and Yield to maturity will be lower than the coupon rate. Coupon rate > Yield to maturity if, Market price > Face value Zero coupon bonds that comprise the majority of G-Secs, are also traded. The disadvantage of these instruments is that there are no regular cash flows. The only cash inflow takes place at maturity. But this translates to an advantage that the yield gets locked. This is due to the fact that while calculating YTM there is an implicit assumption that the cash flows are reinvested at the same interest rate. As interest rates are prone to fluctuations, the yield too is variable. In the next article we will take up how different factors affect the valuation of bonds. To read on various factors affecting valuation of debt instruments please click here.

Risks associated with bond


In our earlier articles, we had introduced debt market instruments and measures of valuing debt instruments (The different measures of debt). We had also looked into some of the factors, which affect the pricing and valuations of bonds ( The yield curve). Although debt market instruments offer safe returns, they are not entirely risk free. There are several risks associated, arising mainly from change in external factors. Change in interest rate is the most influential risk, which primarily affects bond prices. We had earlier analysed the impact of interest rate risk and effect of other factors like monetary policy, fiscal policy, economic growth and inflation on bond prices. The purpose of this article is to highlight some of the other market related risks, which also influence bond prices. Some of the key risks factors associated with bond valuations are listed as follows: 1. Interest rate risk

Equitymaster-Knowledge Centre-Intelligent Investing

82

2. Reinvestment rate risk 3. Yield curve risk 4. Call and prepayment risk 5. Credit risk 6. Liquidity risk 7. Exchange rate risk 8. Risk associated with inflation and erosion of purchasing power 9. Risk due to political & regulatory events and government actions Interest rate risk: Since we had already mentioned about interest rate risk in our previous articles, we will not go in its detail analysis. But just to refresh our memories, there is an inverse relationship between changes in interest rates and bond prices. The value of a bond is the sum total of the present value of its fixed future cash flows, discounted at the appropriate current market interest rate. Therefore, when the interest rate increases, a bond's value drops and viceversa. A bond with longer maturity and higher yield will normally have less impact on price due to change in interest rates. On the other hand, an instrument with shorter maturity and low yield will tend to have larger impact on its price. The price volatility for low maturity and low yield instrument would however be on the lower side, as future cash inflows are lower compared to bond with long maturity period.
Maturity Date 22-Nov-07 15-May-06 26-Jul-03 1-Sep-02 13-Dec-10 22-Apr-05 24-May-13 30-May-13 30-May-21 Coupon Rate Last traded Years to Yield to (%) price (Rs) Maturity Maturity (%) 6.8 6.8 6.5 11.2 8.8 9.9 9 9.8 10.3 74 84.5 90.1 102.6 103.9 107.6 108.4 112.7 114.2 5.9 4.4 1.5 0.6 8.9 3.3 11.4 11.4 19.4 22.7 15.7 12 9.7 6.7 5.9 4.6 3.3 3

Source: NSE web site

Let's take the practical example in order to understand the relationship between maturity, bond price and yield. As can be seen from the table above, bond having the highest yield to maturity (YTM) of 22.7% and longer duration (in this case 6 years) will be relatively more volatile compared to a bond having short maturity and low YTM (6.5% instrument having YTM of 12%). However, impact on price due to change in interest rate will be more on bond having a short maturity and low yield.

Equitymaster-Knowledge Centre-Intelligent Investing

83

Call and prepayment risk: The issuer can call a bond if the call price is below the theoretical market price due to falling interest rates. This is due to the fact that if interest rate declines issuer can raise fresh funds at lower interest rates and would repay the loans raised earlier carrying higher interest rates. Also, the possibility of a call limits or caps the potential for price appreciation (if interest rate falls bond price can rise near the call price and not more than that). In India bonds issued with call options are generally not traded in markets (not listed). IDBI Flexibond 1992 issue (interest rate of about 16.5%) is the latest example of issuer calling the bond. The bond was originally issued for 25 years tenure, with a put and call option after every five years. The decision of the institution has come in the wake of softer interest rate scenario. IDBI could now raise fresh funds by about 500 basis points lower than the earlier 16% debt. Thus before investing in a nongovernment bond, the investor should evaluate the terms given for call option by the issuer which is likely to impact investor's future cash inflow. Reinvestment risk: The bondholder is exposed to the risk of investing the proceeds of the bond (or coupon payments) at lower interest rates after the bond is called. This is known as reinvestment risk. The risk is intense for those investors who depend on a bond's coupon payments for most part of their returns. Reinvestment risk becomes more problematic with longer time horizons and when the current coupons being reinvested are relatively large. Home loan and personal finance companies are generally affected when home and auto buyers prepay their loans. In the lower interest rate environment, the finance companies get back their money sooner than expected, which adversely affects their future revenues. Credit risk: For a bond investor, there are primarily three types of credit risk: default risk, credit spread risk and downgrade risk. Default risk is defined as the possibility that the issuer will fail to meet its obligations (timely payment of interest and principal) under the indenture. Credit spread risk is the excess return earned by a bond investor above the return on a benchmark, default free security (G-Sec). This is to compensate the investor for risk of buying a risky security. Interest rates on bonds issued by corporates are therefore generally higher compared to return from G-Secs. Yield on a risk bond = Yield on a default free bond + Risk premium Downgrade risk: It is the risk that a bond is reclassified as a riskier security by a credit rating agency. The rating agency considers many factors for evaluating the credit worthiness of a particular instrument. This includes the economic environment at large, the ability of the issuer to make good on its promise and the general political condition in

Equitymaster-Knowledge Centre-Intelligent Investing

84

the country. When an issue is re-categorized or its credit rating is changed, the yield adjusts immediately to reflect the new rating. Liquidity risk: It is the risk that represents the likelihood that an investor will be unable to sell the security quickly and at a fair price. Illiquid security will also have the risk of large price volatility. Quantitatively liquidity risk can be estimated through Bid-ask spread. Bid price represents the price at which dealers are willing to buy the security from traders/investors and ask price represents the price at which they are willing to sell the security to investors. The bid price is lower than the ask. The spread between these two prices is known as the bid-ask spread and it is used as a measure of a security's liquidity. High spreads signal an illiquid market. Investors like liquid markets so that they can buy and sell securities quickly and at a fair price. Liquidity may also improve as more participants actively engage in trading a security. For example, a 10.2% bond has the YTM of just 2.7%, but it is one of the most actively traded instruments with a longer maturity period. Thus it offers good liquidity to investors who can buy/sell the instrument easily. On the other hand instrument with a coupon rate of 10.8% with a maturity period of 13 years, although offers high YTM of 6.5%, has a relatively low liquidity.
Maturity Date Coupon Rate Last traded Last traded Current Years to Yield to (%) qty (nos.) price (Rs) yield (%) Maturity Maturity (%) 11-Jun-10 11-Sep-26 24-Jun-06 19-May-15 5-Aug-11 19-Jun-08 23-May-03 21-May-05 11.5 10.2 13.9 10.8 11.5 12.1 11 10.5 2,500 1,500 1,200 100 54 50 45 28 115.5 115 121.4 108 117.1 116.4 99.8 110.4 10 8.9 11.4 10 9.8 10.4 11 9.5 8.4 24.7 4.5 13.4 9.6 6.4 1.4 3.4 3.5 2.7 2.8 6.5 2.7 3.6 11.1 5

Source: NSE web site

Exchange rate risk: When bond payments (coupons/principal) are denominated in a currency other than the home currency of the bond holder, the investor bears the risk of receiving an uncertain amount when these payments are converted into the home currency. For example if rupee appreciates against the foreign currency (US$) of the bond payments, each US$ will be worth less in terms of rupee. This uncertainty related to adverse exchange rate movements in known as the exchange-rate risk or simply the currency risk. Inflation risk: It refers to the possibility that prices of general goods and services will increase in the economy. Since fixed coupon bonds pay a constant coupon, increasing prices erode the buying power associated with bond payments. This is known as the inflation risk. For example, if a risk free bond has a coupon rate of 7.5%, and prices increase at the rate of 4% per year, the

Equitymaster-Knowledge Centre-Intelligent Investing

85

investor's real return is 3.5%. Higher inflation rates result in a reduction of the purchasing power of bond payments (principal and interest). Event risk: These are generally related to the occurrence of a particular event and its impact on bond price. These can be listed as disasters, corporate restructuring, regulatory issues and political risk. Disasters (earthquakes or industrial actions) may impair the ability of a corporation to meet its debt obligations. Corporate restructuring (mergers, spin offs) may affect the obligations of the company by impacting its cash flow or the underlying assets that serve as a collateral. Regulatory issues such as environmental and other restrictions may impose compliance costs on the issuer, impacting its cash flow negatively. Political risk consisting of changes in the government or restrictions imposed on foreign exchange flows can limit the ability of the borrower to meet its foreign exchange obligations. Volumes in the debt market are improving on increasing demand from banks. With credit growth in the system tinkering down, banks are investing in government securities over and above the minimum requirement for SLR. This has offered the good liquidity to the markets. Although, the bias is towards softer interest rates, retail investor should take into account the above risk factors before investing into a debt instrument. This is due to the fact that actual yield earned is determined by the price of a bond which is again the factor of the above listed risks.

The yield curve


In the previous article we had taken up some measures that quantify the returns on debt instruments. Going further we look into some of the factors that affect the pricing or the valuations of the debt instruments. (Kindly note the debt instruments considered in the article are G-secs and T-bills. Other instruments like debentures and zero coupon bonds are not included. ) The very purpose of understanding the factors affecting the yield is to be able to correlate what effect the change in these factors would bear on the price of the instruments. We begin this exercise by looking at a very important graph. This is a plot of the yield (YTM) on various debt instruments against the time to maturity. This is known as the yield curve. Under normal circumstances, bonds with longer time to maturity will offer a greater return as there is a far greater element of uncertainty and therefore, risk (high risk-high return). And of course the instruments of a shorter duration will offer lower returns. Thus, the yield curve is in a normal course of events upward sloping.

Equitymaster-Knowledge Centre-Intelligent Investing

86

Fortnightly closing YTM for benchmark securities (16th July 2001 to 31st July 2001) Source: Debt to Date,SHCIL,Issue no.14

However, the yield curves slope changes as various factors affect the pricing of debt market instruments. The curve might become flat or even slope negatively. A negatively sloping yield curve indicates that the short-term instruments are priced lower than those with longer duration to maturity. Therefore, the yield curve could give an indication about, which instruments are attractive and which are not in a particular market environment. Understanding the forces that shape the yield curve, investors can make qualified decisions in selecting bonds with maturities so as to get an optimal return under different environment. For example take a yield curve that is flat instead of the normal upward sloping curve. In such a scenario, if you were confident that normalcy would return to the markets, you should sell longterm bonds and buy short-term bonds. The monetary policy The government borrows money by issuing G-Secs (longer duration) and T-bills. The interest the government pays on short-term instruments is the benchmark for all financial activity in the country (this rate is considered to be close to risk free). After the rate cut in March the benchmark interest rate in India is 7%. Suppose the Reserve Bank feels that there is too much liquidity in the financial system and there is a threat that inflation may rise. In such a scenario the Reserve Bank will adopt a tight monetary policy. It therefore sells government bonds (and collects money), reducing the money availability in the system. In case the central bank wants to ease the monetary policy, it buys back the bonds, in effect infusing liquidity in the economy. The central bank can therefore effectively control the short-term interest rates and the lower end of the yield curve. When the markets expect the central bank to cut rates the short-term instruments become expensive as they continue to offer higher interest or coupon rates.

Equitymaster-Knowledge Centre-Intelligent Investing

87

Consequently, the yield declines, adjusting to the lower interest rate environment (the yield curve steepens). On the contrary when the expectations are that the central bank will increase interest rates the price of the debt instruments fall causing the yield to increase (the yield curve flattens). The central banks decision to cut interest rates or to increase it also depends on the economic scenario in the country. The central bank has to keep in mind two objectives - to promote economic growth and to keep inflation under control. If the growth prospects of the economy are good then investment activity will be buoyant, resulting in demand for money (to fund expansion). However, unchecked investment activity could lead to a heating up of the economy, giving rise to inflationary pressures. In such a scenario, the central bank needs to adjust the fast rise in demand to the slower growth in supply. The central bank does this by increasing the cost of money. When the cost of money is high, both investment and consumption demand suffer. Economic growth Economic growth and its prospects affect the yield curve. This is because the monetary policy is largely influenced by the health of the economy. The growth prospects of the economy affect the allocation of capital. If there are little or no growth prospects, the demand for capital will be sluggish. Banks would be saddled with surplus funds, which would probably diverted to the debt markets. Also, in a slowing economy, banks themselves might not be comfortable giving loans to the industry for fear of accumulating bad debts. Consequently, the investment avenue that guarantees almost risk free returns is the Gsecs and T-bills. This drives up demand for debt instruments. Higher demand results in prices of debt instruments being marked up, implying that yields decline. On the other hand, when the growth prospects for the economy become brighter the demand for these instruments weakens. Fiscal policy The fiscal policy controls the governm ents earnings and spending. If a government spends more than it earns it will incur a fiscal deficit. A higher fiscal deficit increases the risk of default by a government. Therefore, the interest rates in these countries are higher. Rising budget deficits cause the yield curve to be steep while falling budget deficits tend to flatten the curve. India Incs balance sheet However, in case a fiscal situation of a country looks precarious the short-term interest rates will tend to be much higher than long-term interest rates. The long-term interest rates will be relatively lower on hopes that the situation improves in the future.

Equitymaster-Knowledge Centre-Intelligent Investing

88

But if the fiscal deficit continues to rise then interest rates in the long term will be higher because the government will continue to borrow to meet its fiscal deficit, increasing the demand for money. The markets as a result would demand higher interest rates causing the prices for instruments to decline. Inflation Inflation affects both the long term and the short term yields. If the inflation is around 7% and the long-term yield is about 11%, the real rate of return is just 4%. Therefore, if inflation rises the real rate of return would decline causing the price of the instrument to head south and thereby increasing the yield. This causes the yield curve to flatten. Attractiveness of debt markets The investors who have invested in the stock markets have gone through a bad phase considering that firstly there was the tech meltdown and then of course the scams that were unearthed. Also, with the badla system being banned the investors have only one avenue left where they can get almost risk free returns this has caused the demand for the debt instruments and therefore their prices to move up. However, it remains to be seen whether the demand is more of short-term instrument or for long-term instruments. In the first quarter of FY02, the gross fiscal deficit at Rs 422 bn was almost double compared to Rs 251 bn in the corresponding period in the previous year. The increase in fiscal deficit was due to over 40% drop in revenue receipts. The decline in revenue receipts was caused by a 54% dip in corporate tax collections, which was on account of lower earnings by corporates. This clearly points to the slowing economy. Also, the actual expenditure of the government at Rs 651 bn was higher by 14% compared to 1QFY01. The present scenario is one of uncertainty. In such an environment, the assured returns of government securities may make investment sense. However, one must take a broader view in terms of the overall asset allocation before making a commitment to any one-asset class. In the next article we will deal with how to invest in the debt markets.

Equitymaster-Knowledge Centre-Intelligent Investing

89

Identifying stocks: Do's and dont's


Stocks from different sectors need to viewed differently. Each sector is unique in its own way and so are the companies operating in that sector. At Equitymaster, here is a small attempt to help you understand how to look at stocks from various sectors.

Identifying an aluminium stock: Dos and donts


Investing in commodity stocks is always a risky proposition because the cyclicality of the sector is one of the most important criteria, which decides the fate of your investments. Keeping this in mind, we have tried to highlight here some factors one should keep in mind before investing in an aluminium company.

Profile The biggest trait of the aluminium industry, being a commodity, is the cyclicality of the industry, wherein there are periodic ups and downs. That said, when compared with cement and steel, aluminium is a value-add commodity. It is a highly capital intensive sector (Rs 200 bn required for a 1 million tonne greenfield capacity expansion). Cost efficiency plays a critical role in the survival of a company in the sector for which, control over inputs (say raw material) is of utmost importance. Fortunately, the advantage of having the 5th largest bauxite reserves in the

Equitymaster-Knowledge Centre-Intelligent Investing

90

world coupled with cheap and abundant labour helps the Indian companies to retain the distinction of being the lowest cost producers in the world. Globally, the industry is less fragmented when compared with steel and cement. On basis of scale of operations and level of integration, aluminium producers can be categorized into the following two types: Integrated producers/Primary producers: Integrated producers have presence right from the mining of bauxite (raw material) to producing aluminium ingots (finished product). Some companies may even go a step further and have downstream manufacturing facilities such as manufacturing of semi-fabricated products (foils). Primary producers could either be a company that is just into mining of bauxite and alumina production or pure aluminium ingot manufacturing. For companies, which have restricted themselves from venturing into the downstream segment, the user industries are basically the secondary producers. Secondary producers: For this segment of producers, which are involved in the production of semi-fabricated products, the raw material is acquired from primary producers, which is in the form of aluminium ingots and billets. The user industries for this segment would be the packaging industry (foils), auto ancillary (wheels), to name a few. Aluminium products can be classified under three categories. Rolled products find applications in automobiles, consumer durable, construction and engineering sectors. Extrusions include bars, pipes and tubes that find usage in the electrical and the transportation sectors. Finally, foils are used in the packaging sector, which are high-value products and have higher margins. Now let us proceed with the various parameters indicated in the flowchart above: Revenues Revenues = Volumes * Realisations Lets look at the volumes side first. Volumes Growth prospects of the aluminium industry are a function of economic growth. In the Indian context, economic slowdown does influence the demand for aluminium, as its user industries like infrastructure, transportation, consumer durables and housing get affected. It must be noted that the consumption pattern of aluminium in India is tilted largely in favour of power and electricity

Equitymaster-Knowledge Centre-Intelligent Investing

91

(over 1/3rd of total consumption), as against the world consumption pattern, wherein transportation, especially airlines, have a major role to play. Whenever there is an economic slowdown, demand is affected in these sectors that in turn impact aluminium sales. The key application of aluminium across sectors is in products like power transformers, railways, auto industry (components and body building), housing (furnishing), packaging (competition is from tin and plastic) and consumer durable sector (body parts). Investors could gauge potential for aluminium demand based on the aforesaid user industries. Other user industries The industry is also looking at increasing volume sales by presenting itself to the steel-user industries as a good substitute option on the basis of its qualities of strength and lesser weight. This could be a potential opportunity for aluminum, as user industries like auto, could switch to aluminium. Globally, this is a growing trend in the developed economies. Competition On the domestic front, protection from competition is in the form of tariffs, which makes the landed cost of aluminium into the country comparatively expensive vis--vis the domestic produce. Investors have to keep in mind that when customs duty falls, threat of imports increases unless domestic producers are competitive. Realisations Some factors, which determine the realisations for the company, are: London Metal Exchange (LME): Unlike steel and cement, pricing for aluminium is determined at a global exchange called LME. This serves as a benchmark. Prices are determined depending upon the demand-supply mismatch, which in turn is dependent on the economic cycle. When aluminium prices start firming, in order to cash in on the rise in price, manufactures increase the capacity utilisation, which ultimately distorts the demand-supply picture and prices start to weaken. If demand fails to match production, the consequent rise in inventory impacts prices and vice-versa. Domestic prices closely track international price movements. However, the volatility on the domestic front is reduced to a certain extent owing to factors like import tariff protection and the absence of fragmentation in the domestic aluminium industry (Two players control 70% of the domestic market). Player positioning: This factor plays a crucial role in determining the profitability of a company. Since a company can be largely present in the upstream segment or the downstream segment or be an integrated player, the cyclicality of the industry has a

Equitymaster-Knowledge Centre-Intelligent Investing

92

varying effect on the performance of the company. For example, a company, which is largely present in the upstream segment, will be prone to volatility. This is because raw material prices increase or decrease depending upon aluminium production. Whereas, a company, which has a significant presence in the downstream segment, margins will be squeezed in a cyclical upturn, as aluminium prices strengthen. The ability to pass on the rise in input costs is relatively less. However, an integrated player is best placed as he has the advantage of captive mining, which will protect its input costs, while its presence in the downstream segment will help it to keep a check on the realisation aspect. Value added products: Realisations are also dependant to a large extent on the product profile of the company. Companies with a larger presence in value added segments (downstream segment) like extrusions, foils and aluminium wheels are able to realise higher value for their products, which assists margin improvement. Competition: Competition is more global in nature for the sector, similar to other sectors. However, since Indian companies are among the lowest cost producers in the world, pressure of imports is negated to that extent. Indian companies are also protected in the domestic markets from international competition, owing to tariffs imposed on aluminium imports. However, with the government committed to bringing down the tariff levels, companies will have to improve cost efficiencies to protect margins. Expenses As pointed above, in the face of increasing competition, survival would depend on cost efficiency, more so given the commodity nature of the business. Some of the key expense heads pertain to raw material, power, employees and interest cost. Since raw material and power constitute over 50% of the total operating expenses, companies with captive facilities have an added advantage. Employee expense is the next big contributor with a share of 12%-15% of the total operating expenses. If the company has presence in mining, employee requirements tend to be on the higher side. Freight is another important cost, which is dependent on the companys proximity to the raw material source and also to customers. Finally, as aluminium companies are capital-intensive in nature and have significant exposure to debt, managing interest cost is of utmost importance. Key parameters to be kept in mind while investing in an aluminium company: Cyclicality of the sector: As mentioned above, the industry is cyclical in nature. Nevertheless, identifying the bottom of the cycle is not an easy task. Instead to trying to time the cycle, investors could take a view based on growth prospects of user industries

Equitymaster-Knowledge Centre-Intelligent Investing

93

mentioned in this article. Globally, the performance of the airline industry plays a vital role as well. While this is not true on all occasions, capacity expansion could also be a good indicator. Integration advantage: Whether the company is integrated aluminium producer or not is a key factor for consideration. More so, as backward integration has various advantages such as control over mines (raw material) and also captive power facilities that help keep a check on cost efficiency of the company. Operating performance: Margins tend to improve at a faster pace when cycle is on the path to recovery and vice versa. However, players with larger presence into contract sales and value added products are relatively insulated from the aluminium cycle. In this regard, operating profit margins (OPM) is one parameter to consider. OPM is also dependant on various internal parameters such as raw material consumption and power cost per unit and production per employee. All these information are available in the balance sheet for retail investors. However, it must be noted that in the case of production per employee, the numbers could be skewed to the extent of the companies presence into mining of raw materials. Valuations: Two important ratios to look at before investing in an aluminium company could be the Price to Earnings (P/E) ratio and the Price to Book Value (P/BV). Since the industrys performance is linked to economic growth, the P/E multiple of the stock should more or less hover around the countrys GDP growth. However, at the same time, companies with greater exposure to international markets (exports) and/or larger presence in the downstream segment could command a higher valuation. The P/BV ratio can also be used as a parameter for comparison. To sum it up, large integrated companies with significant economies of scale and high cost efficiencies with presence in international markets and valued added products are the best positioned to capitalize on any increase in demand for the metal.

Identifying an auto stock: Dos and Donts


"It makes nearly 60m cars and trucks a year, and employs millions of people around the world. Its products are responsible for almost half the world's oil consumption, and their manufacture uses up nearly half the world's annual output of rubber, 25% of its glass and 15% of its steel. No wonder the car industry accounts for about 10% of GDP in rich countries."

Equitymaster-Knowledge Centre-Intelligent Investing

94

Economist, 2004 While the above description applies to rich countries, the importance of a well developed auto industry to the overall progress of Indias economy in general and manufacturing sector in particular should not be underestimated. Simply because, while the industry in itself is very capital and labour intensive, it also has strong forward and backward linkages. In other words, if the auto industry does well, chances are that a lot of other industries and businesses are also doing well. But the growth in an industry does not necessarily translate into equally buoyant earnings growth for auto companies as a lot of other factors also come into play here. This in effect forms the crux of this write up. Over the next few paragraphs, we will make an attempt to help investor juxtapose the buoyant growth expected in the Indian auto industry with the company expected to derive the maximum benefit out of it. Please remember that the word company is entirely generic here and implies that we will discuss a few important points that every investor should look at in order to correctly identify a good auto stock from a bad one. Historical demand: Motorcycles steal the show Since different auto companies specialize in different segments, an investor would want to restrict his investment decision to companies present only in those segments, which have the highest potential for growth. The charts and the table laid out below would enable him to arrive at a quick decision

As can be seen above, if domestic sales in different segments were to be rebased to 100 in FY98, then by FY06, motorcycles had touched a volume of 680 units, a near 7x growth or an impressive CAGR of 27%. This is significantly higher than the growth witnessed in any of the other segments. During the same

Equitymaster-Knowledge Centre-Intelligent Investing

95

period, while CVs have grown at a second highest CAGR of 12%, passenger cars and UVs have grown at a CAGR of 10% and 9% respectively. Tractors have fared the worst and have shown just a 0.6% CAGR. It should be noted that the growth numbers are point to point and hence it masks the cyclicality, if any, that persisted within the segments mentioned. Here also, the motorcycles segment comes out on top, as it is the only segment that has enjoyed consistent YoY growth. Although the growth rate is different, growth for any year in the period under consideration has been higher than the previous year. All the other segments however had a few periods where volumes have shown a negative growth on a YoY basis. The reasons behind the same are not difficult to find. With average income levels in the country still very low, growth in car sales have not really taken off and motorcycles have become the vehicles of choice for personal mobility as they are not only easy to maneuver in the countrys congested roads but also have low initial and operating costs. Add to this the fact that the median age in the country is 25-26 years and it becomes further evident as to why motorcycle sales have outpaced cars and UVs. As far as commercial vehicles and tractors are concerned, the growth in these segments is a function of industrial and agricultural growth and hence the higher cyclicality. The CV industry though, is in the midst of some structural changes and hence the higher growth rate than passenger cars and UVs in recent times. On the future growth front, while we expect the growth in the motorcycles segment to outperform the other segments, the gap is likely to narrow down as income levels rise and better infrastructure is made available. Passenger cars and UVs are likely to emerge as the next highest growing sectors for reasons just outlined and are likely to outperform the CV segment as replacement cycle weakens and some one time demand benefits cease to exist for the CV segment in the future. Tractors would however continue to remain a tough nut to crack, as the growth is governed largely by how the rain gods behave. While the top down approach to investing on the basis of growth potential of a particular segment as highlighted above does make sense, it has its own set of limitations. For one, the underlying segment may have a high growth potential but if the competition is so intense that profitability is at risk, then the whole exercise is likely to come to a naught. Further, most of the supernormal gains in this sector in the recent past have come from restructuring or turnaround stories, where the top down approach does not do a very good job. Add to this the fact that quite a few companies are present in more than one segment and this renders difficult if not impossible, the idea of concentrating ones investment in select segments. In view of these facts, it becomes

Equitymaster-Knowledge Centre-Intelligent Investing

96

important to be flexible in ones approach while analysing potential investment candidates in the auto sector. Key would be to be eclectic in ones approach and use a mix of both top down as well as bottom up approaches in order to zero in on an appropriate stock. The flowchart below attempts to break up the analysis into simple, easy to understand steps:

Free cash flows: Cash is the lifeblood of any firm, more so in the case of capital-intensive industries like automobiles. Auto manufacturing is a high fixed cost business and putting up a small car plant with a capacity of 1 lakh units per annum can set a company back by as much as US$ 200 to 300 m (~Rs 8.8 bn to Rs 13.2 bn at an exchange rate of Rs 44 per dollar). Add to this the fact that in order to keep the consumer interest going, auto companies have to continually invest in developing new models, R&D, improving emission standards and various other activities. Hence, it is imperative that an auto company generates good cash flows so that it can plough it back into operations and expand its production capacity as well as its product offerings and not rely too much on external borrowings. As can be seen above, by subtracting capex from the operational cash flow of an auto company, one can arrive at free cash flows. In other words, free cash flow is a function of cash from operations and the capex of an auto company. We will now focus on cash from operations, which can be further broken down into revenues minus expenses.

Equitymaster-Knowledge Centre-Intelligent Investing

97

Revenues: We believe that the popular

(CAGR%) segments (segments within segments like A, FY71-FY01 B,C in passenger cars and entry, premium, FY81-FY01 deluxe in motorcycles) in the auto industry FY91-FY01
are nothing but commodities and hence in

GNP per capita 10.8% 12.0% 11.9%

Cars produced 9.3% 15.6% 12.2%

order to grow the revenues, companies have to rely largely on volume growth. Everything else remaining constant, volume growth in cars and motorcycles is a function of growth in per capita income in the hands of consumers. The table below strengthens this view. While GNP per capita (gross national product) grew at a CAGR of 11% between FY71-FY01, passenger car production increased by 9%. The co-relation seems to be strong, even if one considers the twenty and ten year trend. As economy grows and income levels increase, demand for passenger cars is also likely to improve over the very long term. For motorcycles, demand is likely to grow at a slightly higher rate on account of higher potential customer base and a lower price tag. For other segments like commercial vehicles and tractors, as highlighted above, volume growth and consequently the revenues would largely be a function of growth in industrial activity and agricultural output. As far as company specific factors like brand strength and distribution network is concerned, while these factors may help some manufacturers in the medium term to notch up higher than industry growth rates, over the long term, they are not likely to be of great utility as these factors are not very difficult to replicate for new players provided they have deep pockets. History suggests that even a brand as prestigious as Mercedes Benz has not been able to achieve industry beating returns consistently over a long time period because competitors have come up with their own luxury marquees like Lexus for Toyota, Acura for Honda, Jaguar for Ford etc. Hence, if brands as heavily advertised and as heavily reputed as Mercedes Benz finds it difficult to beat market sustainably over a long period of time, it is unlikely some well-known Indian brands would achieve that feat. Thus, it would be safe to assume that over a longer timeframe, industry growth rate should remain as the projected growth rate for all the auto manufacturers. Expenses: Since the auto companies cannot do much beyond launching new models to grow volumes consistently above the industry growth rates, the major onus of improving profitability and consequently the cash flow falls on the expense heads of the companies. Infact, even the strategy of launching new models is dependent upon how well the costs are controlled. Hence, laying a great deal of emphasis on the cost structure of an auto company becomes critical if one were to separate a good company from the bad. Raw material costs account for anywhere between 65% and 75% of the total revenues of an auto company, irrespective of the segment. And not surprisingly, this is the area that gets targeted

Equitymaster-Knowledge Centre-Intelligent Investing

98

when management decides to cut costs and improve efficiencies. It is often said that if you want to be the best, follow the best and this is exactly what auto companies around the globe, India included, have been doing for quite some time now. Japanese auto companies like Toyota and Honda have revolutionized car making with their cost management techniques like JIT, quality circles, Kaizen and many others and auto companies across the globe have done well to take a leaf out of their book. Furthermore, auto industry is characterised by structurally rising costs like investments in improving emission and safety standards, enhanced fuel efficiency etc and this puts further pressure on the cost structure, as on account of competition, companies are seldom able to pass it on to the end consumer. Thus, these structural deficiencies are forcing auto companies to cut corners rapidly and indulge in practices such as homogeny in parts where a lot of parts are shared across various models. In car companies, economies of scale in themselves are not sufficient if not backed by common parts sharing across various models. By following these practices, auto companies can use their bargaining powers vis--vis their suppliers to good effect and bring about huge cost savings. With operating leverage of auto companies being significantly high, even a small percentage drop in costs can bring about huge improvement in profits. Just to put things in perspective, for a company with 10% EBIT margins and 70% raw material costs as a percentage of sales, even a 5% drop in raw material costs can boost EBIT by as much as 35%. No wonder, analysts and industry observers pay so much attention to the EBIT margins an auto company earns. Capex: Just like any capital-intensive industry, consistently high capex is a harsh reality for auto industry as well and especially in times of capacity expansion, auto companies can burn up huge amounts of cash. While auto companies tackle capex related issues like any other cost heads, we have taken it separately here purely from an accounting perspective. Further, there is also a difference on what exactly constitutes a capex. While some companies capitalise product development related expenses, others depreciate them over a period of time because they believe benefits from the same can over a time span of 4-5 years. While these differences do not affect a companys cash flows, they nevertheless impact companys EBIT margins. However, one needs to be conservative here and deduct all expenses in the year they were incurred except investments in fixed assets and certain other items like goodwill. With capex being critical to maintaining balance sheet strength, which can come to the companys rescue during bad times, a lot of managements time and attention is also diverted towards minimizing companys capex needs. Platform sharing, joint development of products between two car companies and employing an asset light strategy by outsourcing auto parts requirement are just some of the measures being taken by auto companies in recent times in order to bring down capex requirement.

Equitymaster-Knowledge Centre-Intelligent Investing

99

Thus, by looking into the various parameters mentioned above, an investor should be able to zero in on companies that consistently produce higher free cash flows. Because, we believe in the long run, only those companies that produce consistently higher free cash flows will be able to grow and even come out relatively unscathed from an industry downturn, if any. Valuations Automobiles, which include commercial vehicles viz. passenger and goods transportation, passenger cars, utility vehicles, tractors and two-wheelers is a very broad sector. Segments like commercial vehicle are cyclical in nature and car demand is largely influenced by per capita income growth over the long term. Given the high dependence on economic performance, earnings tend to be very volatile and therefore, price to earnings ratio will not be a consistent valuation metric. The ability to generate cash and fund expansion plans is of greater significance and as a result, we believe price to cash flow (PAT + depreciation) is a consistent valuation metric. Good quality companies, which have consistently shown superior cash generation and higher EBIT margins, become attractive to us if they are trading at a price to cash flow of around 7-9 times and the risk return ratio turns adverse if the same ratio touches 12 times forward cash flow per share.

Identifying an auto anc. stock: Dos and donts


In the outsourcing space, the prospects for auto ancillary manufacturers are bright from the longterm perspective. But identifying the right stock from this sector becomes difficult on account of technical complexities involved and higher nature of fragmentation of the industry. In this article, we have made an attempt to simplify this process and help investors identify a good auto ancillary stock. Profile The Indian auto component industry is highly fragmented in nature and has 416 players, employing 250,000 people. The output of the Indian auto component segment, as per ACMA, was estimated at around US$ 5.1 bn (Rs 245 bn) in FY03. Since an auto assembly involves large number of parts, ACMA has classified sector companies on the basis of components that they supply to auto manufacturers. The following table lists the industry segmentation on the basis of components, their contribution to the overall industry revenues and some of the leading players in those segments.

Equitymaster-Knowledge Centre-Intelligent Investing

100

Sub-groups Engine Parts Transmission & Steering parts Suspension & Braking parts Electrical Equipment Others

Products Pistons, piston rings,fuel injection pumps Transmission gears, axles and wheels Leaf springs, shock absorbers Spark plugs, batteries, starter motors Dashboard instruments Fan belts, sheet metal parts

% to total products

Leading companies 24.0% Ucal Fuel, MICO, Lucas 16.0% Sona Kaya, ZF Steering 12.0% Gabriel, Munjal Showa 8.0% Exide, MICO, 7.0% Motherson Sumi, Lumax 33.0% Rico Auto, Sundram

Since auto ancillary companies mainly act as vendors, it is extremely important for them to remain competitive, both in terms of cost as well as quality. As a consequence, the profitability of the company at the operating level assumes great significance. Therefore, we consider operating profits as a good starting point in separating a good auto ancillary company from the rest. Let us throw some light on the various operating parameters presented in the flow chart below: Operating profits: The operating profit of an auto ancillary company is the difference between the revenues earned and the expenses incurred. We shall now focus on the revenue side first.

An auto ancillary company can generate revenues from two major sources, the first is from supplies to OEM (original equipment manufacturers) and the second is through after market sales.

Equitymaster-Knowledge Centre-Intelligent Investing

101

With the advent of the best manufacturing practices in the domestic auto industry, auto players have significantly cut the number of auto ancillary manufacturers they source their components from and in line with the global trend, this has led to the tierisation. Naturally, the auto ancillary manufacturer, which directly supplies to the OEMs and offers more value added products, is the one that is known as a Tier I player. Further, the components and sub-assemblies required by the Tier I players are sourced from Tier II and Tier III suppliers. Thus, an auto ancillary company can generate its revenues from any one of the above-mentioned three ways. In this sector, Tier I players on account of their direct interface with OEMs have a better bargaining power and consequently enjoy higher margins. On the flip side, these players have to be very particular about their quality and have to keep high levels of inventory, thus increasing working capital needs. Apart from direct supplies, an auto ancillary player can also generate revenues from after market sales i.e. it can have a presence in the replacement market. Here, the margins are not only higher on account of superior realisations, but it also provides a cushion against slowdown in the auto industry when the demand from OEMs decline. Thus, while selecting an auto ancillary stock, it becomes necessary to delve into the position of the company on the supply value chain and at the same time, check whether the company derives some of its revenues from after market sales. The higher the company on the value chain and larger the percentage of revenues derived from the after market, the better it is. Since companies in the industry are suppliers to the auto industry, the performance of the auto industry has the single largest impact on the fortunes of the auto ancillary industry. Therefore, it becomes imperative for an investor to track the performance of the auto industry (both domestic as well as international), in order to determine the growth prospects of an auto ancillary company. What would happen if an auto ancillary company generates majority of its revenues by supplying to just a single auto company and the latter shuts down? Not surprisingly, even the auto ancillary company might have to shut down or scout for other clients, which would be hard to come by. Therefore, in order to avoid such a scenario, an investor should look for companies that have adequate client diversification, both in the domestic as well as international markets. The larger and stronger the number of clients, the lesser the risk for the auto ancillary company. Apart from client diversification, geographical diversification, where the company derives a good part of its revenues from exports or supplies to overseas players is also an important criterion for identifying a good auto ancillary company.

Equitymaster-Knowledge Centre-Intelligent Investing

102

Since auto ancillary companies usually supply to leading automakers, quality issue becomes extremely important. This assumes even more serious dimensions while supplying to foreign auto majors. Even a small defect in quality could lead to heavy penalties. Therefore, if a company has some sort of recognition such as the Deming quality awards or best supplier award from respected auto companies, it always adds to its credibility and ability to win lucrative contracts. Thus, after looking into the major aspects of the revenues side, it becomes clear that companies with more value added products and sufficient client and geographical diversification will prove to be a safer bet than its peers, which do not have the same characteristics. Having gone through the revenues part of the flow chart, let us now glance through the major expenses that are incurred by an auto ancillary company. Expenses: The auto industry has evolved to a stage where auto companies have substantially increased the number of components they outsource. Apart from design and development work and manufacturing of some key components, almost all the other components are outsourced. In such a scenario, auto ancillary players have been increasingly burdened with higher raw material expenses, notably steel. Since auto ancillary companies have a weaker bargaining power, majority of the input cost rises are absorbed internally (either through cost restructuring or lowering margins). This increases the risk profile of the sector. Here also, Tier I players have been less affected as opposed to Tier II and III players on account of the formers higher bargaining power. Even for those manufacturers, where steel does not form a major part of input, raw materials prices account for 50%-60% of the total sales (tyres, for instance). So, investors have to monitor prices of steel, rubber and petrochemicals, which are key inputs. Apart from raw material prices, salaries and wages is the other important expense head for an auto ancillary company. These typically tend to be on the higher side (10%-12% of sales) if the operations of the company are more labor intensive, whereas for companies with a high degree of automation, the same stands at 5%-6% of the total sales of the company. For a company, where exports form a significant part of total revenues or where most of the inputs are imported, exchange rate prevailing in the markets also tend to affect the operating margins of an auto ancillary player. Apart from these, asset turnover ratio, return on assets and working capital to sales are other factors that a investors should compare for investment purposes.

Equitymaster-Knowledge Centre-Intelligent Investing

103

Thus, having broadly looked at the parameters that determine the profitability of an auto ancillary company, we now have a look at what kind of valuations should an auto ancillary company command. Valuations: The fortunes of auto ancillary companies are linked to the fortunes of the auto industry and as a result the bargaining power stands considerably reduced. Thus, these companies have little leeway in improving their topline performance by raising prices. The onus of improving profitability therefore falls on cost reduction measures and effective deployment of funds. Hence we feel that P/E multiple is an important metric in evaluating the performance of a company from this sector. Companies that cater to domestic market deserve a lower P/E multiple as compared to a company that derives a significant share from export markets.

Identifying a banking stock: Dos and Donts


In continuation to enlighten investors on how to analyse a sector and identify stocks, here is our analysis on the banking sector this time. To start of with, unlike any other manufacturing or service company, a banks accounts are presented in a different manner (as per banking regulations). The analysis of a bank account differs significantly from any other company. The key operating and financial ratios, which one would normally evaluate before investing in company, may not hold true for a bank (like say operating margins).

Equitymaster-Knowledge Centre-Intelligent Investing

104

However, before we go into analyzing ratios, we take a look at the way a bank functions. The primary business of a bank is to accept deposits and give out loans. So in case of a bank, capital (read money) is a raw material as well as the final product. Bank accepts deposits and pays the depositor an interest on those deposits. The bank then uses these deposits to give out loans for which it charges interest from the borrower. Of the cash reserve, a bank is mandated to maintain a certain percentage of deposits with the Reserve Bank of India (RBI) as CRR (cash reserve ratio), on which it earns lower interest. Whenever there is a reduction in CRR announced in the monetary policy, the amount available with a bank, to advance as loans, increases. The second part of regulatory requirement is to invest in G-Secs that is a part of its statutory liquidity ratio (SLR). The banks revenues are basically derived from the interest it earns from the loans it gives out as well as from the fixed income investments it makes. If credit demand is lower, the bank increases the quantum of investments in G-Sec. Apart from this, a bank also derives revenues in the form of fees that it charges for the various services it provides (like processing fees for loans and forex transations). In developed economies, banks derive nearly 50% of revenues from this stream. This stream of revenues contributes a relatively lower 15% in the Indian context. Having looked at the profile of the sector in brief, let us consider some key factors that influence a banks operations. One of the key parameters used to analyse a bank is the Net Interest Income (NII). NII is essentially the difference between the banks interest revenues and its interest

Equitymaster-Knowledge Centre-Intelligent Investing

105

expenses. This parameter indicates how effectively the bank conducts its lending and borrowing operations (in short, how to generate more from advances and spend less on deposits). Interest revenues: Interest revenues = Interest earned on loans + Interest earned on investments + Interest on deposits with RBI. Interest on loans: Since banking operations basically deal with interest, interest rates (read bank rate) prevailing in the economy have a big role to play. So, in a high interest rate scenario, while banks earn more on loans, it must be noted that it has to pay higher on deposits also. But if interest rates are high, both corporates and retail classes will hesitate to borrow. But when interest rates are low, banks find it difficult to generate revenues from advances. While deposit rates also fall, it has been observed that there is a squeeze on a bank when bank rate is soft. A bank cannot reduce interest rates on deposits significantly, so as to maintain its customer base, because there are other avenues of investments available to them (like mutual funds, equities, public savings scheme). Since a bank lends to both retail as well as corporate clients, interest revenues on advances also depend upon factors that influence demand for money. Firstly, the business is heavily dependent on the economy. Obviously, government policies (say reforms) cannot be ignored when it comes to economic growth. In times of economic slowdown, corporates tighten their purse strings and curtail spending (especially for new capacities). This means that they will borrow lesser. Companies also become more efficient and so they tend to borrow lesser even for their day-to-day operations (working capital needs). In periods of good economic growth, credit offtake picks up as corporates invest in anticipation of higher demand going forward. Similarly, growth drivers for the retail segment are more or less similar to the corporate borrowers. However, the elasticity to a fall in interest rate is higher in the retail market as compared to corporates. Income levels and cost of financing also play a vital role. Availability of credit and increased awareness are other key growth stimulants, as demand will not be met if the distribution channel is inadequate. Interest on Investments and deposits with the RBI The banks interest income from investments depends upon some key factors like government policies (CRR and SLR limits) and credit demand. If a bank had invested in G-Secs in a high

Equitymaster-Knowledge Centre-Intelligent Investing

106

interest rate scenario, the book value of the investment would have appreciated significantly when interest rates fall from those high levels or vice versa. Interest expenses A banks main expense is in the form of interest outgo on deposits and borrowings. This in turn is dependent on the factors that drive cost of deposits. If a bank has high savings and current deposits, cost of deposits will be lower. The propensity of the public to save also plays a crucial role in this process. If the spending power for the populace increases, the need to save reduces and this in turn reduces the quantum of savings. Key parameters to keep in mind while analysing a banking stock: Please click on the link to read our detailed report on parameters for a banking stock However, we would like to touch upon one key aspect. Why price to book value is important while analysing a banking stock rather than P/E? As we had mentioned earlier, cash is the raw material for a bank. The ability to grow in the long-term therefore, depends upon the capital with a bank (i.e. capital adequacy ratio). Capital comes primarily from net worth. This is the reason why price to book value is important. But deduct the net non-performing asset from net worth to get a true feel of the available capital for growth. The banking sector plays a very vital role in the working of the economy and it is very important that banks fulfill their roles with utmost integrity. Since banks deal with cash, there have been cases of mismanagement and greed in the global markets. And hence, in the final analysis, investors need to check up on the quality of management. This is the last factor but not the least to be brushed aside.

Identifying a cement stock: Dos and donts


One of the key factors that seem to have a major say on stock price movements of cement companies are cement prices! Given the volatility and seasonality involved in the same, should one place such high weightage on cement prices to ascertain investment decision in cement stocks? Here is an attempt to simplify the analysis of a cement company. Profile Since cement is essentially a commodity, brand premium is almost non-existent in the industry. In terms of value-addition, this sector ranks below even steel and aluminium. It is a highly capital-intensive industry. A green field project for 1 MT requires capital expenditure to the tune of Rs 3 bn (2 MT is a ideal size for a company to have some kind of economies of scale). The

Equitymaster-Knowledge Centre-Intelligent Investing

107

sector operates with a high level of fixed cost (maintanence cost is around US$ 5 per tonne annually) and therefore volume growth is critical. Access to raw materials (limestone and coal) and consuming markets are equally important in the long term. The Indian cement industry has to be viewed on a regional basis viz. northern, western, southern and eastern. Since demand is unfavorable in certain regions, cement companies that focus on these regions are affected if there is a decline in prices. The Indian cement industry is also highly fragmented with the top six accounting for about 60% of industry capacity. The rest 40% is distributed among 40 small players. The cement industry in India has emerged as the second largest in the world, boasting of a total capacity of around 144 m tonnes (including mini plants). However, on account of low per capita consumption of cement in the country (110 kgs/year as compared to world average of 260 kgs) there is still a huge potential for growth of the industry.

Let us throw some light on the various operating parameters presented in the flow chart above: Operating profits: The operating profit of a cement company is nothing but the difference between the revenues earned and the expenses incurred. We shall now focus on the revenue side first. Revenues generated, is a function of volumes i.e. the quantity of cement sold multiplied by the price realisations. Volumes: Cement selling, which was previously a 50 kg bag affair only, is now also being sold in the form of bulk cement as well as RMC (Ready Mix Concrete). Bulk cement (selling of

Equitymaster-Knowledge Centre-Intelligent Investing

108

cement in specially designed rakes) is especially useful for regular users of cement such a builders of large housing projects, as it ensures a continuous supply of pure cement, not touched by human hands. RMC, on the other hand is a factory made concrete and a value added product that can be used for large construction projects, thus obviating the need to make concrete on the site and it also leads to quick delivery of fresh factory made concrete. However, these modes of selling still have a long way to go before making any impact and as a result, the majority of the cement (over 70%) is still sold in bags. The cement industry in the country is entirely domestic driven. As a result, exports account for very small percentage of the total cement off take in the industry. So, we focus more on domestic factors in this article. As far as the demand is concerned, more than half of the demand for cement comes from the housing industry. Infrastructure projects such as highway construction and construction of flyovers and ports also contribute towards the demand for cement. Moreover, certain calamities such as war and earthquakes can sometimes provide a short-term boost to the demand for cement in the country. Apart from these external triggers, the companys strategy of locating its plants and the level of competition also has a bearing on the quantity of cement sold. Since cement demand is closely linked with the economic development, companies that have plants in regions of high urbanization and industrialization are better placed than their counter parts. Also, the larger the number of players, the more difficult it would be to grab a larger pie of the market share. Realisations: Among the different factors that affect the realisations of a company, the demand-supply mismatch is the most important. The cement industry in the country has not been able to realise its full potential mainly on account of the high demand supply mismatch in the country. In FY03, the excess capacity in the country stood at more than 30 m tonnes and this resulted in the prices touching an all time low. This, more than anything, highlights the importance of the demand supply mismatch in the fortunes of the industry. Therefore, a retail investor has to keep a tab on demand growth and capacity expansion plans for players. The level of fragmentation and competition also play an important role in determining the prices since the larger the number of players, the more difficult it would be to ensure stability in prices. Institutional sales or big government contracts are normally won through bidding and this can also help determine the level of prices for specific projects. Lastly, cement like any other commodity

Equitymaster-Knowledge Centre-Intelligent Investing

109

business is cyclical in nature and hence its realisations also depend upon the position of industry in the business cycle. Having gone through the revenues part of the flow chart let us now glance through the expenses involved in the manufacturing of cement. Expenses: Capacity utilisation: Since the industry operates on fixed cost, higher the capacity sold, the wider the cost distributed on the same base. But one should also keep in mind, that there have been instances wherein despite a healthy capacity utilisation, margins have fallen due to lower realisations. Power: The cement industry is energy intensive in nature and thus power costs form the most critical cost component in cement manufacturing (about 30% to total expenses). Most of the companies resort to captive power plants in order to reduce power costs, as this source is cheaper and results in uninterrupted supply of power. Therefore, higher the captive power consumption of the company, the better it is for the company. Freight: Since cement is a bulk commodity, transporting is a costly affair (over 15%). Companies, that have plants located closer to the markets as well as to the source of raw materials have an advantage over their peers, as this leads to lower freight costs. Also, plants located in coastal belts find it much cheaper to transport cement by the sea route in order to cater to the coastal markets such as Mumbai and the states of Gujarat and Tamil Nadu. On account of sufficient reserves of raw materials such as limestone and gypsum, the raw material costs are generally lower than freight and power costs in the cement industry. Excise duties imposed by the government and labor wages are among the other important cost components involved in the manufacturing of cement. Let us have a look at some of the key points that should be borne in mind while investing in a cement company: Operating margins: The company should have a consistent record of outperforming its peers on the operational performance front i.e. it should have higher operating margins than its competitors in the industry. Factors such as captive power plants, effective capacity utilisation results in higher operating margins and therefore these factors should be looked into.

Equitymaster-Knowledge Centre-Intelligent Investing

110

Geographical spread: Since cement is a regional play on account of its high freight costs, the company should not have all its plants concentrated in one region. It should have a geographical spread so that adverse market conditions in one region can be mitigated by high growth in the other region. Important valuation parameters: Apart from the P/E ratio, the other important valuation metric to be considered while investing in a cement stock is the PCF ratio (Price to Cash flow). This ratio is important because cement is a capital-intensive industry and hence depreciation forms a huge part of the total outgo. In the past decade, the growth in the cement industry has always been 2%-3% greater than the GDP growth rate and as a result a cement stock should be given a P/E, which is a couple of percentage points higher than the GDP growth rate in the country. However, a company with consistently higher operating margins than its peers should command a higher valuation.

Identifying a construction stock: Dos and donts


After being in the limelight for the past two years, stocks from the construction sector have witnessed tremendous pressure in the recent market meltdown with the pressure being aggravated by the Finance Ministers clarification that tax benefits under Section 80-IA would not be applicable for entities executing projects through work contracts (i.e. sub-contracting of projects won by the entities). Companies across the construction segments like real estate construction, industrial construction and infrastructure creation have been beneficiaries of the buoyancy in the countrys economic performance over the past few years. Especially the sectors of industrial construction and infrastructure are likely to benefit in the future as well, considering that India spends a miniscule percentage of its GDP per annum on such activities, indicating huge potential for growth. While all this may sound like a smooth ride for investors in construction stocks, when it comes to analysing these stocks, the situation becomes a bit tricky, considering the not-so-good disclosure levels. In such a scenario, it becomes imperative for the investors to carefully study any investment proposition from the sector before putting in his/her hard earned money in any construction stock. In this write-up, we will try to discuss some of the important things that you, as an investor, need to keep in mind before investing in a construction stock. Construction sector The construction sector can be broadly classified into three sub-segments:

Equitymaster-Knowledge Centre-Intelligent Investing

111

Infrastructure (roads, power, ports and urban infrastructure) Real estate (residential and commercial construction) and Industrial construction (steel plants, textile plants, refineries, pipeline etc.)

Infrastructure: The government spending on infrastructure is the most important demand driver for the construction industry. Since adequate infrastructure is essential for sustained economic growth, infrastructure construction has gained significant importance over the past few years, mainly in the form of development of roads, water supply & sanitation, irrigation and ports projects. In most of the segments of infrastructure construction, the government is focusing on private public partnership (PPP) model to achieve faster execution of projects. The basic framework for PPP involves constructing projects on BOT (build-operate-transfer) basis, whereby a construction company builds and operates a project for a period of say 20 to 30 years (called concession period) and then transfers the project in a well-maintained condition to the government free of cost. During this concession period, the entire toll revenues collected by the construction company belong to it. Then, there is a second type of BOT contract, called as annuity contracts, whereby the toll is collected by the government and is then shared (predetermined) with the construction company that had constructed the project and is operating the same on behalf of the government. Real estate: Demand supply-gap for quality residential housing, favourable demographics, rising income levels, availability of financing options as well as fiscal benefits available on availing of home loan are the key drivers supporting the demand for residential construction. In addition to this, demand for office space from IT/BPO segment is expected to continue due to emergence of India as a preferred outsourcing destination. Also, buoyancy in organised retail is expected to result in huge demand for real estate construction. Industrial:Industrial construction is primarily driven by capacity expansion plans of manufacturing companies, which in turn is dependent upon the aggregate demand in the economy and

Equitymaster-Knowledge Centre-Intelligent Investing

112

consequently current capacity utilisation levels. For instance, metal and refinery companies, which have been operating at high utilisations levels, have planned huge capacity expansion going forward, which shall entail large spends on construction activities. Revenues growth drivers

Balance sheet strength:The Indian construction industry is witnessing market share gains by bigger players. This means that bigger companies are growing bigger and bigger at the expense of smaller players. As per a survey conducted by CMIE, over the past 10 years, the market share of top 30 construction companies has increased from 50% to 90%. This is primarily due to increasing complexity of projects, stricter technical qualifications, and cumbersome process of forming consortiums for smaller players. We believe that this trend will continue going forward and hence investors need to invest in bigger construction companies that are more likely to win orders based on their pre-qualification status (determined by the balance-sheet strength and experience in handling similar projects). Order book: Order book of a company has a direct bearing on its future revenues. Since the construction business is primarily a tender driven business, strong order book provides revenue visibility to the firm. It should, however, be noted that order book only includes cash contracts and not projects allotted on BOT (build-operate-transfer) basis. In case of BOT, returns are in the form of annuity and toll and are generally spread over a period of 15, 20 or 30 years. Execution period:For a construction company, revenue is primarily a function of order book size as well as the execution period. The order book tenure (or the execution period) in turn, is dependent upon the order mix of the company. For instance, transportation projects have a lower gestation period as compared to power and tunnel projects. Hence, a company with higher proportion of low gestations projects in its order book is likely to witness higher conversion rate and a faster growth in revenues.

Equitymaster-Knowledge Centre-Intelligent Investing

113

Increased investments in infrastructure and huge capacity addition plans by manufacturing companies have resulted in huge order books for construction companies. We believe that the timely execution of projects in the wake of human resource shortage will be the key challenge for construction companies going forward. Hence, one should be a bit conservative as far as the sales growth is considered. Margin drivers Order mix: Depending upon the nature of projects in hand, the margin profile of the company keeps on fluctuating. Due to the fragmented nature of the industry, project margins are generally dependent upon the level of competition in a particular segment, which in turn is dependent upon the level of expertise required to execute such projects. For instance, power projects involve higher margins as compared to road projects, since the execution of the former involves greater expertise. Construction cost: Since projects are bid on cost estimations, any increase in price of inputs will have a direct impact on the companys profitability. On an average, material costs account for 45% to 50% of the operating cost of a construction company. Unprecedented rise in prices of key inputs like cement and steel might affect margins. Though most of the projects have priceescalation clause for increase in input cost, they are not sufficient to cover the incremental rise in prices. This is mainly due to the linking of the price-escalation clause with the wholesale price index (WPI). Therefore, if the rise in input cost is higher than the rise in WPI, the additional cost will have to be borne by the company. Contracts that include star price on key materials like cement and steel is also becoming increasingly popular. In such contracts any increase/decrease in prices goes to clients account. Key parameters for selecting a construction stock For an average investor, size of the order book remains the sole criteria for investing in construction companies. More often than not, their decisions are based on order book to sales ratio of companies with little or no importance attached to the execution time and the margins of the projects. While order book to sales definitely gives an indication of visibility in growth of companys revenues, there are a few more things that inv estors need to consider before investing in stocks from the sector. These include: Management:Though management is an important criterion for investment across the sectors, we believe that the same assumes greater significance in the construction industry considering the poor disclosure standards followed by the companies.

Equitymaster-Knowledge Centre-Intelligent Investing

114

Segment presence:As mentioned earlier, the segment(s) in which a company operates has a direct impact on its revenues as well as profitability. Investors should invest in companies, which have expertise to execute diverse projects as also has the required skill-sets to execute projects with greater complexities (as these earn relatively better margins as compared to plain road construction type of projects). Key ratio:Besides looking at order book to sales ratio, investors should focus on working capital to sales (considering high gestation period of projects), debt to equity, operating margins and return on capital employed ratios. Also, considering the huge amount of funding required for timely executing of projects, investors should also keep a check of the possible dilution in equity going forward. Valuations: We believe that Price to earnings (P/E) ratio, is an appropriate metric for valuing construction companies. Besides, investors can also use Price to sales ratio (P/S) ratio for valuation purpose. As we have explained earlier that order book should not be the sole criteria for looking at construction stocks, one should refrain from using some of the frivolous parameters like price to order book.

Identifying a domestic pharma stock: Dos and donts


There is a famous saying that while investing in equities, investors are actually buying the business of the company and not the scrip per se. If this is the case, there are lots of complexities involved when it comes to picking a pharma company for investment. Here is an attempt by us to enable a retail investor to identify a domestic pharma company for investment.

Equitymaster-Knowledge Centre-Intelligent Investing

115

As can be seen from the chart above, Indian pharma companies derive revenues from the domestic and international market. Domestic market: The domestic market can be broadly divided into two categories i.e. bulk drugs and formulations. Two key factors that have to be borne in mind are that the Indian pharma market is highly fragmented due to the lack of a patent regime. Therefore, pricing power is very less and any player can duplicate a product in a very short span of time. Coming to bulk drugs, they primarily represent the basic raw materials used in the manufacture of a formulation. If the company is engaged in the bulk drugs business, what the investor must look into is the extent of the Drug Price Control Order (DPCO) cover on the companys products. DPCO is a government regulation that fixes the ceiling prices for the bulk drugs. Thus, a company manufacturing drugs covered by the DPCO loses its pricing power, resulting in lower margins. Therefore, lower the exposure to products covered by DPCO, the better. Another important thing to be looked at is whether the bulk drug company carries out any contract manufacturing activity. In this case, the company acquires a contract from another company for manufacturing its products, which will subsequently be sold by that other company. But why contract manufacturing? Low labour costs and US-FDA approved plants are advantages on which the Indian pharma companies can capitalize and increase revenues.

Equitymaster-Knowledge Centre-Intelligent Investing

116

On the other hand, if a company is dependent on formulations, the investor must ascertain the extent to which its products fall under the National Pharmaceutical Pricing Authority (NPPA) cover. NPPA fixes the ceiling price for formulations. Thus, as in the case of bulk drugs, lower the exposure to products covered by NPPA, the better for a formulations company. Here again the company could enter into a manufacturing contract with an MNC. Even in formulations, there are two broad categories i.e. lifestyle segment and traditional segment. Lifestyle segment comprises of drugs that are used to cure diseases that are linked to stress, urbanization and changing diet pattern and lifestyle of high-income level population. Major drugs in this segment are anti-diabetes drugs, cardiovascular system drugs, gentio-urinary and sex hormones drugs, CNS drugs, anti-depressants and psychiatry. These segments are not price sensitive and are less fragmented. The traditional segment, on the other hand, comprises of anti-infectives, pain management and anti-biotics. This segment is highly fragmented. Thus, if a company has higher exposure in the lifestyle segment, the growth prospects and margins of the company will be higher. International market: As far as international markets are concerned, as apparent from the graph above, is broadly divided into three categories viz. generics, Novel Drug Delivery System (NDDS) and developing a New Chemical Entity (NCE). Generics are a bio-equivalent of a patented drug. Simply, if erythromycin is coming out of patent, a company can launch the same erythromycin, but with a different composition (end effect however, is the same). Every year, a number of drugs come out of the patent regime. So, a company in India who does not have the R&D capabilities or funds to invest in R&D launches the generic version of the drug that is coming off patent. The advantage here is that the Indian company need not invest large sums in R&D. However, legalities are very complex (like Para I to IV) and time consuming. When the companys research is at a very nascent stage, it concentrates on the sale of off-patent drugs. Read in detail about Pharma R&D and its structure. Starting from Para I to III, there is no restriction on the number of players that can enter the market (competition is global in nature). Margins therefore, are not very high. It is basically a volume driven strategy.

Equitymaster-Knowledge Centre-Intelligent Investing

117

Gradually, as the company grows, it shifts its focus onto developing a new drug delivery system for an existing drug and also challenges existing patented drugs by introducing their bioequivalents. A company files an ANDA for NDDS when it has developed a new method or dosage of delivering a patented drug to the patient. When a generics company challenges an existing patent, it is required to prove that the patent is not infringed or that the patent is invalid. He is thus required to prove that his drug is bio-equivalent to patented drug. If successful, the company gets a 180-day exclusivity period during which it has the sole right to sell the drug in the market. Consequently, the company enjoys very high margins during this period of exclusivity. However, the litigation expenses are very high in such a case. An investor has to put more emphasis on the total number of Para 4 ANDA filings rather than the aggregate number of ANDAs filed. Further, the investor should look into the long-term prospects of the company and not base his decision on the outcome of a single legal suit, or a single blockbuster generic success. Read in detail about New Chemical Entity: What is it all about? Major aspects that need to be observed: Government policies have a major influence on the domestic pharma sector. As can be seen from the table below, due to the absence of a good health insurance policy, India has one of the lowest public health expenditure as a percentage of GDP. Moreover, even on the health infrastructure front, India has a long way to go as compared to other developing nations. A long way to go Country Public health expenditure Per capita health No of hospital as a % of GDP expenditure ($) beds per 1000 people India Brazil China Malaysia USA 0.8% 2.9% 2.0% 1.4% 5.8% 94 453 143 189 3950
Source: World Bank website

0.8 3.1 2.9 2.0 3.7

Management is the most crucial aspect for any companys success. While this is true for every industry, it attains even more significance in the pharma sector. Being an extremely specialized sector, it is very important that the management has the requisite expertise and skills to handle the complexities involved it this business. Thus having the right person at the right place is key to the success of a company. Watch out for this in the annual reports.

Equitymaster-Knowledge Centre-Intelligent Investing

118

R&D expenditure as a percentage of revenues is a very useful tool for evaluating the companys R&D thrust. As product patents come into effect, only companies with high R&D investment will survive. Thus, higher the ratio, higher will be the R&D focus of the company and the better placed will it be to face the uncertainties of the future. Of course, R&D has its inherent risks as well. Last but not the least, keeping aside growth prospects, the sector has significantly high-risk profile due to the dynamism. Even erstwhile big names in the global pharma industry like Upjohn, Burroughs, Knoll, SmithKline Pharma, Pharmacia and Hoechst, found the going tough alone. Ultimately, they had to join hands with bigger players in a bid to survive. Indian companies are still relatively small. If this is the case, a retail investor has to exercise caution. So pick and choose.

Identifying an engineering stock- Dos and donts


If one were to consider one of the biggest beneficiaries from any countrys infrastructure sector development, engineering companies have a vital role to play. As in any other sector, choices for a retail investor are high for an equity investment. However, it does that mean each stock in the sector is a BUY? In this article, we have tried to discuss the dynamics of this sector and the key aspects that one should look in, before selecting an engineering stock. Profile Engineering, as a sector, has many facets. A company from this sector can be an equipment manufacturer (like transformers and boilers), execution specialist (say BHEL, L&T, Engineers India) or a niche player (like Thermax in environmental solutions, Voltas in electro-mechanical projects, ABB for automation technologies and so on). To define the user industries in broad terms are power utilities, industrial majors (refining, automotive and textiles), government (public investment) and retail consumers (pumps and motors). Thus, every company has a specific role to play in the industry and are looking forward to cater a specific target market. Given this backdrop, prospects of a particular company in the engineering sector have to be viewed with respect to the specific user industries. So, if the engineering sector does well, not all companies stand to benefit in equal proportion. When will an engineering company grow? It is highly dependent on the level of private and public sector investment in the economy. When investments in capacities and infrastructure gains momentum, more jobs are created and demand for goods in general increases. This in turn leads to higher economic growth. Historically, the growth of the engineering sector has been

Equitymaster-Knowledge Centre-Intelligent Investing

119

sensitive to economic performance (as is evident from the graph below). The industry is relatively less fragmented at higher end, as competencies required are high. It is therefore that the barriers to entry are also high. But in some cases, competition is also global in nature (like dam construction, roads, refineries and power plants).

Lets have a look at the demand drivers for this sector

Order Book An engineering company can derive revenues from domestic as well as global markets. Usually, there is something-called order book that is declared by most of the companies in its annual report. This is nothing but the quantum of projects that have been won, but are still to be executed. Therefore, order book position indicates the future growth prospects.

Equitymaster-Knowledge Centre-Intelligent Investing

120

Domestic market The power sector accounts for approximately 60% of total revenues for this sector. Therefore, growth in power capacities is very important for engineering companies. So lets hav e a brief look at key fundamental factors that influences power sector performance. Historically, politics have played a vital role in shaping the power sector as opposed to economics (profitability in easy terms). What a retail investor has to keep in mind is that power capacities will only increase when there is a political will to charge consumers for what they consume. Industrial sector pays higher tariffs while agricultural sector derives power free of cost. This is the root cause for the poor financial health of the SEBs (state electricity boards). SEBs are financially weak and private sector have been reluctant to invest, as they are apprehensive of receiving money for the quantity of power supplied to the SEBs. Retail investors have to keep in mind that India is power deficient (demand is more than supply). The simple way to gauge growth of a engineering company that is targeting the power sector is to understand what kind of capacity SEBs and private sector players are planning. It costs Rs 30-35 m to set up one MW of power capacity. If a player is planning to set up a 1,000 MW plant, then the project size could be around Rs 30 bn to Rs 35 bn. This could be assumed roughly as the potential addition to the order book. If public sector power majors are expanding capacity, then it has to be borne in mind that public sector engineering companies benefit the most (as a matter of preference). Industrial and Infrastructure spending The industrial sector contributes around 30% of the total revenues of engineering sector. The demand from this segment largely depends on GDP growth, which in turn is a function of the quantum of infrastructure spending and capacity expansion plans of corporate India. A lot depends on government policies. Formulation of policies favorable to industrial sector can boost the investments and expansion plans for both private and public sector companies. Talking of policies, when government increases participation of foreign companies in infrastructure development, the sector gets a fillip. Demand growth in this sector is fuelled by expenditure in core sectors such as power, railways, infrastructure development, and private sector investments and the speed at which the projects are implemented. The topline trends of major engineering companies since last five years have shown a high degree of correlation with the IIP (Index of Industrial Production) growth . Thus a fair idea

Equitymaster-Knowledge Centre-Intelligent Investing

121

can be taken about the sector looking at the IIP growth. Lets look at the correlation in the graph below.

Exports While an engineering company from India could tap global markets for contracts, there is a vast difference when it comes to competitors. Players like Bechtel and GE have muscle power and have executed projects on a global scale. This is one of the reasons increasing contribution from international markets is not easy for any company. Retail investors have to tread with caution on this front. Due to intense competition in the international arena, suppliers do not enjoy much bargaining power. Moreover, in order to win big contracts you need to have big balance sheet size, because only some part of entire contract money is paid up front and rest comes after installation of project. Moreover, in some cases, the engineering company buys stake in the projects during the financial closure. Key points to be kept in mind before investing Order book and operating margins: Order book, as we had said earlier, indicates a companys standing in a year in terms of future growth in revenues. A consistent rise in order book on a year on year basis (and not quarter on quarter) is also vital. Though order book may be huge for a company, it has to be remembered that operating margins are low in projects. In a downturn, operating margins of an engineering company comes under pressure. If a company acts as an engineering agency (i.e. buys and installs equipment), margins tend to be on the higher side. Balance sheet size: One should look at the balance sheet size of the company. It will tell you whether company is capable of bagging and executing big contracts. In order to win big contracts and execute them, company needs huge working capital. In this case, past track record of projects executed could be useful (available in the balance sheet).

Equitymaster-Knowledge Centre-Intelligent Investing

122

Revenue growth: Usually, an engineering company derives a large share of revenues in the third and fourth quarter. So, quarter on quarter comparisons is meaningless in this sense.

Valuation ratios: One of the key factors used when it comes to putting a value for an engineering company is market capitalisation to sales. Why the emphasis of assigning a value to revenues and not to earnings? The ability to grow for any engineering company is dependent on the kind of order book, which then translates into revenues. Internationally, the average of 0.4 times to 0.5 times is a benchmark. If price to earnings is used, it has to be remembered that the sector is highly dependent on the economy. So, a P/E in line with the long-term economic growth could be useful.

Apart from what all has been said above, investor needs to look at the past record of the management, its vision and its focus on business. After all its the management of the company who is the final decision-maker and the future of the company solely depends on the decisions taken by it.

Identifying an FI stock: Dos and Donts


Financial institutions (FI) are specialized organisations that undertake long-term project finance, both for the public and private sectors in the country. However, their role in the economy is slowly losing relevance as banks have over the years entered this domain, i.e. term lending. FIs on their part have expanded their focus to encompass working capital requirements of corporates and thus the distinction between FIs and banks is slowly getting blurred. Recognizing this aspect, the government has taken a decision to restructure ailing FIs like IDBI and IFCI by converting them into banks. We take a look at how FIs go about their business and the changes that are taking place in the way they work. A bank accepts deposits and gives out loans. So, in case of a bank, capital (read money) is a raw material as well as the final product. A bank accepts deposits and pays the depositor an interest on those deposits. The bank then uses these deposits to give out loans for which it charges interest from the borrower. An FI on the other hand, largely performs the same function, however with some minor differences. For an FI, borrowings are a bigger source of capital, unlike a bank where deposits are the major source of income. Also, FIs do not lend to the retail segment, as their role is to promote industries by providing term as well as working capital lending.

Equitymaster-Knowledge Centre-Intelligent Investing

123

FIs are distinct from banks in another major area, as they are not mandated to make CRR and SLR provisions like banks. FIs are, however, permitted to raise capital by issuing fixed deposits like any other company. This also supplements the capital requirements of the institutions. FIs revenues are basically derived from the interest they earn from the loans they give out as well as from the investments they make. As FIs are not bound to maintain a CRR and SLR provision (unlike banks), their investment income (especially interest earned on investments) as a proportion of total income is low. Therefore, the main focus in this article will be on interest income of the FIs from the lending operations that they carry out. Having looked at the profile of the sector in brief, let us consider some key factors that influence an FIs operations. One of the key parameters used to analyse an FI is the Net Interest Income (NII). NII is essentially the difference between the FIs interest revenues and its interest expenses. This parameter indicates how effectively the FI conducts its lending and borrowing operations (in short, how to generate more from advances and spend less on borrowings). NII = Interest on loans Interest expenses Interest on loans Since FI operations basically deal with interest, interest rates prevailing in the economy have a big role to play. So, in a high interest rate scenario, while FIs earn more on loans, it must be noted that it has to pay higher on borrowings also. But if interest rates are high, corporates will hesitate to borrow. But when interest rates are low, FIs find it difficult to generate revenues from

Equitymaster-Knowledge Centre-Intelligent Investing

124

advances. While borrowing rates also fall, it has been observed that there is a squeeze on a FI when market interest rate is soft. An FI does not have the flexibility of a bank, which can lower deposit rates at will. It has to rely on the market determined interest rates. Since an FI lends to corporate clients, interest revenues on advances also depend upon factors that influence demand for money. Firstly, the business is heavily dependent on the economy. Obviously, government policies cannot be ignored when it comes to economic growth. In times of economic slowdown, corporates tighten their purse strings and curtail spending (especially for new capacities). This means that they will borrow lesser. Companies also become more efficient and so they tend to borrow lesser even for their day-to-day operations (working capital needs). In periods of good economic growth, credit offtake picks up as corporates invest in anticipation of higher demand going forward. Interest expenses FIs have bonds and debentures as their main source of funding apart from borrowings from banks and other term lending institutions. And hence an FIs main interest expense is in the form of interest outgo on total borrowings. This in turn is dependent on the factors that drive cost of borrowings. FIs, unlike banks, do not have the flexibility to manipulate the borrowing rates (except for their fixed deposits). Hence, their interest expenses cannot be lowered as fast as banks in a falling interest rate scenario. Institutions like IDBI and ICICI raise capital by way of bonds that are sold directly to the public. In this regard they still have the flexibility to lower (or increase) fixed deposit rates in tandem with the movement of interest rates in the economy. However FIs, are still not allowed to access low cost savings and current deposits and hence there is a limit to which they can improve their margins. Also another hindrance in the flexibility of cost of capital for FIs (especially deposit capital) is the fact that deposit rates for bonds issued by a FI (like IDBI) has to be more attractive than that offered by a bank so as to attract the retail investor. Key parameters to keep in mind while analysing an FI: Similar to a bank, one key aspect in analyzing an FI stock is the price to book value (more important than P/E). As we had mentioned earlier, cash is the raw material for an FI. The ability to grow in the long-term therefore depends upon the capital with an FI (i.e. capital adequacy ratio). Capital comes primarily from net worth. This is the reason why price to book value is important. But deduct the net non-performing asset from net worth to get a true feel of the available capital for growth. Most of the other parameters used to analyse an FI is common to that of banks. FIs, like banks, play a very vital role in the working of the economy. However, with the blurring of functions between banks and FIs, the business model of a bank is being increasingly accepted

Equitymaster-Knowledge Centre-Intelligent Investing

125

even for FIs also. Thus the move to restructure ailing FIs like IDBI and IFCI. One also needs to understand the fact that a majority of these FIs are controlled by the government and in the past politics has played a major role in their functioning. Any investment decision in FIs must be made taking into consideration government policies apart from pure fundamental considerations. As long as FIs are government controlled, their ability to keep up with the market dynamics will always be in question.

Identifying an FMCG stock: Dos and donts


Rather than look at the various segments, prospects or market shares of the FMCG sector, this week let us take a look at ways to identify a good FMCG stock. With the markets currently on an upswing, it is even more important to differentiate the chaff from the wheat . Here goes Key drivers As we all know, Indias per capita consumption of most FMCG products is well below the global average. That is largely because of the economic conditions, i.e. the purchasing ability, and also because of lack of awareness of these products. A look at the chart below gives a snapshot of the key growth drivers for the FMCG industry.

Equitymaster-Knowledge Centre-Intelligent Investing

126

Logistic strength While the purchasing ability is a function of economic growth, awareness is a function of the product reach and its usability. It is in this context, that a companys logistics strength gains importance. But logistics does not only mean a companys reach in terms of retail outlets, it also means the level of sophistication of this distribution reach. How intelligent is this supply chain, how well geared for the companys future growth? For example, Company A products reach 1 m retail outlets, but the reach is largely people intensive using the traditional dealer stockist method. Also, the retail outlets are largely small provision and shop owners. On the other hand, Company B has a retail reach of only 0.5 m retail outlets, but almost 70% of its stockists are electronically networked. In the above case, even though Company B reaches out only to half the number of retail outlets as compared to A, it is likely to be more efficient and profitable for the companys growth going forward. For an FMCG company, once a distribution chain is set up, it is the quality of that set up that gives it an edge. Using the same chain, an FMCG company can introduce more products and brands at a faster pace and at a lesser cost, and optimize the channel benefits. In the long run, such a distribution network will be more profitable as it helps the company to keep adding to its product folio at more or less the same fixed cost. Product folio MNC companies form almost half of the branded FMCG industry in India. In case of MNC companies, therefore, it is relevant to look at the parent support and commitment to its subsidiary before taking an investment decision. Again, support and commitment alone is not enough. Have a look at the parents product profile and what are its plans for its subsidiary in India. If the parent itself is present only in a few categories globally, all its support is of little help owing to the product hindrance. For all companies, be it domestic or otherwise, a look at the companys product introduction track record is an eye-opener. How many products has the company introduced in its years of existence, how relevant are they to Indias consumer habits. What are the future plans of the company? Competitive strengths FMCG companies success is often attributed to their marketing and branding skills. Ability to continuously create successful brands and advertising which gets the message across often spells success for a company. Once a brand is successful, it easier for a company to piggyback on its initial success introduce more products and associate them with the known brand. As they say, nothing succeeds like success.

Equitymaster-Knowledge Centre-Intelligent Investing

127

As said earlier, the more the number of product offerings, the more each resource is utilised, be it the distribution channel, the marketing or branding strengths. It is in this context, that single or a few product companies are risky. Number one, they have to continuously be wary of competitors coming in and weaning away market share. Therefore, they have to continuously spend higher on advertising and marketing. This is a double whammy for a company under pressure. On one hand, revenues are under pressure and on the other, costs go up and margins are squeezed. Also, due to this, the company is often shy of investing in new products and expanding its distribution network. Bottomline, future growth prospects get stunted. We talked of MNC companies earlier. One very important thing that an investor should look at is the number of subsidiaries the parent has in the same country. For example, P&G and Glaxo SmithKline, both have a few other subsidiaries, beside the listed entities. If the parent has another subsidiary, especially if it is unlisted, then it is likely that the foreign parent would be inclined to introduce new brands and products through the 100% subsidiary. As such, shareholders of the listed subsidiary will not be able to reap the rewards of the product portfolio expansion. Investors should be wary of investing in such companies where parent focus and plans are under a cloud. Key financials and valuation ratios to look at Last 5 years revenue growth (CAGR) and what is the reason for the said growth. If encouraging growth has come about due to continuous new product introductions and growth in market share, it is an encouraging sign. Operating margin trend What sort of margins is the company earning, vis--vis its peers. Whether the trend is improving or is there a continuous decline. Find out reasons for both. If it is improving due to efficiencies in supply chain and product focus, it is encouraging. If it is declining continuously due to hike in advertising spends etc., it is a sign of the company facing intense competition. However, if the margin decline is a blip and has come as a result of a new product introduction, it is a good long-term sign. Look at the companys cash flows and the working capital efficiencies. It will give you an idea of the companys bargaining power as well as its ability to utilize its resources and supply chain. Look at the return ratios, especially ROCE (return on capital employed) trend. It will give you an idea how effective the company is in optimising its resource strengths. Also, look at the dividend paying track record. A healthy dividend payout, i.e., the ratio of dividends

Equitymaster-Knowledge Centre-Intelligent Investing

128

to earnings, is also a good indicator of the companys willingness to share wealth with small shareholders. It is also important to look at the P/E (price to earnings multiple) and market capitalisation to sales, which the company is trading at vis--vis its peers. Growth oriented companies will most likely be trading at a premium to peers based on these parameters. If so, then one has to gauge whether that premium is justified. If the premium is unrealistically high then it may not be a good idea to invest at that juncture. After all, valuations have to justify the companys prospects. Above all this, look at the past record of the management, its vision and its integrity. For it is the management finally, which is decision maker and therefore the guardian of your interests in the company. So if the management has a track record of being on the sly or slow to react to market conditions, then the biggest distribution channel and the most diversified product folio may not give you your rightful share of the companys growth and profits.

Identifying a hotel stock: Do's and don'ts


How to analyse a company? This is the first question a retail investor has in mind before taking investment decisions. In continuation to the article last week on ways and means to identify an FMCG stock (Read more), consider key factors to be borne in mind when it comes to identifying a Hotel stock. Profile Unlike FMCG, auto or even banking, hotel industry is more global in nature. As a result, geopolitical events, say September 11 attack, play a vital role in influencing tourist arrivals into and outside India. The ability of a player in the sector to attract the bulk of tourists coming into India and travel within the Indian border depends on select factors. These include the strength of the property portfolio (whether near a heritage site, near airport, commercial capital and so on) and brand awareness. For example, Taj (Indian Hotels) and Oberoi (EIH) are generic names in India when it comes to premium hotel chains. Normally, hotels are capital intensive in nature having long gestation periods, which not only has a bearing on the free cash flows of hotels but also affects the return on capital employed (ROCE) for a period of time. Revenues for a hotel chain are a factor of occupancy rate (number of rooms occupied) and average room rates (popularly termed as ARRs). Revenues are also derived from food and

Equitymaster-Knowledge Centre-Intelligent Investing

129

beverages, management services and so on. Consider key factors that influence occupancy rate and ARRs. Occupancy rates Consider the chart below. The hotel sector benefits from both holiday and business travel. Holiday travel in India is generally seasonal in nature. Historically, over 60% of total tourist arrivals into the country is during the period between September-May. On the other hand, business travel is a factor of various factors. This includes governments effort to promote India as a tourist destination, long-term economic growth prospects and higher foreign participation arising by hike in FDI and FII holding limits in Indian companies and joint ventures.

For the last few years inbound (coming into the country) tourists have been around 2.5 m while out bound (going out of the country) tourists have been around 30 m. Out of the inbound, a large part of the travelers to the country are of the business class, while the rest are leisure segment. Connectivity between cities in the form of better road infrastructure, airports and seaports also play a vital role in increasing the share of India in the global tourist pie. India is a country of various cultures and has some of the world-class heritage sites, which when promoted in the global arena, can attract the global tourist. On the domestic leisure travel front (i.e. people traveling within India for both commercial and leisure reasons), there is lot of seasonality involved. Besides, as income increases, aspiration level of the population also gains ground and consequently, spills over into better occupancy rates for hotel chains. While it may not be true for luxury hotels, players in the budget hotel sector and time-share segment benefit in a large way.

Equitymaster-Knowledge Centre-Intelligent Investing

130

Average room rates (ARRs) Without getting into complexities, there are three classes of rooms in a hotel i.e. business, leisure and luxury. It is important to understand that room rates are less elastic to a fall in price at the higher end of the segment (luxury) than at the lower end of the spectrum (business/leisure). Therefore, even in a downturn, players like Indian Hotels are relatively able to maintain higher operating margins than EIH. Established players in India have an edge over MNCs and the unorganized segment, due to properties near heritage sites.

Competition also plays a vital role in determining the sectors ARRs. Currently, the big hotels have average occupancies of 60%. This points to excess supply. That itself is sometimes a dampener on ARRs. The global scene International hotels are derive a big chunk of revenues from casinos and betting arenas. Margins in this segment are also higher. But for Indian hotel majors, setting up casinos and betting arenas is not allowed according to Indian laws. However, when domestic hotels are compared to international hotels then they are fairly competitive in terms of average room revenues. How to put a value to a hotel chain? Net Asset Value (NAV) is the answer. For arriving at a Net Asset Value Setting up a 5 star hotel Add Deduct Net Asset Value (NAV) Divide NAV per share Compare with current market price
* depending upon the area of setup

= Rs 30-35 m* = Cash + investments = Debt Total No. of Shares = Rs x

Equitymaster-Knowledge Centre-Intelligent Investing

131

Coming to the NAV of domestic hotels, on the basis of replacement cost method let us see the value of the hotels at current prices. By NAV we can arrive at the actual value of the properties of the hotels. Based on that, NAV per share can be calculated, which gives the actual value the shareholder should be paying for being a part of the company. However, for hotels, which have been in the industry for a period of time their NAV would be on the higher side, as the property bought would be at a much lower rate than the present times. Like for instance the NAV of Taj and Oberoi Hotels would be higher than that of ITC Hotels and other hotels. Key things to look at before investing in a hotel stock 1. What are the strategy and the capex plans of the company over the next 5-10 years? As mentioned earlier, hotels are capital intensive in nature having long gestation periods, which not only has a bearing on the free cash flows of hotels but also affects the return on capital employed (ROCE) for a period of time. So the bigger the capex plan, the more caution one should exercise. This criteria is favorable for established hotel chains. 2. Economic cycles also determine earnings prospects (during a downturn, properties are cheaper and hotel chain generally tend to increase capacity). Moreover, in tough times like September 11, hotel stocks take a beating. It is at this time that the established players should be looked at, for when the concerns fade away, these will be the first ones to benefit from an economic upturn. 3. A hotel chain should not be leveraged on any specific segment i.e. luxury or leisure. Though elasticity is lower at the premium end, when tourist flow is affected, this player could be the worst hit. Diversification reduces volatility in earnings, to an extent. While growth prospects continue to remain heartening, the sector is typically a high-risk-highreturn game due to the vulnerability to external factors. Buyers beware!

Identifying an MNC pharma stock: Dos and donts


The case for an MNC pharma company for retail investors as far as equities are concerned stems from the fact that earnings visibility is relatively stronger compared to domestic pharma companies. Unlike Indian peers, risks regarding R&D is also absent. However, while MNCs, in general, bring in a culture of professionalism, there have also been instances of Indian shareholders getting an unfair deal when these very MNCs delist from the domestic stock exchange or when they are taken over by another company (like Digital-HP and Kodak to name a few). In this article, we shall understand the various factors that should be borne in mind while

Equitymaster-Knowledge Centre-Intelligent Investing

132

investing in an MNC pharma stock.

Consider various revenue streams for an MNC pharma company first. A global pharma company establishes an Indian subsidiary with an intention of taking advantage of the huge potential that the Indian market holds in view of its large population and growing health awareness. Hence, it derives a major portion of its revenues from the domestic market. The companys revenues from the domestic market are influenced by various factors that are briefly discussed in the following paragraphs. The most important aspect that influences an MNC pharm a companys revenues from the domestic market is its parents outlook and strategy for India. The parents view on the growth prospects of the domestic pharma industry which is influenced by factors such as rate of growth of population, per capita medical expenditure and health insurance infrastructure in the country. It is pertinent to understand that global pharma major, as the name itself suggests, have a worldwide presence. So, the parent will focus on those subsidiaries that could make a meaningful contribution in the long term. Though the contribution could be even less than 1%, consider the rate of growth of the Indian subsidiary with the parent companys growth in revenues. One of the ways in which parents commitment towards the Indian company can be evaluated is by calculating the contribution the Indian arm makes to the topline and the bottomline of the parent. This will help us know the relative importance the Indian subsidiary holds for the parent. Another aspect that needs to be looked into is the core segment-wise product profile of the

Equitymaster-Knowledge Centre-Intelligent Investing

133

parent. We must compare the Indian arms therapeutic break-up with that of the parent. Here, one should check whether the Indian arm has a similar therapeutic break-up as compared to its parent. The higher the resemblance, the better it is for the Indian subsidiary. This also suggests that the parent major is keen on the Indian market. This apart, the parents R&D pipeline should also be looked into. This will help us know the prospective launches in the future. The Indian arm could benefit immensely. Further, an investor should also keep in mind that the global pharma industry is consolidating. If the existing parent is acquired by another global major (like Pfizer and Pharmacia), it will have a direct influence on the Indian arm. It could dilute the importance of the Indian arm or result in an unfair deal for the domestic shareholders. Given the fact that Indian subsidiaries market capitalisation is miniscule as compared to the parents market cap, the parent may be tempted to buyback and delist it from the Indian stock markets. There have been numerous instance of this kind in the past and retail shareholders have no option but to participate in the buyback/delisting. Finally, a very important aspect that needs to be looked into while evaluating the MNCs parent is the existence of parents 100% subsidiary in India. In such an instance, what if the parent launches new products through the other 100% subsidiary and not through the listed entity? Shareholders will lose out significantly in the long term. Once, we have made a detailed study on the parent, the next aspect that could affect the companys revenues is the therapeutic segment in which it operates. If the company generates a major portion of its revenues from the high margin lifestyle segments like diabetes, cancer and asthma as compared to low margin traditional therapeutic segments like anti-infectives and antibiotics, obviously, the growth prospects and margins of the company will be higher. Revenues in the domestic market are also influenced by the prices fixed by the regulatory bodies like the DPCO and NPPA. These organizations fix very low ceiling prices for bulk drugs and formulations, thereby limiting pricing power. Although, powers of these bodies is expected to reduce tremendously with the introduction of product patents, there is an apprehension that they might survive in some form even after product patents are implemented. A companys product portfolio age is also a crucial factor that affects the companys growth prospects. As a drug matures, its volumes decline. Thus, a company with a relatively older product portfolio is likely to witness slower growth rates as compared to a company that makes aggressive new product launches. Moreover, aggressive new product launches also demonstrates parents commitment towards the Indian arm.

Equitymaster-Knowledge Centre-Intelligent Investing

134

Outsourcing is the second avenue of revenue available for an MNC pharma company. Here, the company can either manufacture its parents patented drugs or act as an R&D base. An MNC pharma company can utilize the lowest cost manufacturing ability of the Indian subsidiary for drugs sold globally. However, to get such manufacturing contracts, the Indian arm will have to prove its cost effectiveness not only in comparison to its fellow subsidiaries but also Indian companies specializing in the same. This apart, the demand for the parents product is another key factor that could influence the flow of revenues from this avenue. MNC pharma companies could also act as an R&D base for its parents. This is in view of the fact that highly skilled scientist and research personnel are available in India at a relatively lower cost as compared to other countries. Moreover, they could also act as a clinical research center for the parent given the availability of large number of patients with ethnic diversity at a much lower cost. Key parameters to be kept in mind while investing in an MNC pharma stock: Relative importance of Indian arm to the parent: As was mentioned earlier, Indian arms topline and bottomline as a percentage of the global revenues and profits of the parent should be calculated. This will give us an idea about the relative importance of the Indian arm to the parent. Parents R&D expenditure as a percentage of sales: In a regulated market, new drug discovery research and product launches are key to a global pharma companys survival. Aggressive new product launches can only be made if the company is committed towards making R&D investments. This can be numerically measured by calculating the parents R&D expenditure as a percentage of its sales. The higher this ratio, the more committed the company is towards its R&D initiatives. Advertising and sales promotion expenses as a percentage of sales: In the domestic market, an MNC pharma company has to compete with generics manufacturers who sell drugs at a much lower price as compared to the MNC. Hence, to justify its premium price, an MNC pharma company has to undertake nation-wide product awareness programs and also conduct seminars and conferences. Although these initiatives eat into the companys margins, they are essential in the long term. Market capitalization to sales: This is a very important ratio while analyzing an MNC pharma company, as it will give us an idea about the markets perception of the companys brand value. Higher the ratio, bigger the companys brand. Other parameters: Apart from the above ratios, the usual ratios like operating profit margin, net profit margin and P/E ratio should also be considered before investing in an MNC pharma stock. As far as price to earnings is concerned for an MNC pharma major,

Equitymaster-Knowledge Centre-Intelligent Investing

135

better earnings visibility (provided the parent is committed) and access to the parents global expertise could result in a premium valuation compared to domestic pharma majors.

Identifying a paint stock: Dos and Don'ts


In the consumers hierarchy of needs, the importance of housing cannot be understated. Given the fact that the housing sector has been growing at an impressive rate in the last five years on the back of various factors like tax incentives and the decline in interest rate, it is pertinent to look at sectors that benefit from this scenario. Apart from banks, cement, steel, the paint sector also benefits in a large way. In this article, we look at factors that have to be borne in mind while identifying a paint stock. Profile The application of paints can be broadly divided into three categories viz. decoratives, industrial and automotive. The decorative segment is broadly divided into interior paints (emulsions, enamels, wood finishes) and exterior paints. Historically, not much emphasis was placed on the level of technology in the manufacturing of decorative paints in light of the large presence of unorganised sector. The growth in revenues is dependent on the housing sector. Here demand is from both new houses and repainting. The industrial and automotive paint manufacturing however, is technology intensive wherein domestic majors have tied up with select global majors like Nippon Paints, DuPont, PPG and Kansai for technology. Industrial paints have applications in automobiles, consumer durables, infrastructure projects (roads and ports) and in the manufacturing sector (protection and powder coatings). The growth in revenues therefore, is directly linked to investments by corporate sector and infrastructure development. Having looked at the profile of the sector in general, the next step is to analyse factors that impact revenues and costs. We have concentrated on operating profit here because the sector is not capital intensive in nature as compared to commodity sectors. Since depreciation to sales on an average is low at 3% of sales, it is pertinent to consider operating profits.

Equitymaster-Knowledge Centre-Intelligent Investing

136

Revenues Since Revenues = Quantity sold * Average price, we consider factors that affect these two broader heads independently. A. Quantity Sold The Indian paint sector is highly fragmented i.e. there are both organised and unorganised players. It is estimated that organised players account for around 60% of paint sales in the country. This has risen from around 40% five to six years back. One of the key reasons for this shift is the decline in excise duty over the years. Since unorganised players were not paying taxes, they were able to sell products at a cheaper rate without any significant investments in technology. With the advent of fall in excise duty, unorganised players are losing competitiveness. This is further helped by lowering of customs duty, which results in cheaper raw material cost for organised players. So, watch out for announcements on these fronts in the annual Budget. As we mentioned earlier, there is the decorative paint segment and industrial paint segment. Decorative Paint Demand for this segment is seasonal in nature i.e. demand increases in festive seasons. Festive season demand in turn is dependent on monsoons and economic performance. Good

Equitymaster-Knowledge Centre-Intelligent Investing

137

monsoons result in higher agricultural output and has a positive effect on the GDP growth. Decorative paint demand has a good co-relation with GDP growth. So, when GDP growth is higher, the paint sector will benefit and vice versa. In order to capitalize on the demand, paint companies like FMCG companies, need a well spread distribution network. A retail network with a computer dealer tinting machines has proved to be highly productive. Reforms also play a vital role in providing a fillip to decorative paint demand. By reforms we mean change in interest rates, land reforms, increased thrust on infrastructure by the government, better irrigational facilities to the rural sector and excise/customs duty structure. Investors therefore, have to place utmost importance to any change in regulation on these broader factors. Industrial Paints Increased demand for automobiles tends to have a positive impact on automotive paint manufacturers. Demand for automobiles in turn is dependent on income growth prospects and interest rates. Automotive paint manufacturing is technology intensive and Indian manufacturers have technical collaboration with foreign players like Kansai, Nippon and PPG of USA. In the case of automotive paint manufacturers, the ability to pass on any rise in input is weaker i.e. bargaining power of customers is higher. As far as industrial paint segment is concerned, increased spending in infrastructure plays a vital role in boosting paint demand. So, when the government announces higher public spending, it benefits industrial paint manufacturers. B. Price The ability of a paint manufacturer to increase prices depends on which segment it operates in either decorative or industrial. In industrial paints, the bargaining power of customers (i.e. auto manufacturers, industrial majors and government agencies), is higher. As a result, whenever there is an escalation in input cost, industrial paint manufacturers are not in a position to pass on the cost to customers. The importance of economies of scale is higher in industrial as compared to decorative paints. However, though decorative paint sector is extremely competitive, there is room for raising prices. This would depend on factors like brands, product-mix (exteriors, wood finishes and interiors) and the market share. Since paint demand is seasonal, manufacturers tend to decrease prices in the festive season. Unlike the past where paint selection was restricted to construction companies, the dealer tinting machines have played a vital role in increasing customer involvement. Therefore, the sector is investing more on brand building and consequently has a FMCG aura to it.

Equitymaster-Knowledge Centre-Intelligent Investing

138

So, investors have to understand the industrial and decorative sales mix. If a predominantly decorative paint player has plans to increase contribution from industrial sector, margins could come under pressure and vice versa. Having looked at the revenue side, consider the factors that impact the cost side. Crude prices and dollar rate Raw material cost typically account for around 50% of sales of a paint company. There are more than 300 raw materials used in manufacturing of paints with titanium dioxide being the key raw material. It accounts for around 30% of sales. While some are crude derivatives, in the manufacturing process of some materials, crude is used as a source of energy. So, whenever there is an increase in crude prices in the international markets, paint companies feel the pressure. Of course, factors like economies of scale in sourcing do have a positive impact on large players. Since domestic manufacturers mostly import titanium dioxide due to lack of quality (there are two types here) in the domestic market, rupee-dollar movement in critical. When a spurt in crude prices is accompanies by rupee depreciation against dollar, paint manufacturers face a double-whammy. So, investors need to keep a close watch on this factor. Another critical factor is the strength of the supply-chain of a company. Since this sector is highly working capital intensive (more than 300 raw materials), manufacturers with a wide spread distribution network benefit. Having looked at the broader sector dynamics, what are the ratios that investors have to analyse before investing in a paint company? 1. Operating margin: Margin for a paint company, as we mentioned earlier, is dependent on the industrial/decorative sales mix and economies of scale. Ascertain the sales mix and where the sales mix is heading. If the sales mix is shifting favorably towards decorative, margins could improve provided the distribution is well spread. 2. Working capital to sales: Since the sector is working capital intensive, high working capital to sales ratio indicates cash locked in inventory or debtors. Compare working capital to sales with competitors and ascertain the reason for any diversion. The lower the working capital, the better it is, as cash flow tends to be strong. To that extent, interest costs tend to be lower. 3. Price to earnings: Since revenue growth prospects of paint majors are co-related to economic growth, price to earnings ratio is a good indicator. Premium will be accorded

Equitymaster-Knowledge Centre-Intelligent Investing

139

to those companies that have managed to perform GDP consistently over a five-year period. Companies will higher operating margin, favorable decorative mix and lower working capital to sales will command a premium. 4. Management: Indian paint sector has both domestic and international players. For MNC paint majors, it is pertinent to look at the parents strategy for India in the broader context. Ascertain whether the management of the company has managed to outperform competitors in a downturn. Since the paint sector is fragmented, consolidation is a longterm reality. Therefore, it is important to consider whether a company can survive in the long-term and reward shareholders adequately, as there are a number of Indian family managed business houses. The Indian paint sector is slowly shredding its commodity image and moving towards a FMCG status. A study of global players like Sherwin Williams of US and Kansai of Japan would also help investors.

Identifying a power stock: Dos and Donts


When you think of digitizing India there will be a massive amount of power required and I pray to this government that you have to push and push and push to invest in infrastructure Mr. Jack Welch Profile Power can be generated from water (hydro), thermal (coal or naphtha), wind and nuclear. Since the Indian power sector has not been opened up for private sector participation in its true sense, the centre and state governments have a major role to play. It is a politically sensitive sector i.e. tariffs cannot be hiked as the vote bank could be affected. A power company can be a generator, a transmitter, a distributor or a combination of all three. Barriers to entry are high because it is capital intensive and regulated. While technology in state government undertakings is poor, it will play a big role in the future, as consumers will require good quality and uninterrupted supply of power. Currently, in India, we have 1,07,533 MW of generation capacity out of which private sector contributes 11%. Lets have a look at the revenue model for a power company.

Equitymaster-Knowledge Centre-Intelligent Investing

140

Total revenues = Revenues from generation + transmission + distribution. Generation For a company involved in generation of power, revenues will be a function of electricity generated and tariffs applicable. Generation of electricity is a function of PLF (plant load factor) and the capacity installed. PLF, in simple words, is like capacity utilisation. The level of PLF varies depending upon the kind of generation plant. Generally, a hydro power plant or a wind energy plant have low PLF (industry average 35%-50%). Thermal and nuclear power plants have higher PLF (industry average 50%-65%), which ultimately results in higher production. Investment in capacity in the power sector depends on various factors like: demand-supply gap (in simpler words we can say deficiency), availability of funds, economic growth and regulatory framework. All these factors are inter-related to some extent. Demand and supply One critical factor when it comes to analyzing a power company is the fact that demand expands as per supply. There is nothing like a market size per se. The level of the growth in the industrial sector, per capita consumption of consumer durable and electronic goods would indicate the growth potential. For instance, the penetration level of air conditioners in India is just 0.5%. If more people buy A/C or television or refrigerator, demand for power will increase.

Equitymaster-Knowledge Centre-Intelligent Investing

141

Therefore, as far as demand-supply gap for a developing economy like India is concerned, it is irrelevant. The country is power deficient. Availability of funds As we had mentioned before, the sector is capital intensive. It costs almost Rs 40 m to Rs 45 m to set up one megawatt (MW) of capacity. If a company is planning to increase capacity by 1,000 MW, it requires Rs 40 bn. From a retail investor perspective, look at the cash balance and the current debt to equity ratio of the company from the balance sheet. This will give an idea whether the company really has the muscle power to expand the stated capacity in the time frame mentioned. Economic Growth will lead to increase the purchasing power of the people, which will raise the living standard and in turn increase electricity demand. So, the circle starts again. Regulatory framework If a company is just into generation, it has to supply to a distributor for realising value for the quantity of power sold. If the distributor is a SEB (i.e. state electricity board), the chances of delayed payment are high, as SEBs are in poor state. Failure to receive money from SEBs could hamper a companys capacity expansion plans. Having looked at the capacity side, consider factors involved on the tariffs front. For a generation company that supplies electricity to a SEB, the respective state governments fix tariffs. However, a power generation company can also supply to the national grid at a specific rate. The national grid say, Power Grid Corporation, in turn could take the onus of meeting SEB requirements. While the advantage is lower risk of delayed payment and fewer losses on account of T&D, the disadvantage is that the tariffs are lower compared to a T&D player. To put things in simple terms, the generation company gets a specific rate on power supplied whereas it is not the case with a T&D player where there is differential tariff structure. For a distribution company (like Tata Power or BSES in Mumbai), tariffs are different depending upon the customers. Usually, industrial units are charged higher as compared to households (cross-subsidisation). Agricultural sector is a mixed bag. While some states actually charge for power supplied (like Tamil Nadu), in most other states, it is free. The advantage for a generation and distribution company is that it can pass a rise in cost to customers in a deregulated market. However, power theft and default rates are high for a distribution major. Watch out for this as well. Transmission There can be independent transmission companies as well (like backbone service providers in

Equitymaster-Knowledge Centre-Intelligent Investing

142

the telecom sector). The revenue model is similar. A transmission company buys power from a generation company and hands it over to SEBs or a distribution company. When it comes to advantages, it is like less capital and technology intensive. But a transmission company faces the risks of default of payment by a distributor, high leakage losses and a cap on transmission charges. Approximately 30%-35% or power generated is lost in transmission currently. Distribution The distribution company can also generate electricity in-house, but the process remains same. Distribution Companies have pre-defined areas called circles where they can supply electricity. For a distribution company, metering plays a vital role. Metered units = Inhouse power generated (if any) + Power sourced from a generator to meet additional requirement T&D losses. A major concern for the Indian distribution companies is heavy T&D losses due to poor infrastructure. Due to weak anti-theft laws, 10%-15% of power supplied is lost in distribution. Key operating and financial parameters to be looked at Guaranteed return: A power company is guaranteed a certain return on capital employed on generation by the government. If input cost increases, a generation company passes on the cost through increasing the capital employed to maintain margins. Watch out whether there is a possibility of the government reducing the guaranteed return. If it does, it could affect profitability of a power company. Valuing a power company: Since this sector is all about assets, arriving a NAV is important from a retail investor perspective. It is simple and information is available in the balance sheet itself. As we mentioned earlier, it costs around Rs 40 m Rs 45 m to set up one MW of capacity (including distribution costs). For a pure generation company, it could range between Rs 20 m to Rs 25 m. NAV = (Capacity * rate per MW depending whether it is pure generation company or a combination of both) Debt + Cash. Divide NAV by number of shares outstanding to get an approximate NAV. This could serve as a benchmark. Dividend yield: Since power companies have strong cash flows, dividend is one key parameter to look at. Dividend yield is a very useful parameter. But if the company is in the process of expanding capacity, the dividend payout is unlikely to be high in initial years. Apart from what all has been said above, the investor needs to look at the past record of the management, its vision and its focus on business. After all its the management of the company

Equitymaster-Knowledge Centre-Intelligent Investing

143

who is the final decision-maker and the future of the company solely depends on the decisions taken by it.

Identifying a refinery stock: Dos and Donts


It is often said that the dynamics of the world economy are often altered due to the crude oil price movement. As a result, the dynamics of companies operating in this sector are very different. Here in this article, we deal with key factors that impact the performance of petroleum products companies. Profile Petroleum products can be broadly classified as kerosene, diesel, petrol, naphtha, aviation fuel (ATF) and liquefied petroleum gas (LPG). As the name itself implies, crude is refined into various usage based products or distillates. Without going into much complexity, the three broad classifications are heavy distillates (furnace oil and bitumen), middle distillates (diesel, kerosene, aviation fuel) and light distillates (LPG and petrol). This is how most of the companies in India classify products in their balance sheets. Margins are higher in middle and light distillates. Globally as well as in Indian markets, government has a vital role to play in internal policies and external diplomatic relationships. This is because crude oil involves diplomatic relationships on the sourcing front and outgo of foreign exchange. On the other hand, the government also plays a key role in fixing excise duties on petroleum products. Moreover, it also deals with basic requirements of industries and public in general.

Equitymaster-Knowledge Centre-Intelligent Investing

144

Revenues Revenues are a function of volumes and realisations. Lets look at the volumes side first. Volumes Volumes in case of oil sector are linked to economic growth. Why? Economic growth, as you know, is linked to the performance of the agriculture, industrial and services sector. When growth gains momentum, demand for petroleum products tends to increase and vice versa, as it is a source of energy. This is not just restricted to the industrial side but also from the retail market (more units of cars and CVs sold, higher is the demand for fuel). The industrial side Demand for petroleum products is relatively inelastic to change in prices. In case of industrial, the key user segments are fertilizer (naphtha or natural gas), utilities (naphtha or natural gas) and aviation (ATF). Any increase in power capacity, growth in tourism sector and better agricultural sector performance has a positive impact on petroleum companies. Hence, one should keep abreast of developments in these user segments. However, alternate sources of fuel like natural gas may adversely affect volumes growth. The retail side On the retail sector, demand drivers are primarily linked to income levels at the hands of people. Higher income growth will lead to a rise in automobile demand as well as usage

Equitymaster-Knowledge Centre-Intelligent Investing

145

of LPG. On the auto sector front, diesel accounts for an estimated 40%-45% of total consumption. Kerosene and petrol account for 8% and 13% of consumption respectively. Realisation One cannot however, ignore the realisation angle. Earlier before deregulation in 2002, the government fixed prices of petroleum products. Prices were cross-subsidised. While petrol prices were higher compared to the actual cost, kerosene, diesel and LPG were sold at lower rates. But with the dismantling of APM (administered price mechanism), prices of these products are now linked to international crude prices. What this means is that whenever crude prices go up, petrol and diesel prices will mirror the trend. Though LPG and kerosene continue to be subsidised, the government has decided to remove the subsidy in a phased manner. As mentioned earlier, government has an active role to play in this sector. Hiking diesel and petrol prices is a politically sensitive issue, which could affect the vote bank of any ruling party. In this context, prices of LPG, diesel and kerosene are not based on reality. Government intervention and policies play a major role in determining the prices and hence one should be aware of these developments. Expenses Since the prices of crude oil (major raw material) are linked to international prices, one must be aware of the prevailing prices internationally. Crude oil price is known to be very volatile (has moved from a low of US$ 10 per barrel to a high of US$ 147 per barrel) and is a function of demand and supply and also various geo-political situations. This apart, currency fluctuations alter the cost significantly. Key parameters to look into Consider key things that one should look while analyzing the companies in the sector. Refining capacity: To set up a 1 MT plant, an investment of Rs 10 bn is required. Of course, the cost goes down if one goes in for a higher MT plant. So, it is a very capitalintensive industry and therefore, barriers to entry are high. Besides, with environmental regulations expected to become stricter, watch out for the companys status on this front. Higher contribution from light and medium distillates is beneficial. Higher the refining capacity, higher the chances of altering product mix to derive more revenues. Though branding is possible, petroleum products are largely a commodity. Integration benefits: Another key aspect is to note whether a company is integrated forward (distribution), backward (crude oil exploration) or a standalone player (only refining). Standalone players have less bargaining power, as products have to be sold to

Equitymaster-Knowledge Centre-Intelligent Investing

146

consumers through an external distribution network. Integrated players have an upper hand. Distribution network: Petroleum products are usually sold through retail outlets that offer lot of leveraging opportunity for a company. Look out whether the company owns most of the outlets or it is franchise based. It costs Rs 20 m to set up a retail outlet and if a company owns a major part of the distribution, it can be valued accordingly. By leasing out part of its distribution, a marketing company can maximize revenues (like ATMs). Valuations: Since it is a commodity sector, valuations should be in line with the economic growth in the long-term. But some companies get lower valuations due to the PSU status. But if a player in integrated, valuations tend to be on the higher side. Price to earnings and price to book value are useful tools. And last but not the least, the managements past track record. Though the government owns some companies, watch out whether the management has been proactive in branding the product and new capacity expansions. But government intervention is still a reality and therefore to that extent, caution has to be exercised.

Identifying a Retailing stock: Do's and Don'ts


Retail as a whole can be divided into various categories, depending on the types of products serviced. It covers diverse products such as food, apparel, consumer goods, financial services and leisure. The proliferation of hypermarkets and supermarkets has led to a growth in food and grocery retail; thus, value retailing is seen to be gaining ground in India. The other high growth verticals are apparel and durables. Impulse goods like books and music are also gaining a larger share in the organised retail market, with players making stores more accessible to consumers. Retail business is linked to consumption patterns of the consumers and hence dependent not only upon likes and dislikes and changing preferences regarding goods and services but also on availability of disposable income in their hands. Thus, the growth of the sector is linked to discretionary income in the hands of the people, which is linked to economic growth. Here is an attempt to simplify the analysis of a retailing company. Revenues drivers Growth in Indian retail industry has been driven by the country's economic fundamentals over the

Equitymaster-Knowledge Centre-Intelligent Investing

147

past few years. Increasing number of nuclear families, easy financing options, increase in the population of working women, emerging opportunities in the service sector and rising disposable incomes during the past few years have been the key growth drivers of the organised retail sector in India. Consumers are now showing a growing preference for organised retail, which has resulted in increased penetration.

In case of retailing business revenue is a factor of sales of per square feet and total area under operation during the period under consideration. Since retailing is a business of volumes, analysis of revenues on per square feet basis provides better insight into topline growth - indicting whether the growth achieved is owing to more sales on the same footage or is the result of increased reach across geography. The company may witness topline growth but revenue per square feet (sq ft) may witness reverse trend i.e. declining revenue per sq ft. In this case, the topline growth can be attributed to the increased area under operation (increased sq ft) as new store sales generate more revenues than the same store sales. Thus, the topline growth alone does not help to evaluate performance, rather at times is camouflaged owing to new store momentum. To negate the effect of the same one should consider the revenue per sq ft, which helps to understand whether the topline growth is the result of additional area under operation or effect of penetration, or better merchandising mix or the effect of increased footfalls and the retailers ability to convert increased footfalls into cash memos. While evaluating a retail business on revenue per sq ft basis to find out whether there is actual volume growth one must also consider whether the retailer is in the business of value retailing (low margin - high volume business) or lifestyle retailing (high margin - low volume business) as margin scenario depends upon the type of retailing mix. A lifestyle retailer showcasing private labels (own brands) will have better margins compared to value retailer.

Equitymaster-Knowledge Centre-Intelligent Investing

148

Cost and margin analysis Raw material cost: This is one of the major cost head on which gross margin scenario is dependent apart from the industry related costs. A retailer's cost of goods sold includes the cost from its supplier plus any additional costs necessary to get the product into inventory and ready for sale. Generally its seen that in case of retailer who sources the final product i.e. the one who sells products of different brands, the margins will be on a lower side as compared to the retailer who sells in-house brands or private labels. The margins may differ to the extent of 25% or more, depending upon merchandising mix. It is not uncommon for a retailer to expect a minimum gross margin of 50% (also referred to as keystone mark-up) and fluctuates depending upon level of operation, competition, region etc. Personnel and administrative cost: Retailing is a service-oriented business. Apart from products offered what matters more is the attending customers and helping them in their purchase decisions. Thus, these costs are incurred to cater to the consumers needs (front end staff). Costs are also incurred for planning marketing strategies, administrative purposes, providing a good ambience for shopping, etc. Further, retailing companies do spend a considerable amount on advertising, in order to position themselves the minds of the consumer, to increase footfalls, bring to notice new offers and new initiatives. Rentals: This is one of the major costs. Store roll out and expansion plans depend a lot on availability of real estate at desired place at reasonable price. The location is the one of the main key factor that impact sales and earnings. Right location can boost sales, but high rentals take a toll on margins. In the light of expansion plans and new store roll out programme, this is an important decisive factor for domestic players. Rentals have been escalating in past two years owing to booming real estate sector and eating up into retailers margins. The rentals are around 10% of sales, and operating at such high lease rentals for a business with already skinny margins is not lucid. To combat the same retailers are tying up with mall developers or real estate developers or venturing into more profitable areas, or delaying their expansion plans. Other operational costs: Apart form these costs retailers also have to incur power and electricity charges, general administrative costs, transportation and handling expenses etc. Cash outflow is also accounted for maintenance and other services such as parking facilities etc. that result in shopping convenience and may also turn out to be a decisive factor for choosing a particular retailer. Expenses are also incurred on technology such as e-billing, tagging, security, etc. Other than operational costs, like any other business retailers too have to incur costs such as interest cost, tax payments, replacement (maintenance cost or depreciation charges w.r.t storesthe asset of the retail business) cost. Incase of e-retailing concept huge technology related costs are involved. In a service industry like retail, the one who is not only able to increase footfalls but

Equitymaster-Knowledge Centre-Intelligent Investing

149

also convert them into cash memos is considered to have understood the nerve of the consumer. The increased cash memos from the same stores owing to increased footfalls directly flows to the bottomline. Key parameters for selecting a retailing stock Sales growth and revenue per sq ft: One should look at the past five years sales growth and revenue per sq ft growth. Whatever be the trend robust, stagnant, declining trend or volatile, one needs to look further and evaluate the reason behind same as mentioned above. Further, consider whether the company has increased space, have taken up new initiatives etc. Operating margin comparison with peers provides an insight of com panys operational efficiencies. Find out how has been the trend in the past. If the company is able to sustain margins despite cost-push and competitive scenario, it is positive. If margins have been eroded. The same needs to be evaluated with much care, is it that the company has underperformed or the same has been impacted owing to rising cost of operation and increased competition, such issues to some extent are industry wide and impact players across industry. An efficient player and well-managed company is able to overcome these issues with improved sourcing, revised expansion plans (as many players in recent have started tapping Tier II and Tier III cities to boost sales and reduce costs). If margins have increased owing to increased sales from same stores or increased cash memos, it is an encouraging sign. While operating margin takes care of majority of the cost heads one should also look at gross margins that precede operating margins. Gross margin comparison with peers, help to understand the business and highlights the reason behind the same. As mentioned earlier, retaillier dealing in private labels or more focused towards lifestyle retailing with better sourcing capabilities will have better margins. Look at ratios such as current ratio and/or working capital to sales inventory levels, lower the better, and whether the company is able to generate cash for working capital requirement. Low levels of inventory indicate quick stock turnaround (either because of efficient sourcing capabilities). A negative working capital to sales ratio indicates that the company is able to generate revenue from operations to fund working capital requirements, which is a positive sign. Return ratios such as return on asset (whether the company has be able to leverage space to boost topline), return on invested capital (indicate whether the company has used its resources optimally or not). Look at dividend payout ratio, which also indicates

Equitymaster-Knowledge Centre-Intelligent Investing

150

whether the earnings are shared with the shareholders or entirely are ploughed back into the business. Valuations Retail industry is not fixed cost or capital intensive but is highly co-related to consumption patterns that decide spending. The growth prospects are indirectly related to the economic growth. Further, it is a working capital intensive industry. A look at price to earnings ratio will help to compare to the two companies and provide earnings visibility. Companies with better margins, working capital efficiencies and execution capabilities (fulfilling consumers demand, ex pansion plans on track etc.) will command premium. One must also take a note of the management quality, as ultimately the companys future prospects are dependent upon the managements moves. If the management is not proactive and does not react timely to changing situations, the companys growth may hinder and in turn impact the returns to shareholders.

Identifying a shipping stock: Dos and donts


Shipping industry is a primary means of international transportation of any essential commodity. Around 80% of the cargo moved today is seaborne and almost 100% of hydrocarbon is transported through ocean. The global shipping industry can be broadly classified into wet bulk (like crude and petroleum products), dry bulk (like iron ore and coal) and liners (like containers and others). There are various benchmarks that determine freight rates for these segments. The prominent amongst them are Baltic Freight Index, Baltic Handymax Index (for dry bulk segment) and World Scale (for tankers).

Equitymaster-Knowledge Centre-Intelligent Investing

151

The capacity of Indian shipping industry is estimated at 8.6 million grt (gross registered tonnage) with a fleet size of about 686 ships. The average age of Indian shipping fleet is 17.9 years compared to the world average of 19 years. Let us take a look into the demand and supply drivers for the shipping sector and also discuss the key factors that investors need to consider while investing in stocks from the sector. Demand drivers I. Trade growth World GDP growth: Shipping is a global industry and its prospects are closely tied to the level of economic activity in the world. A higher level of economic growth would generally lead to higher demand for industrial raw materials (like oil, iron ore and coal). Oil demand/Supply: The tanker market cannot exist without the demand for oil and in particular how much of the demand is met through domestic production and stocks. Besides demand, oil supply (which mainly comes from OPEC) is also of significance. The quantum of oil produced by OPEC has a direct impact on the tanker market. For instance, if OPEC cut downs its production in February 2007 (to keep oil prices at desired levels), shipping industry might be left with surplus capacity considering that the tanker fleet is already growing at a rate faster than growth in demand for tonnage. Oil inventory levels: The amount of oil held in storage which can be drawn upon to meet future requirements also impacts the demand for oil tankers. Generally, consumers hold stocks and levels are drawn down in winter and replenished in spring. Steel production: Iron ore and coal together represent about 42% of the total global dry bulk trade. Since iron ore and coking coal are key inputs in the production of steel, steel production plays a significant role in determining the demand for dry bulk carriers. II. Trade patterns Refinery locations: Before it can be used for final consumption, crude oil needs to be refined into products like petrol, diesel and kerosene. Since refineries are generally located away from the places of production, crude tankers are used to transport crude oil from producing countries to refineries. Tanker transportation is generally more viable for inter-regional trades while pipelines are preferred for intra-regional trades. To distribute the refined petroleum products to places of consumption, product tankers and pipelines are used. Varying levels of capacity and the sophistication of refineries' processing capabilities also play a role in oil markets. Many refineries are located in consuming regions, facilitating response to weather-induced demand spikes and seasonal shifts.

Equitymaster-Knowledge Centre-Intelligent Investing

152

Sourcing areas: The distance between the place of origin and the place of destination is an important demand driver since a shift from a shorter haul movement to a longer haul one (for the same amount of cargo) is likely to result in increased tonne-mile demand for vessels. Regional grain production: Grain, along with iron ore and coal represents a significant portion of the total dry bulk trade. In case of a drought in a particular region, arrangements are made to import food-grains from countries with surplus production. This, in turn, influences the demand for dry bulk vessels.

Supply drivers I. Ordering Shipbuilding capacity: The number of vessels that a shipyard can build and the time taken to build a vessel plays an important role in determining the growth in tonnage supply. Since new capacities take time to set up, shipyards are unable to cope up with any sudden increase in demand. This impacts the delivery of ships and thereby acts as a supply constraint. Considering the huge order backlog of global shipyards, especially those in the Asian regions of Korea and Japan, ship owners are currently being quoted deliveries that will be beyond 2011.

Equitymaster-Knowledge Centre-Intelligent Investing

153

New building prices: In case of high new building prices, shipping companies are likely to slow (or defer) their new purchases as the break even becomes higher. Similarly, lower new building prices can lead to increased orders (assuming that companies are expecting demand to pick up in the future), thereby increasing the total tonnage available in the market. II. Scrapping Economic Life: Higher the age of the fleet, higher is the expected scrapping and lower the net fleet growth. Economic life differs across vessel category (crude tankers have a relatively lesser economic life than dry bulk vessels). At present, the average age of the global shipping fleet is 19 years. Regulations: Statutory regulations on age and safety norms set by International Maritime Organisation and the European Union may place restrictions on particular kinds of vessels, thus affecting fleet augmentation. For instance, the International Maritime Organistaion (IMO) has stipulated that all single hull ships be scrapped by 2010.

Equitymaster-Knowledge Centre-Intelligent Investing

154

Over and above these fundamental demand and supply parameters, freight rates can witness spikes due to short-term events. These could be natural catastrophes, accidents or political upheaval in the form of strike/war, or even as basic as port/canal congestion. Shipping stocks: Key considerations Management: The ability of the management to foresee trends and alter the fleet mix accordingly to improve realisations is of high significance considering the volatile nature of the shipping industry. Since freight rates are highly volatile, it would be prudent for shipping companies to maintain sufficient revenue coverage through time charters. The company thus insulates its earnings from the highly cyclical nature of freight rates, thereby increasing its revenue visibility. Even though this comes at a cost of losing out on substantial upsides in case of attractive spot freight rates, the company can alter its mix of time charters and spot rates depending upon their outlook on freight rates. Fleet mix: As mentioned earlier, shipping companies operates in different segments viz., tankers (crude and product), dry bulk, gas, containers and offshore. The segment in which a particular company operates, and the freight outlook in that segment, will ultimately determine the future prospects of the company. As compared to the dry bulk and crude segment, the offshore business provides higher visibility and lower volatility. Oil rigs provide long term visibility to the companys revenues and with the rise in exploration and production (E&P) activities, the demand for offshore support vessels is likely to remain strong. Valuations: Shipping is a highly volatile business and freight rates are determined depending on global supply and demand. Therefore, valuing a shipping company on the basis of price to earnings may not be meaningful. However, considering the asset intensive nature of the shipping business, price to book value (P/BV) would be an appropriate method of valuation. Though the book value does not indicate the market value of the fleet, book value capture the essence of the balance-sheet strength of the company. It has to be remembered that when freight rates are higher, the asset value of the fleet increases and vice versa. If the company declares the net asset value (NAV), investors could use that as a very good indicator. Otherwise, we suggest investors to value a shipping business on the basis of P/BV. For offshore companies, price to earnings would be an appropriate tool as the revenue visibility is higher and also less volatile.

Equitymaster-Knowledge Centre-Intelligent Investing

155

Identifying a software stock: Dos and donts


As global economies are getting more integrated, technology companies are finding it an onerous task to align to the changing realities. In such a scenario, analyzing stocks from the technology sector require utmost caution and understanding. We will, in this article, try to elucidate the factors one should keep in mind before investing in a software sector company. Profile Large english speaking population and low employee costs compared to developing countries have been the foundations upon which the Indian software sector has evolved over the years. Software sector sells man-hours i.e. its earnings are from billing rates (dollars/rupees earned per hour of work) multiplied by number of hours worked by an employee in a year. However, there is one critical factor here. A software company can increase revenues by adding employees and/or by increasing utilization (number of employees actually working on projects as a percentage of total employee base) and/or by charging more per hour (i.e. billing rate).

THE LEFT-HAND SIDE (Hours Worked) Scalability Not every software company has systems in place to manage large addition in employees per annum. A company can increase its staff strength to say 3,000 in the first three years. However,

Equitymaster-Knowledge Centre-Intelligent Investing

156

to increase the number to 6,000, the business model should be robust. Scalability therefore, is of high significance. To succeed on the scalability front, a software company needs to figure out the kind of capacity (physical infrastructure like development centres, marketing and distribution channels), people, and technology it needs to invest in. However, the most important aspect of scalability is to make sure that employees are absorbed and trained (including the understanding of the companys culture and values). Utilisation Another aspect of scalability is the level of utilisation. A software company needs to make sure that its capacity is utilized as effectively and fully as possible. This will result in revenue maximization and higher productivity per employee. But both the factors listed above depend on the management vision, talent and ability to foresee future industry trends. Employee retention Owing to increasing competition for talent, the need to reward employees for the value they create is another critical factor that determines sustainable growth. The need to attract proper talent and retain it gains utmost importance. Software companies resort to measure like performance based incentives and ESOPs to reward their employees. THE RIGHT-HAND SIDE (Billing Rates) Having looked at factors that influences hours worked per annum, consider billing rates now. The value-chain Put simply, value chain has low-value add services like body shopping at the bottom of the chain to products at the higher-end. Moving up the value chain is delivering a service or product for which the customer is willing to pay a higher price because he perceives a higher value. However, moving up the value chain involves a whole set of issues. While marketing and branding play a key role, delivery of services is even more important. One way to measure the delivery strength of a software company is revenues from repeat business (basically, satisfied customers). Moving up the chain is an ongoing process. It takes time for a company to attain critical mass before it has the ability to bid for large value-add contracts. Onsite and offshore As per the outsourcing model, employees and their efforts are divided into two elements onsite (at clients location) and offshore (at companys premises). Although most of the Indian software majors are growing, success depends much on the way these onsite and offshore efforts are integrated in the most efficient manner to provide seamless services to clients. While onsite involves higher billing rates, offshore offers higher margins because costs are relatively lower.

Equitymaster-Knowledge Centre-Intelligent Investing

157

Competition Competition, both from domestic players and global players, also has a bigger say in billing rates. Since Indian companies are miniscule when viewed on the global scale, the bargaining power is on the lower side. Competition has surfaced from global majors setting up development centres in India in an effort to replicate the Indian offshoring model. Another thing to note here is, the higher a company is in the value chain, the lower the competition. Key things to look at before investing in a software stock Management: A management with vision is one of the major competitive advantages. Since the software sector is dynamic in nature, management quality has a high weightage. The ability to foresee threats/opportunities without diverting from the vision is important. Retail investor could gauge this from how the company has performed in a downturn/upturn compared to its peers in their respective competencies. Scanning the companies annual reports or the official web site also gives an indication of the managements future vision. Employee productivity: Productivity (revenue per employee divided by cost per employee) indicates how much value a companys employees are adding relative to the costs that are incurred on them. These are relative terms and have to be compared with the peer group. Revenue concentration: Since this industry has a high risk-profile, it becomes important to understand from where (geographical mix), from whom (client concentration) and how (industry verticals) is the company generating its revenues. Though few clients accounting for larger share of revenue is not necessarily a negative, diversification insulates a software company from volatility. Remember, earnings visibility in the sector is relatively poor. Financial ratios: Some quantitative measures evaluating a software company stock are P/E (relative to the sector), Return on Equity, Return on Assets and Return on Capital (for profitability) and Operating margins (for efficiency). Some companies command a higher premium due to subjective factors like management quality and their position on the value chain. A final note: Global IT spending and a move towards outsourcing Apart from the inherent features as mentioned above, there are a few external factors like the level of global IT spending and the percentage share India is likely to get from the same (simply,

Equitymaster-Knowledge Centre-Intelligent Investing

158

move towards outsourcing). At some point, the advantage of low employee costs could dry out and the sector could get commoditised. Besides, India has competition from the likes of China and South East Asia as other outsourcing destinations. So, building a competitive advantage is very important and for that, management quality plays a vital role. Investors do need to apply great caution before investing into software stocks.

Identifying a steel stock: Dos and donts


Steel stocks have been the object of heavy reviews off late in discussions about the Indian equity markets. And this is not without reason. In recent times, steel stocks have gained tremendously on the bourses. Whether this is a factor of rising speculation or fundamentals of steel stocks, is a different story altogether. However, in this article, we try to elucidate factors one should keep in mind before investing in a steel sector company.

Profile Steel industry plays an important role in the economic development of a country. India, being the 9th largest steel producer in the world, has a share of about 3.2% in world steel production of a little over 900 million tonnes (MT). Despite this, the per capita steel consumption in India is one of the lowest, thus providing the domestic industry with a huge potential to scale greater heights.

Equitymaster-Knowledge Centre-Intelligent Investing

159

On basis of scale of operations and level of integration, steel makers can be categorized into the following two types: Integrated Steel Producers (ISP)/Primary producers: These have manufacturing facilities right from the iron ore (raw material) stage to the finished steel stage. They use the blast furnace methodology for manufacturing steel. Secondary producers/Mini Steel Plants: This segment uses scrap and sponge iron as raw materials to produce steel. Their production method comprises mainly of Electric Arc Furnace (EAF) and induction furnace units. As far as the steel products are concerned, they can be classified into three categories. Semis, which are intermediate products, are cast from liquid steel for further rolling into finished products (longs and flats). Longs are primarily used in construction, infrastructure and heavy engineering. Finally, flats are used in automobiles and consumer durables. These are high-value products and thus enjoy higher margins. Now let us proceed with the various parameters indicated in the flowchart above: Revenues Revenues are a function of volumes and realisations. Lets look at the volumes side first. Volumes The demand from steel comes both from the domestic and export fronts. Also, this being a core sector, its volume performance is directly linked to the economy. This is because the demand for steel is derived from spending in infrastructure, housing, automobiles and consumer durables sectors. Fortunes of the steel sector are, thus, linked to the prospects of these sectors. Competition also plays a significant role in determining the prospects of the steel industry. Domestic steel producers face intense competition from global majors, chiefly due to the latters larger scale of operations (giving them benefits of economies of scale). Going forward, this sector is likely to face competition from aluminium, which is not only as strong but substantially lighter than the former. This could create a threat for steel, as user industries like auto, railways, etc. where fuel efficiency is an important factor, could switch their preferences to aluminium. Realisations Apart from the cyclical nature of the industry, realisations are also dependent on the following: Contract sales: Companys policy pertaining to its sales has an impact on realisations. Ideally, steel companies, to avoid uncertainty regarding realisations created due to volatility in global steel prices (due to cyclical downturns or unexpected events), get into

Equitymaster-Knowledge Centre-Intelligent Investing

160

forward sale contracts with their customers, which could be anything from a month to a year. However, at times of cyclical upturns, companies over exposed to long-term contracts are not able to fully exploit the benefits of rising steel prices. Value added (CR): Realisations are also dependant to a large extent on the products profile of a steel company. Companies with a larger presence in value added segments (like Cold Rolled (CR) products) are able to realise higher prices (about 20%-25% higher) for their products. Competition: Competition plays a major role in affecting realisations, as international steel companies with huge capacities (thus an appetite to bear lower realisations) tend to offload their produce in the markets at lower prices, thus making Indian steel exports price uncompetitive. Indian companies also face international competition on the domestic front when lowering of import duties result into international majors flooding their products into the domestic market. In this case, cost efficiency plays a major role for survival. Expenses As said above, in face of increasing competition, survival would depend on cost efficiency, more so in times of a downturn. It is, thus, imperative for these companies is to keep a strict check on their expenses and maintain (if not improve) their standards of efficiency. Some of these expenses are pertaining to raw materials, power, employees and interest cost. On raw material and power fronts, companies with captive facilities have an added advantage as purchasing these requirements from the market is expensive relative to their sourcing from internal (captive) facilities. Employee efficiency also plays an important role due to the large number of employees employed by this industry. Finally, as steel companies are capital-intensive in nature and have significant exposure to debt, managing interest cost is of utmost importance. Key parameters to be kept in mind while investing in a steel company: Cyclicality of the sector: This is a very important point, which should be remembered, before investing in a steel stock. This is because; this very factor can make or mar the fortunes of the sector and steel companies. Investments into a steel stock near the peak of its cycle could result in a huge chunk of the investment being wiped it. Nevertheless, identifying the bottom of the cycle is not an easy task. Integration advantage: Whether the company is backward integrated (ISP, as discussed above) or not, is a key factor for consideration. Backward integration has various advantages as have been mentioned above (captive facilities).

Equitymaster-Knowledge Centre-Intelligent Investing

161

Operating performance: The operating performance of a steel company is dependant to a large extent on the cyclicality factor. However, steel players with larger presence into contract sales and value added products are insulated, to a relatively greater extent, from the steel cycle. In this regards, operating profit margins (OPM) is one parameter to consider. OPM is also dependant on various internal parameters such as power cost per unit and production per employee. However, it must be noted that in the case of production per employee, the numbers could be skewed to the extent of the companies presence into mining of raw materials.

Valuations: Two important ratios to look at in a steel company could be the Price to Earnings (P/E) ratio and the Price to Book Value (P/BV). Since steel is a core industry and its performance is linked to economic growth, the P/E multiple of steel stock should more or less hover around the countrys GDP growth. However, at the same time, companies with greater exposure to international markets (exports) could command a higher valuation. The P/BV ratio can also be used as a parameter for comparison. This is considering the fact that the steel sector is capital intensive in nature with huge asset base and debt. Book Value is basically the NAV of assets in the balance sheet. P/BV thus indicates, theoretically, what the shareholder would receive if the company would ever go into liquidation.

Identifying a sugar stock: Dos and Donts


Sugar being a commodity, the sugar industry is cyclical in nature. It is a typical cycle which is affected by cane supply and sugar demand. In this article, we take a look at how to identify a good sugar stock. Currently, with the sector looking bitter, it is even more important to identify the right stocks to sweeten the gains. Profile Sugar is a cyclical and a highly regulated industry. Trade barriers, including production quotas, guaranteed prices and import tariffs, impart a significant degree of distortion to international prices. The relatively longer plantation cycle, coupled with restrictive trade practices, has imparted a fair degree of volatility to sugar prices. In India, sugar production follows a three-five year cycle. Higher production leads to increased availability of sugar thereby declining the sugar prices. This leads to lower profitability for the companies and delayed payment to the farmers. As a result of higher sugarcane arrears, the farmers switch to other crops thereby leading to a fall in the area under cultivation for sugar. This then leads to lower production and lower sugar availability, followed by higher sugar prices, higher profitability and lower arrears and thus the cycle continues.

Equitymaster-Knowledge Centre-Intelligent Investing

162

The production of sugar is seasonal. Sugarcane is crushed from November to April. The critical growth driver for the industry is consumption based on the population growth rate. The supply of sugar is dependent on a number of factors including sugarcane production (area under cultivation, yield), sugarcane utilisation for sugar production, duration of the sugar season, sugar recovery rates and cane pricing. By-products Additional revenue

Due to this cyclical nature, sugar manufacturers are vulnerable to industry oscillations. However, sugar by-products like molasses (ethanol, ENA and rectified spirit) and bagasse aid the sugar producers in diversifying risks and lending stability to their revenues.

Equitymaster-Knowledge Centre-Intelligent Investing

163

Products Stand-Alone Mill Sugar (Kg) Total Revenue Cane price Contribution

Quantity Revenue (Rs) 100 1,750 1,750 1,150 600

Integrated sugar Mill Sugar (Kg) 100 Ethanol (litres) 10 Power (kwh) 114 Total Cane price Contribution

1,750 180 330 2,260 1,150 1,110

As can be evinced from the above table, if 100 kg of sugarcane is crushed, an integrated sugar mill will generate revenues of around Rs 2,260 versus the standalone sugar mill, which will earn Rs1,750. Net contribution for the same will be around Rs 1,110 for the integrated sugar mill and Rs 600 for the standalone sugar mill. So the more integrated the firm is, the better is the cushion. Key financials and ratios to look at Revenue breakup: The sugar industry is closely linked to the sugar price cycle. Higher cane and sugar production results in a decline in realisations for companies. Due to this cyclical nature, sugar manufacturers are vulnerable to industry oscillations. However, sugar by-products like molasses (ethanol, ENA and rectified spirit) and bagasse aid the sugar producers in diversifying risks and lending stability to their revenues. The company that has an integrated business model stands to survive the downturn cycle. The margins of the byproducts are higher than that of the sugar segment. So companies with an integrated model are a better play. Recovery rate: This plays an important role for a sugar company. If the recovery rate is higher than its peers, it shows the efficiency levels of the company. Higher recovery rate leads to higher volumes thereby increasing the sales. Operating margin trend: The sort of margins that a company has vis--vis its peers is an important factor that needs to be looked at i.e. whether the trend is improving or is there a continuous decline. By products have higher margins than the sugar segments. Those companies that have an integrated model stand to benefit in terms of higher margins.

Equitymaster-Knowledge Centre-Intelligent Investing

164

Cash flows: A look at the companys cash flows and the working capital efficiencies will give an idea of the companys bargaining power as well as its ability to utilizeits resources and supply chain. It is also important to look at the P/E (price to earnings multiple) which the company is trading at vis--vis its peers. Companies with an integrated model, larger capacities, better relations with farmers, contracts with power and oil companies will most likely be trading at a premium to peers based on these parameters. If so, then one has to gauge whether that premium is justified. Stocks trading at an unrealistic premium will not be a good option to invest in. After all, valuations have to justify the companys growth prospects. Above all this, look at the past record of the management, its vision and its integrity. The management is responsible for the survival of the company and enhancement of the shareholders return. If the management has a track record of being on the sly or slow to react to market conditions, then even if the company is the largest or the most efficient, it may not give you your rightful share of the companys growth and profits.

Identifying a telecom stock: Do's and Don'ts


Telecom has been one of the fastest growing sectors in India, with the performance of services providers being led by mobile telephony. From around 2.8% tele-density (connection per 100 population) in March 2000, the sector now connects around 17% of India's population through a host of services, which include mobile, fixed line and Internet. Thriving Indian businesses, especially the IT and BPO industries have also helped the strong growth in another segment called 'Enterprise services', which include wholesale proviosion of data and bandwidth services.

Equitymaster-Knowledge Centre-Intelligent Investing

165

In this write-up, we shall analyse the telecom sector in its most fundamental terms, thereby studying the basic business models of companies in the sector. We shall also outline certain key points that investors need to consider before investing into a telecom stock. Let us begin by brief definitions of the four major sub-segments that make up the telecom sector: 1. Mobile/Cellular 2. Fixed Line 3. Internet 4. Enterprise We shall first take up the revenue analysis of these segments and then moving on to the cost structure for telecom services providers. Let us first understand the mobile/cellular services business in its entirety. REVENUE ANALYSIS I. Mobile/Cellular services The cellular mobile service providers (CMSPs) make available mobile telephone services where

Equitymaster-Knowledge Centre-Intelligent Investing

166

by a customer on possession of a handset and obtaining a connection by way of SIM (Subscriber Identification Module) card (for GSM based technology phones) is able to connect to the network of the service provider. This is a wireless service that allows the customer to connect with other wireless customers as also wire line customers. A CMSP derives its revenues by way of tariff charges for outgoing calls made by subscribers on its network. As such, revenue for a CMSP is simply a multiple of average revenue per subscriber per month (ARPU) and number of subscribers. Let us now understand what determines the ARPUs and subscriber base. ARPU: Average revenue per subscriber per month, or ARPU, is the amount of money that a CMSP generates per subscriber per month. It can be obtained by dividing the total wireless revenues by number of subscribers and then dividing the output by number of months in a period (i.e., 3 months for a quarter and 12 months for a year's calculation of ARPU). To even out the volatility in ARPUs, if any, it is better to arrive at the figure by averaging the wireless revenues and subscriber base for the latest two years. However, considering the rapid pace of subscriber addition for Indian CMSPs, ARPU calculated as dividing the trailing 12-months wireless revenues by latest subscriber base is also an appropriate figure. For instance, if a CMSP has earned a total of Rs 50,000 m as wireless revenues in the past 4 quarters (or trailing 12 months) and its current subscriber base stands at 20 m, its ARPU will be Rs 208 per month (Rs 50,000 m of wireless revenues divided by 20 m subscribers divided by 12 months). Another way to arrive at ARPU is to multiply the average number of minutes of usage (MOU) per subscriber per month with the per minute tariff. Most of the Indian CMSPs generally disclose their MOUs and per minute tariff and as such, these can be used to determine the ARPU. While there might be a direct correlation between change in MOU and change in ARPU, it might not work the same in India's case as tariffs are falling at a rapid pace. As such, even if a subscriber talks for a longer time, the CMSP's ARPU might not increase at the same rate as per minute rate might decrease. Subscribers: Growth in a CMSP's subscriber base is dependent on several factors, the key amongst them being: Economic growth: With growth in the economy, and the consequent increase in activity, it requires people to be in touch even when on the move. This brings out a pressing need for owning mobile/cellular phones. Thus, with a growth in economic activity there will be more and more people subscribing to telecom services, thus leading to growth in subscriber base for CMSPs.

Equitymaster-Knowledge Centre-Intelligent Investing

167

Rising income level: As the real income levels in a society rise, more and more people are able to afford usage of cellular phones. Also, with rising incomes, as personal consumption expenditure (as percentage of income) reduces, the consumer does not feel the pinch of rising telephone bill, thus having the propensity to talk more, thus leading to higher MOUs for telecom services providers.

Affordability: While there may be a need to be in constant touch as outlined by the above two factors, it is the increased affordability that really increases the demand for such services. The affordability is interplay of lower tariff charges and availability of cheaper handsets. While lower handset costs make mobile more affordable at the entry level thus allowing more people to be a part of the 'mobile community', lower tariffs allow for an increased usage of telecom services, while not having such an overbearing impact on telephone bills.

II. Fixed line services The fixed (wireline) services are dominantly provided for by the PSUs (BSNL and MTNL) in India. A customer can obtain a connection where by a wireline provides him with the last mile connectivity on the national telecom network. Although this had been a dominant mode of telecommunication in the past, it is fast being replaced with mobile telephony, which has the advantage of connectivity on the move. The fundamental business of a fixed line operator is almost similar to that of a CMSP, in terms of ARPU and Subscriber base. III. Internet/Broadband The Internet services are provided either by telecom service providers or independent Internet service providers (ISP) who deal exclusively in providing this service. There are two forms of Internet that are currently popular - the dial-up connections and the broadband connections. While both these forms are used for transmitting and receiving data, a broadband connection (Internet access that allows minimum download speed of 256 kilo bits per second from the point of presence of the service provider) allows you to transmit data at faster rate. The Internet business also works like a generic telecom business but for the fact that here, a personal computer (PC) is used for data/voice transmission instead of a phone unit (mobile or fixed line handset). Apart from the usual - economic growth and rising income levels - the growth of the Internet business is dependent upon: PC penetration: Internet penetration in India is currently at very low levels, as compared to its developing peers. This is set to take off with the rise in PC penetration, which will again be a consequence of affordability in terms of lower PC costs and reduced cost of

Equitymaster-Knowledge Centre-Intelligent Investing

168

data transfer. The cost of data transfer depends on whether one is using a dial-up or a broadband connection. The dial-up package entails a fixed charge for Internet access and a variable charge for the telephone connection. On the other hand, tariffs for broadband are usually designed on the basis of quantum of data transmission. As there is rationalisation of these tariffs going forward, Internet will become more affordable and this will drive growth, as the recurring expenditure will reduce. Parental encouragement: An interesting change that has come is the way parents now look at computers. The age of a typical computer user has dropped significantly as parents increasingly realise the growing importance of computers in education in the years to come. So, unlike most products where children are targeted to drive sales of consumer durables, in the case of computers, it is the parents who are going all out to ensure that their child grows up to be a computer literate. Thus, with computers coming into homes, it will not be long before parents will wish their children to be wired to the web owing to the rich source of information. IV. Enterprise services Moving on from the individual, who is the major user of mobile, fixed line and Internet services, let us now briefly analyse the 'Enterprise services' business of telecom companies. These services are used by large and medium corporates for data transfer between their offices and/or their suppliers' offices, which may be spread in a city, or a country, or even across continents. The need of users to have a seamless connectivity with their associates is what drives this business for telecom companies. Considering that this business takes care of data transfer needs of corporates, who are not as 'affordability' conscious as the individuals (who use mobile, fixed line or Internet services), telecom companies generally earn higher margins on Enterprise services than they earn on any of the other three business lines. IT and BPO sectors, whose business is so data dependent, are the major users of Enterprise services. COST ANALYSIS After discussing the revenue aspects of telecom service providers, let us now understand the major cost heads for these companies. These cost heads can be broken up into regulated and non-regulated costs. Entry fee, access deficit charge and license fee are regulated. On the other hand, sales, general and administrative (SG&A) and employee expenses are non-regulated in nature. Entry fee: The companies providing national and international long distance (NLD and ILD) services are required to pay a flat entry fee of Rs 25 m each (from earlier fees of Rs 1,000 m and Rs 250 m respectively). These fees are to be paid to the central government for obtaining a license for providing these services.

Equitymaster-Knowledge Centre-Intelligent Investing

169

Access deficit charge: The government also collects from the cellular operators an access deficit charge. The charge payable is 1.5% percent of non-rural annual gross revenue (AGR) of the telecom service providers and the amount collected is used to subsidise the telecom service provided by BSNL in rural areas.

License fees: Telecom companies are required to pay an annual license fee of 6% of their AGR to the Government of India. Licenses offered to the telecom players are for a limited period of time and these are required to be renewed on expiry.

SG&A expenses: Telecom companies incur expenditure in the form of advertisement costs for enhancing their visibility and also to make their brand more appealing to the consumers. Expenses are also incurred on customer acquisition and on maintenance of telecom equipment and network.

Personnel expenditure: These are costs incurred for maintaining the staff for executing the telecom companies' marketing strategies, for general administrative purposes, for maintenance and repair of telecom infrastructure, and customer relationship management in call centers.

Apart from these operating costs, telecom companies also incur cost for servicing debt and tax payments. Telecom is an operating leverage play (indicates that each new subscriber will come at a higher profitability than the previously added subscriber), and, as such, the benefits of faster subscriber addition are directly seen on companies' improving operating profitability (as fixed costs are apportioned over a larger subscriber base). Key factors for identifying telecom stocks After analyzing the fundamental factors driving a telecom company, let us now understand certain key factors that you need to consider before investing into a telecom stock. Management vision and depth: Apart from rollout of services into newer territories and subscriber addition, what leads to sustenance in a telecom company's growth is the management's capability to discern ongoing trends, innovate and have a vision for the future. This is of critical importance, as it helps them to formulate the right strategies keeping on track the company's performance. Owing to the fact that the management and ownership are different in a public limited company, an investor (owner of a part of the company) must ensure that the near term goals of the management are aligned with the long-term objectives of the company. Scale of operations: Investors must look for telecom companies with a large coverage not just in terms of geographical area but also in terms of services offered. In a telecom industry, it is possible for the company to generate multiple revenue streams by utilising the network in an

Equitymaster-Knowledge Centre-Intelligent Investing

170

efficient manner. This also helps create a natural hedge against a slow down in any particular segment. Capex plans: India is a vast country and telecom companies are required to expend huge sums in the form of capital expenditure for roll out of services. As a result, it is important to look at the company's capex plans and how is it going to fund the same. While for most companies in the initial period of rapid growth, net cash generation (after meeting operating expenses) might not be adequate to meet the funding requirements, it is pertinent for the investor to understand whether the management has been prudent enough in its funding plans. Too high a dependence on debt in times of rising interest rates might impact profitability. Key financial metrics: Before investing in a telecom stock (or for that matter any stock), an investor must closely look at the key financial operating and profit ratios of the company. The ratios are nothing but an arithmetical representation of a company's financial data that help in gauging the health of the company. Key ratios to be look at for a telecom company are as under. It is important to look at these ratios for 3-5 years in the past, considering that most telecom companies in India do not have a history before that. Sales growth Average revenue per user Subscriber growth EBIDTA margins or Operating margins [(Sales - Operating expenditure)/Sales)] Interest coverage [Profit before interest and tax/Interest] Net profit margins [Net profits/Sales] Earnings per share EBIDTA per share Debt to equity Return on equity [PAT/Equity or Net worth] Return on capital employed [PBIT/Capital employed, which is Equity + Debt] Free cash flow [Profit after tax + Depreciation - Dividend & Dividend Tax - Capex Working capital changes] Apart from these, investors should also compare other key ratios like receivable days, working capital turnover and asset turnover, amongst others to arrive at a final view on the company (not the stock!). Importantly, these ratios must not be looked at in isolation and one should look at the past data as well to arrive at a trend, which shall give a better perspective of the company's performance

Equitymaster-Knowledge Centre-Intelligent Investing

171

over the years. Also, an investor must compare ratios of the company with the industry leader and its peers to gauge a company's relative performance. Valuations: As we have indicated above, comparing a host of financial metrics will give the investor a final view on the company, but not the stock. For arriving a final view whether to buy or sell the stock, one needs to study the key valuation ratios. Telecom companies can be valued by using the 'Price to earnings (P/E) ratio'. Also, considering the high levels of depreciation (that is a non-cash expense), a 'Price to cash flow (P/CF)' valuation can also be considered. Investors can even use the 'Enterprise value per subscriber (EV/Subscriber)' ratio, which indicates the price at which a company can be bought over.

Identifying a textile stock: Dos and donts


The debt-laden Indian textile industry that was embroiled in BIFR cases until the early part of this decade, spun a turnaround with the lowering of interest rates and dismantling of the quota regime. Aided by lower interest rates, restructuring packages from financial institutions and the more recent Technology Upgradation Fund (TUF), the sector today is well poised to capture growth opportunities. Apparels vs. Home textiles The product profile of domestic textile players needs to be understood in relative terms with that of players in the lead competing nations. What differentiates Indian textile industry from its low cost peers (namely China, Pakistan and Bangladesh) in the highly competitive post quota era is the relatively de-risked business models. While players in the apparel business have upgraded their product mix to meet customised demand of apparel exporters and developed made ups from fabrics, the home textile players enjoy a distinct advantage against their peers in the neighbouring countries in terms of being first-movers.

Equitymaster-Knowledge Centre-Intelligent Investing

172

While competition is relatively lower in the domestic apparel fabric market (due to high degree of sophistication required in designing and finishing), the market for export of home textile is very favourable for Indian players, with most of the European companies having gone into bankruptcy. Also, while the apparel segment enjoys higher margins (as compared to home textiles), the home textile division is a hedge against changing fashion trends in the apparel segment. The two business models thus, offer diversification in terms of products, customers, fashion cycles and currency risks. Cyclicality parallel to discretionary income The cyclicality in the textile business is closely linked to the discretionary income in the hands of people, in other words - the buoyancy in the economy. However, here one needs to note that with the global markets now being accessible, the industry slowdown related risks in the domestic economy remains limited. We therefore enlist some of the key demand and supply drivers taking into consideration the dynamics of the global textile markets. Demand drivers: The global textile industry is valued at US$ 440 bn. US and European markets dominate the global textile trade accounting for 64% of apparel and 39% of textile fabrics market. With the dismantling of quotas, global textile trade is expected to grow (as per Mc Kinsey estimates) to US$ 650 bn by 2010 (5 year CAGR of 10%). Although China is likely to become the 'supplier of choice', other low cost producers like India would also benefit as the overseas importers would try to mitigate their risk of sourcing from only one country. India's textile export (at US$ 15 bn in 2005) is expected

Equitymaster-Knowledge Centre-Intelligent Investing

173

to grow to US$ 40 bn, capturing a market share of close to 8% by 2010. India, in particular, is likely to benefit from the rising demand in the home textiles and readymade apparels segment, wherein it has competitive edge against its neighbours. Nonetheless, a rapid slowdown in the denim cycle poses risks to fabric players. Supply drivers: India is the third largest producer of cotton in the world after China and US and has the largest area under cultivation. Cotton, a key raw material in the textile and garment industry, accounts for about 30% of the fabric cost and 13% of the garment cost. India has an abundant supply of locally grown long staple cotton, which lends it a cost advantage in the home textile and apparels segments. India also enjoys a significant lead in terms of labour cost per hour (US$ 0.6 in 2004), over developed countries like US (US$ 15.1) and newly industrialised economies like Hong Kong (US$ 5.1), Taiwan (US$ 7.1), South Korea (US$ 5.7) and China (US$ 0.9). Also, India is rich in traditional workers adept at value-adding tasks, which could give Indian companies significant margin advantage. Textile stocks- Key considerations Demand slowdown: Although the domestic demand for textile remains robust, the same is not true for the branded garment segment. Therefore, manufacturers largely rely on the overseas markets for vending their products. Of this, the US and the EU consume nearly 90% of exports. For home textile companies, the domestic market being dominated by unorganised players, nearly 90% of the produce is exported. However, with the US and the EU economies now showing signs of slowdown, the same will inevitably have an impact on the incremental demand. Key ratio Exports / Total turnover Exchange rate risks: Given the volatility of the rupee against foreign currencies (especially against the US dollar), the exposure to the overseas markets renders the textile companies to significant foreign exchange risks. Although most textile companies have some hedging mechanisms (example, forward bookings) in place, an unexpected movement in the rupee can obliterate such efforts. Key ratio Forex loss / Operating expenses Hardening interest rates: Rise is interest rates at a time when most textile companies are heavily leveraged due to the ensuing or ongoing capex plans is bound to pressurise their interest coverage ratios. In fact, this is the time that will test whether the companies have taken cognizance of the lessons learnt during the previous interest rate cycle. Nevertheless, companies that have already taken advantage of the TUF (Technology Upgradation Fund, offering loans at 6% subsidy - proposed to expire in March 2012) to fund their capex are, however, better off than their peers. Key ratios Debt /Equity, Interest coverage

Equitymaster-Knowledge Centre-Intelligent Investing

174

Overcapacity: Companies in the apparel and home textile segments alike have huge capacities coming up in the near term. However, the underutilisation of these capacities, led by flagging demand, may deny any operating leverage, thus forcing them to compromise on their operating margins. Key ratio Capacity utilisation Logistic disadvantage: India's logistic disadvantage due to its geographical location can give it a major thumbs-down in global trade. The country is distant from major markets as compared to its global competitors like Mexico, Turkey and China, which are located in relatively close vicinity to major global markets of US, Europe and Japan. As a result, high cost of shipments and longer lead-time coupled with lack of infrastructure facility may prove to be major hindrances. Companies that have achieved integration between the various links in the supply chain through their global subsidiaries stand to gain in this regard. Competition against global leaders: With foreign brands being allowed to make a foray into to India through the FDI route (FDI in single brand retailing) it calls for competitiveness on the part of the Indian players. Be it through the joint venture route or otherwise, companies that have so far been taking the advantage of in-licensing the established brands now need to focus on building their own. How to value a textile stock? Earnings of the textile sector have been very volatile in the past due to reasons like change in raw material prices (wool and cotton), slower demand growth, foreign exchange sensitivity and competition. The scenario is likely to remain the same in the future as well, despite growth opportunities in international markets. Since textile is a mature industry, companies in the sector are valued on the basis of their price to forward earnings multiple (P/E). Having said that, investors should also accord some premium in valuing companies that have differentiated themselves on the following parameters. Value addition: Focus on higher value addition and thrust on enriching product mix is India's attempt to differentiate itself from regional peers such as China and Pakistan. India's higher price realisations have reasonably compensated for the relatively lower market share of exports to the US as compared to China. Further, once the higher capacities get commissioned, we believe that the Indian companies (into value added products) would be in a position to garner better margins and healthier profitability in the future.

Equitymaster-Knowledge Centre-Intelligent Investing

175

Yet to reap the fruits of capex: Most companies in the sector timed their expansion plans FY04 onwards, so as to avail themselves of the funding under TUF (earlier due expiry in March 2007). This led to the capex-spending phase in the textile sector peaking in the last two fiscals. Against this backdrop, we believe that a majority of the capex in the sector has already been incurred or is in the last leg of completion, the benefits of which should start filtering in from FY08 onwards, once the new capacities stabilise and the utilisation levels get normalised. Nonetheless, with the TUF duration getting elongated and proposed investments set to be completed by FY10, the capex benefits are yet to become visible. Overseas alliances to help move up the chain: Several Indian textile companies have formed alliances with their global counterparts, particularly those with strong front-end capabilities, in a bid to access global markets, tap technological know-how, design skills and branding and retailing ability. The alliances have been struck in most cases by way of JVs or stake acquisition. Retail footprint: Most large textile companies in India, realising the growth potential in domestic retailing, have drawn up aggressive strategies to expand their footprint in the domestic market. These include companies like Welspun and Himatsingka, which were traditionally export-oriented, as also Raymond, which has been the pioneer in domestic textile retailing. Home textile (furnishing) companies like Himatsingka and Welspun have also taken steps in this direction with their outlets Atmosphere and Spaces respectively. While strong business prospects, valuations and peer comparison do serve the purpose of identifying a textile stock, the investment argument must be backed by a strong track record of the management, its vision and its integrity. The same especially holds true in case of the textile sector where the management is responsible for the survival of the company in times of downturn and enhancement of the shareholders return in good times.

Source: http://www.equitymaster.com/research-it/help/knowctr.html Equitymaster-Knowledge Centre-Intelligent Investing 176