index: falling prey to the numbers

Have a look at the below table for Sensex:

We can see that over 22 years, the compounded growth of the Sensex has been at a respectable rate of 14.53% pa. This means Rs.100,000 invested directly in the market would have grown to about Rs. 2,000,000. No stress, no trades, no commissions, no research, no-nonsense.

During this period, too many events have taken place - trade deficit crisis, currency crisis, terrorist attacks, IT bubble, policy scams, financial crisis, the global meltdown; and the policy reforms, growth in corporate earnings, growth in the GDP and the global recognition.

It looks like in the final analysis, positive events driven by the fundamentals beat the negative events. Hence, the march of the Sensex.

We have seen it before in Dec-2011 and Oct-2012. Where do we stand today?

We saw the peak values of 52.6 P/E, 9.4 P/B and 0.51 Dividend yield in April 1992; and the low values of 10.2 P/E, 1.7 P/B and 2.2 Dividend yield in October 1998.

While we do not know when we will see those values in future, today it looks like this:

17.4 P/E, 2.9 P/B and 1.5 Dividend yield.

Compare this to the average values:

21 P/E, 3.7 P/B and 1.4 Dividend yield.

It looks like we are in the range of average values. Is this the buy time then?

The average values may have to be reworked backing out outliers.

Let's have a look at values when the Sensex peaked at 20509 in December 2010:

22.9 P/E, 3.7 P/B and 1 Dividend yield.

There isn't big difference between P/B and Dividend yield of today and December 2010. P/E was a little higher in December 2010 though.

The Sensex is neither very cheap nor very expensive now.

What we need is a set of assumptions for long term investing:

1. The government will take the right policies for reforms in the key sectors of the economy;
2. The interest rates (and the inflation) will remain at reasonable levels;
3. The corporate profits will grow; and
4. Positive events will outweigh negative events over the period.

I am optimistic about those assumptions. The next decade or so should bring in a lot of opportunities to make money.

Two options are available:

Be very passive and invest in the market itself. Don't trade, speculate, or predict. Don't track or time the market. OR

If interested and time is available, get into equity research business and play the investing game for long term. It can be fun and rewarding.

We don't just need the new year wishes; we need wishes for the new decade.

beat them in the (investing) game

The players and their fate
There are investors. Then there are speculators...traders and punters. And there are mutual funds. All of them trying the same thing. Beat it. Make it.

Investors have noble thoughts though. They want to protect their downside and aim to earn adequate return which is some points over the market return. Some do; some don't.

Speculators, well, want to do what they are good at..speculate. They win some and lose more, much more. Negative-sum game players. Their instincts never let them stop playing. They will play until they are gone. Needless to say, their net returns are poor. They always lag the market. Don't believe them when they say they do.

Institutions (mutual funds and the like) want to beat the market by some solid points. They hire managers with special skills; they talk the jargon; they use presentations; they want to be high profile. But overall, they remain good only at that, crunching numbers. Their result is mediocre. No, the majority is not able to beat the market.

They continue playing the same game
When the large majority cannot even equal the performance of the market itself, it is surprising that none of them think of doing something different. That is, work towards beating the market or at least equaling the market.

A new game: Beat it
Beating the market, though not impossible, requires different skill set. Not the jargon or the gibberish. It requires an acceptable investing framework and rational behavior. It appears simple, but in reality can test anyone.

Key requirements are treating investing as a business by itself (you are the business owner), and devoting sufficient time to learn about it: prepare the framework and develop the right behavior.

This is a lengthy process like any other business. As you go along, you will learn about various securities (businesses) and how to value them under different circumstances.

If you run this business of yours properly, you should be able to aim for market beating returns, that is, some points over market. And over the long run, these additional points should be able to make you rich enough.

Another game: Beat them
Well, if you don't have time and patience to start your own investing business, or you don't enjoy this process since you consider there are better things in life to have fun, it's not a big deal. You can still make money..in the long run. You will not beat the market but you will beat the majority of those players out there.

All that is required is discipline and patience. This game is called index investing which is investing in the market itself. You will get the same result as the market.

If the market goes up by 10% you will see 10% (almost) upside, and if it goes down by 5% you will see 5% downside too. In short, your performance will mirror the market performance.

With this you will beat a vast majority of those so-called investors (individuals and institutions) out there. What more do you need?

It works like this: You invest X amount each month (week, quarter, half-year or year will do) in a broad index fund (exchanged traded or managed) irrespective of the index value. You continue this process for sufficiently long period, say, 10, 20 or even 30 years. The result should be pretty good indeed if you work the math. The magic of compound interest is marvellous.

You should not skip investing; and should not track (worry about) the market in the entire period.

There are detractors to this kind of investing. They argue: Companies in the index change all the time; Index funds invest in only large-cap companies; Index funds have to invest in expensive stocks; As the index value goes up (that is, as market cap of the companies in the index goes up), the large base effect restricts profits.

Consider this: The Nifty value in Jan-1994 was 1083; now it is 5908; The Sensex value in Jan-1991 was 982; now it is 19444. Even at today's weak market conditions (high interest rate and low demand) the market performance has been at a compounded rate of over 10% pa.

There is far lower risk (and stress) in index investing since it goes for a long time. You see much volatility in the mean time, but over the long period the risk is virtually not there.

There is no reason why we cannot see market return of about 10-15% pa compounded over the next 10-20 year period.

This is certain if two things hold good: reasonable interest rates and higher corporate profits. India has virtually no choice in its policies. The reform policies may be delayed but they will have to come lest we will be in debt and danger. The potential for growth is there with so much to be done in infrastructure, energy, agriculture, manufacturing and services.

That points that index investing is, after all, not that bad. Do the math with your choice of monthly investment, number of years and a return of 10-15%, and check.

So for all those beach lovers or what have you, there is a choice to have fun in life, do the favourite day job and make money.

Wonder if those institutions are listening. If they aren't, you will be beating them at their favourite game in their field in the next 20 years.

Low risk, low stress, more fun and more money. Too good to be true, but it is true.

business that needs capital

All businesses need capital: Capital is required to start a business; for it to continue as a going concern, it needs capital; and for it to grow, it needs capital. There isn't anything new to this story.

what we don't want
However, there are businesses which unfortunately require loads of capital to start, then loads of it to continue, and loads of it again to grow. It is the nature of the business, that's it. These will then have to look for sources of capital: equity and debt combinations. This continuous look out for large capital can make the firm vulnerable to circumstances.

Take for instance, capital goods manufacturing and heavy transport companies.

There are at least two characteristics, arising out of leverage, that stand out in such a capital-intensive business:

It has a high percentage of property, plant and equipment compared to its total operating assets. Due to this, it is exposed to operational leverage. In good times, with rising output, the profits will be higher. However, with a very low portion of variable costs, in a downturn the business will suffer.

Because of its capital needs, the business will have to borrow more compared to its equity. The firm will be able to (required to or tempted to) borrow based on its physical assets. The result is a high debt ratio.

Due to higher operational and financial leverage, a capital-intensive firm will find it very difficult to adapt to changes required by market conditions. Changes in technology or in consumer demand could challenge the firm's fundamentals.

A slump in the economy could lead the smaller firms to question their survival and the larger firms to question their prominence.

An investor has to be careful in investing in these type of businesses. Assessment of long-term survival is vital.

what we want
But how about a business that requires capital, but not that much, to grow? And how about one that generates its capital on its own?

Enough cash is generated by the operations which is used for reinvestment purposes, and excess cash is returned to shareholders.

These firms largely run on the strength of their brand created by high quality management and top quality products purchased more often (customer satisfaction; high demand). These businesses generally provide higher return of investment.

There are enough of these type out there, if not plenty; we just need to explore!

Let's get on to that. 

making millions...the hp way

It is not that difficult to have a business with a valuation of millions of dollars. It is easy if you start off with a business worth billions, and then continue losing some billion here and some there regularly; slowly but surely, your business would be worth millions.

It looks like HP has taken this strategy rather seriously; you can see it from HP's style of running the business. Buy assets for billions and then write them down. HP's value has fallen from $60 b to $25 b in less than a year.

Loss of wealth over the years:

Physical growth does not necessarily translate into profits. For growth to add value, it has to generate return in excess of cost of capital. When this does not happen, it is destruction of wealth. Key to achieving excess returns is to ensure that purchase price is not heavy. Often, synergy effects are pointed out as value drivers to justify whatever the price paid.

When things fail, the blame-game begins. There are investment banks and audit firms, who gain fees irrespective of the deal. Then there is the board, who is supposed to oversee the proceedings and approve acquisitions before management can complete it. And the management, who does it. Collectively, these parties can destroy shareholders' wealth in the name of acquisition, control, growth and synergy. DCF presentations are made in support of any (acquisition) price. Cheery consensus.

Good corporate governance is what matters in the end for shareholders to see their wealth grow. If there are conflicts of interest among the managers, shareholders and others, it does not bode well.
 

towering bucks...bharti infratel

The upcoming IPO of Bharti Infratel aims to raise about Rs.4,500 crores at the price band of Rs.210-240. Representing a public offer of 18.89 crores shares (about 10% of total shares outstanding), the market value of the company will be almost Rs.45,000 crores.

If the issue becomes successful, the promoters will be richer instantly - some of them will cash out some part of their holding at some (significant) profit. Bharti Airtel, reportedly holding about 86% of Bharti Infratel, will see its shares worth Rs.38,700 crores.

Just for comparison, Reliance Com equity is currently worth about Rs.15,000 crores. This means Bharti's tower business itself is supposed to be 2.5 times more valuable than Reliance Com. It is best left to the investors to ponder over this matter than anyone else.

What is uncertain at the moment is how much the (potential) investors will make out of this IPO. This game is best played on batting-first-hitting-quick basis - those who start off first and get out early stand any chance of benefiting from the momentum, if there is any. History suggests that on average the late comers haven't had much to gain.

Let the play begin!

suzlon: show me the money

It is difficult to say whether the debt recast is good for Suzlon or for its lenders or for its shareholders.

The current market value of the company is:

Majority shareholders manage and control the company on all corporate decisions.

Take a look at the financial position -

And the income statement for the year ended 31 March 2012 -

And the cash flows -

For the last 3 years the operating profit has not matched interest costs.

With a total debt of about Rs.11,000 crores (or Rs.14,000 crores)and equity value of about Rs.3,000 crores, the company has not much choice.

Yet, there are questions to be asked -

1) How could the management let the company borrow so much and why?
2) Why did lenders let the management / shareholders borrow so much?
3) Could the lenders have written more restrictive covenants to protect themselves including investment decisions of the company?
4) Did the lenders lose their prudence alongside management?
5) Was the company properly rated by the rating agency on its debt capacity?

These conflicts between lenders, managers / shareholders have resulted in huge agency costs. Since control is with the shareholder-manager we cannot say that managers have let shareholders down. However, minority shareholders, also the marginal shareholders, have definitely suffered.

Poor decisions lead to poor market performance:

A comparison with the market performance:

Market value fell from about Rs.40,000 crores (2008) to about Rs.3,000 crores (2012), about 93% destruction of shareholders' wealth. No dividends; just capital loss. Something cannot be undone.

Somewhere, somehow the managers did not get it right on their projects selection and debt selection, resulting in higher risks on cash flow generation.

It is obvious that if the debtholders' interest is not protected, the shareholders' interest doesn't get any better. To put it differently, if the bond of a company is not worth buying, the stock is not worth either.

There are at least 5 parties in this blame-game to share some responsibility for the colossal loss of wealth -
1) The managers - for taking those poor investing and financing decisions;
2) The board - for letting managers take those poor decisions;
3) The shareholders - for letting managers and the board take those poor decisions;
4) The lenders - for lending on risky cash flows; for not protecting themselves through covenants adequately.
5) The rating agencies - for not rating the debt in a way it should be.

It gets complicated when the controlling shareholder is also the manager and the chairman of the board.

There are many ways one could deal with this if reduction of debt is the only option -

a) Issue stock to pay off debt - at Rs.17 the company will have to issue about 650 crores shares to raise Rs.11,000 crores.
b) Issue stock to the promoters - and pay off debt.

These options are not possible in the present circumstances.

c) Sell assets to pay off debt - The earning power of the company will come down and may lead to its decline.

What was left for the company was: to talk to the lenders.

d) Issue stock to the lenders - equity-for-debt swap.

e) Reduce debt - bring down interest rate, principal or both; extend repayment period.

f) Cheaper debt-for-expensive debt swap.

Any combination of the last 3 options will do something for the company for the time being.

The lenders have several options -

1) Forgo their entire Rs.11,000 crores (worst case), or
2) Ask for the sale of the entire company and accept about 27.5% distribution, or
3) Ask for the liquidation if in their judgment net assets of the company have more value than the current market cap, or
4) Believe that the company is a going concern and accept negotiation, which is what perhaps they are planning to do.

In any case, they will have to take a substantial hit on their loans; a huge write-off is imperative.

Life would have been simpler for every stakeholder - if the managers had asked the lenders 'can we afford it?', and if the lenders had said, before lending, just like Suzie Orman would have said 'show me the money'.

Or screamed like Tom Cruise in Jerry Maguire -

As for the shareholders, they have only 2 options -

 

1) Accept those sunk costs which anyway they have to, and wait for lowering those costs (stock price appreciation post debt restructuring). It depends on at what stage the shareholder became one. Hope and prayer might work.

 

2) Exit, collect that cash whatever little the market is offering and invest in any sensible security.

 

Either way, remember to vow, not to buy into castles-in-the-air-stories-based-on-hope-and-prayer. It is better to stick to proven businesses than get in an Apple-or-Infosys-to-be transport.

 

gold buggers

Too much has been said about gold: store of value; hedge against inflation; asset of last resort; and more: show of wealth and prestige; symbol of recognition; and more: investment opportunity.

 

There have been too many experts (economists, analysts and the like) who emphasize the importance of having gold in one's portfolio. And there are those who sit back and say gold is a useless asset, almost. I am sure the former category outnumbers the latter by a wide margin.

 

The demand is out there

Everyone buys gold: the governments, banks, trusts, institutions, investment funds, and the public. The aura of this yellow metal is simply majestic.

 

To see why we need to go back to history. Gold has a bright yellow color and luster traditionally considered attractive, which it maintains without oxidizing in air or water. It represents wealth and prestige and symbol of recognition. Gold has been the single most admired commodity dating centuries.

 

Gold was the medium of exchange for a long time. Gold coins served the purpose everywhere.  The gold standard monetary system required currency to be backed by gold. Even now gold is being stocked up by the governments and central banks.

 

We know the demand is out there, in abundance. It is estimated that annual production of gold is about 2800 tonnes. The major producers are: China, Australia, US, Russia and South Africa. The dominance of South Africa has undergone a significant change since the rise of China. Since demand is more than supply, consumption has been equal to production.

 

Gold consumption has been predominantly in jewellery (50%) and for investment purposes (40%), with only about 10% for industrial purposes. The major consumers of gold are: India, China and US.

 

The inventory is out there

It has been estimated that an aggregate of about 170,000 tonnes of gold has been mined (and consumed) to date. This translates into about 5.5 billion troy ounces. Since gold does not beget more gold or any other thing for that matter, almost all, say, 85% or more of it, is still out there somewhere with some banks, institutions and people in the world. At a price of $1725 per t.oz, the 4.7 billion t.oz stockpile is worth over $8 trillion.

 

India, a major consumer

India is the world's single largest consumer of gold, contributing about 25% of the world consumption. Let's not talk about gold production in India. It produces a dot (an interesting 0.5%) of its annual gold consumption. Over the past decade, Indian household gold consumption increased at a cagr of about 20%. Everyone owns gold here, from the poor farmer to the rich businessman. For Indians primary investment vehicle is gold and property. Annual demand is about 900 tonnes (over $50 billion). While RBI holds about 558 tonnes of gold, Indian households have over 18000 tonnes. The value is over $1 trillion at the current price. 

 

And an importer

As importers of gold, Indians put a heavy dent on the country's foreign exchange reserves. A significant amount of reserves is depleted and too much of gold is brought in. As the currency weakens the cost of gold rises even when the dollar price is kept constant; a sharp double edge.

The price
The price of gold is determined by market forces primarily through trading and derivative markets. 

 

Historical returns

With this background, let's have a look at how gold has fared in the past.

 

From 1969 to 2012: cagr of 9.25%.

 

 

  

From 1992 to 2012: cagr of 7.77%.
 

   

 From 1997 to 2012: cagr of 10.15%. 



 

From 2002 to 2012: cagr of 17.91%.

  

 

 

From 2007 to 2012: cagr of 17.85%

  

 

  

From 1969 to 2005: cagr of 7.57%.

 

 

  

From 1980 to 2005: cagr of (-0.55)% - a dud.

 

 

From 1969 to 2012, gold has gone up from a low of $35 to $1715. But where are the returns?
 

Whatever has contributed to that very-long-term return of 9.25% has largely been due to the rush from 2005 onwards. Barring 1980-81 when it peaked at $850 the prices have been flat until 2005 and later.

If the long-term graph has to say anything it is: gold has not returned enough for an investor except for that weird rise from 2005 onwards.

 

Safe haven fallacy
Generally, whenever there has been a period of uncertainty such as war, inflation or currency crisis, gold prices have gone up. Gold prices went up in 1980 due to higher inflation in most countries; strong oil prices. Since 2005 and later from 2008 global financial crisis and recession, investors have been flocking to gold like no other. How far this craze is going to continue is anybody's guess.

 

All prices and no value

Gold itself is produced from mines but once mined that gold does not produce anything. A pile of gold today is the same pile that was 100 years ago and is going to be somewhat the same pile in another 100 years. There is nothing much we can do about it. Gold is not a source of income for it does not provide any cash flows. Due to this, it is not possible to value gold. The perceptions change, the demand changes and price is set. Even if the price were to fall to say, $800 (a fall of over 50%) it will not be possible to say with confidence that gold is undervalued. Any valuation, however high or low, is good enough valuation for investors.

 

The greater fool

The mechanism for pricing of gold is through perceptions only. If everyone thinks that gold is a store of value, hedge against inflation, asset of last resort, show of wealth and prestige, and symbol of recognition, its demand will go up and so would its price. Typically, it is perceived that when nothing else works, gold does and presto, there is a case for buying gold.

 

What if suddenly these folks think differently, rather more rationally? What if they decided that all this time they had been some sort of fools trying to price up a piece of glittering commodity? What will happen to that stockpile that has been there? That same physical volume of $8 trillion (India: $1 trillion) will go down to some other value. 

 

The only way investors have been able to profit from gold has been trying to be a bit faster and wiser than another. The investor who has bought gold has to sell it at a higher price to earn profit. For that to happen the new buyer has to hope that the price will go up (for some reason or the other) after the purchase so that it can be sold later at a profit. Initially it appears like the wise men buying and selling, but in reality it is fools chasing greater fools. Without this you cannot price this commodity since gold has very limited industrial or production use. Almost everything that has ever been produced has been there either in the form of decorative or in solid forms just like that.
 

Gold is for.....

Where do we stand? If you are convinced that you will be able to find a buyer for your gold at a higher price (than you would for another asset) you are justified in buying gold. However such conviction has to be backed by facts, not hopes. Since it is not possible, investors in gold are not investors; they are actually punters or speculators with high hopes.

 

Gold as a store of value is just a myth as there is no value there. Gold as a hedge against inflation cannot be proved by facts since gold prices and inflation do not move in tandem. Inflation is largely due to higher costs of production and depreciation of currency. Consider this: nominal gold price of $850 in 1980 translates into inflation-adjusted price of over $2000. Where is the hedge? Gold prices are based on hopes. Gold as the last resort can be forfeited easily since that 18000 plus tonnes stockpile which Indian household owns, largely in jewellery, will probably fetch far less than prevailing market price since any sale of gold by the households has typically been during the times of distress with no (bargaining) power. Any portion that is held in solid form could fetch higher though.

 

Where is the value in gold? On the contrary, it could be argued that gold destroys value. All capital invested is stored under lock and key with no production and cash flow, and hence no real profit. At over $50 billion a year in India if you are calling that an investment you are kidding.

 

It is difficult to understand what makes gold a good investment. In the rational world gold is for someone else. However, we are not in the rational world; so there is allowance for some insanity.

 

Alternative investments...the only investments

Capital invested for productive purposes creates value. We have that $1 trillion worth of stockpile stacked up. That's about equal to the total market capitalization of our stock market. This $1 trillion (plus $50 billion each year) could be invested in some selected business corporates which create employment and generate cash flows for reinvestment. Alternatively, that money could also be invested in any other cash flow generating assets, such as, farms or real estate.

That is if you believe in planting trees for tomorrow's generations lasting a long, long period of time. The shades of those trees could be very soothing indeed. Think about it.

One wise man has already talked about investing in productive asset classes rather than gold and another has said that more blatantly. What's your call?

 

Oops, I forgot to mention that gold production pollutes as well, in a very hazardous manner causing long-term repercussions. Is investing in gold hazardous?  

kfa: flying on the fly

What happens to a business that requires tons of money on a regular basis, and does not earn enough on that capital? It loses that money!

Moreover, if that business continues for long it eventually fails. Isn't this simple enough to understand? The more capital it receives the longer it operates, and the longer it operates the more it loses that capital.

If that is the case why should that business continue? Kingfisher Airlines owes truck loads of money to various stakeholders, viz. employees, suppliers and lenders. There is one problem though: it does not have cash to pay them. It also owes big time to its shareholders is another matter.

Those stakeholders have only two choices: Ask for the full amount owed which is not possible or accept a big write-off and restructure the amount. That's like something is better than nothing for them. That hope that they will get something someday will keep them. But will they?

The company has never earned before; market share has gone way down; costs will build up. More capital will be required, and more often. Who will supply the capital now - promoters and related parties? The shareholders of the airline have already lost their money. Now if the shareholders of the related parties start funding a deteriorating business..well, it will be a bold move.

Then there are some others who can supply: the FDI. Will they? Why?

More than anything it is a bad business to be in. Leaking boats can be replaced with another boat. But what if it is not a good idea to be in any boat?

Airline is that boat; it is one such business.

reporting flaws..blame it on regulation

All listed companies have an obligation towards an effective corporate governance framework. One of its key tenets is that these companies should provide all important information related to the company, including aspects directly or indirectly affecting the business, in a timely manner.

The key words are all important and timely. An information is considered important if non-disclosure of that affects, directly or indirectly, stakeholders' decision-making. Stakeholders include employees, suppliers, lenders and shareholders; and all those who have a business-relationship with the company; they include potential investors as well for this is what a listed company has asked for to begin with. Needless to say that any disclosure is meaningless if not made on a timely manner.

Does it really matter if some of such information disclosure is not mandated by the regulation? It is the moral obligation of the board and management to provide information which otherwise they would have expected if the positions were switched.

Yet, it is not surprising to see companies world-over hiding and/or delaying/manipulating information to the stakeholders. They either breach the regulation or blame it on the regulation. This is true not only in India but everywhere - it is the same human breed.

To test this aspect of corporate governance, pick any annual report, quarterly report or corporate announcement and see if the information is sufficient for you as an investor for your analysis; see if this information is timely or should have been provided to you much earlier.

The regulation (the companies act, the SEBI, the stock exchanges, the accounting rules and the like) provides some minimum rules regarding information disclosure. It is not sure, however, whether it is both sufficient and timely.

Take for example, quarterly reporting from companies. All they throw is some information regarding revenue, costs and profit or loss. Is that sufficient? Don't you think as investors we need a full set of financial information including the balance sheet, income statement, cash flows, changes in equity and key events during the quarter? To get to know of information related to cash, new loan, acquisition or equity, we have to wait until the year-end annual report. Isn't this ridiculous?

Whatever happened to the shareholders' rights?

What sort of governance is this - both from the board and the regulation? If the regulation does not provide for this, a responsible board should voluntarily supply; if the board does not supply, the regulation should wake up and mandate it.

Is this asking for too much?
 

extreme publicity

Greed is good said Gekko. Debt generates economic growth and amplifies returns says this. Well, Modigliani–Miller also said something and got the Nobel.

Debt can only be good when there is capacity (earning power: cash profits) to repay it with coupons. This happens when one is certain that return on debt capital is much higher than cost of debt.

It is easy to say this than see it, which is why we are witnessing the global financial crisis and the European sovereign-debt crisis; weaker US; slowing down China, and slowed down India; and the obvious consequence - the recession in the global economy.

And when someone says debt is good, it is just an extreme publicity!

deccan chronicle: debt is what it does.....to lenders

The story goes: when a borrower owes his bank 100,000, he loses some sleep; when he owes 1,000,000, the banker loses sleep.

When does it make sense to lend money? Simple answer would be when it is certain that the borrower is able to repay the money and interest payments.

When and how will that certainty be there? That is when the borrower is worth several times over the money borrowed.

That sounds prophetic. But then why would the lenders do what they are not supposed to do?

Year ended 31 March 2011:

Quarter ended 31 March 2012:

As per this article the company's debt stands at whopping Rs.4,000 crores in 2012. How did the company manage to borrow so much?

Correction: how did the lenders lend so much to that business? How did the lenders view of their loans?

Repayments do not come out of air; no assurances no promises; you need to see cash profits for the business to be able to repay.

And ouch! the analysts:

With a market valuation of about Rs.180 crores for equity, and debt running many times over, the lenders deserve that treatment. The only problem is: it is not their money; it is the lenders' lenders' and lenders' owners' money.

While we can get away with saying that the lenders' owners deserve that treatment too, it cannot be said for the lenders' lenders. For the lenders' lenders are the common people who have put their hard-earned money into the savings account with those lenders.

Too bad!
 

innovation for existence...Apple

The firm value
What drives a business? The only rational reason for a business to continue as a going concern is to continue to earn a fair rate of return on its capital in order that the capital providers are not let down. If this were not to happen, the business is meant to fail and will be better dead than alive.

What drives return on capital? It is the combination of nature of business itself and invested capital. If a fundamentally economical business is provided with adequate capital it will be a good deal. This is true at least for the foreseeable future as opposed to infinite time.

Capital, growth and return on capital will influence the firm's value.

Growth can come either through efficiency in current operations, although with a limited power, or it can, and more likely, come from reinvestment. Without reinvestment, no business can continue to grow for long. However, growth requires reinvestments to continue to earn return on capital similar (good) to, if not better than, the business currently earning. If not, this additional capital will not add value, or worse, might destroy value. That is why just physical growth does not matter.

The technology business
What about technology companies? What about a technology company earning very high return on capital?

Growth for this business should come in just the same manner as to any other business. However, the key difference is that technology business is never a sustainable business. This means (even) for a truly wonderful technology, there will be periods of high growth followed by lower yet decent growth, and then followed by sudden or slow death depending on the extent and impact of the competition and change in technology.

The key driver for the technology business is innovation. As long as this business, with its wonderful technology, continues to innovate, it will experience growth. Nevertheless, the high return will attract competition and this will bring down the return initially (that is, slower growth) and then ultimately will evaporate all excess returns or even bring about its fall. Research In Motion and Nokia should be able to vouch on this based on their bitter direct experience.

For a technology business which has experienced, say, a decade of growth, it is absolutely crucial to innovate even for its sheer existence. There is one problem though: for any business it will be very difficult to innovate until eternity; innovations cannot come every year.

Apple
Apple is a case in point. With ridiculously high return on capital (don't even try to calculate), crazy amount of excess cash (it's really crazy), and a history of extensive growth and innovation, now it is at crossroads. It must innovate or perish by its own standards.

Given its past records and investor expectations, it will be extremely difficult for Apple to replicate. Too many smart phones and tabs have been floating around and many more to come from competition.

The Samsungs are dominating; the Sonys, the Microsofts and the Googles are giving more for less to consumers; there are many other players in the market; and the RIMs and the Nokias are not giving up (don't ask why). 

Sooner or later this will deepen the price and volume war, and lead to an eventual loss of market share. It will be foolish for investors to think that that pile of cash is going to produce miraculous returns. From now on, Apple needs to innovate simply to exist, i.e. to maintain its market (scope for growth has become limited).

Extraordinaire
In this situation, what better way than to do something that has never been done in such doses in the past? It is time for Apple to return that cash to where it belongs; to its shareholders.

But then
While an extra-large cash dividend or stock-buyback is unlikely from the management, it will be interesting to see how the story unfolds into the future.

Since a high ego usually hurts, management will be well advised and shareholders will be well off if a rational decision is taken.

But then you never know...there could be an i-computer, i-tv, i-kitchenware, i-anything..

The contrast
Check out some samples: Apple witll hit 1650 and Law of limits - what do you think?

The insight
You see, since I am extremely good with hindsight, I should very well be able to tell you in a few years time.

ril: conflicting analysts

Have a look at the valuations from analysts:

The highest valuation is Rs.301,550 crores and the lowest is Rs.230,540 crores. That is a difference of Rs.71,010 crores, and a change of about 23-31% of total value.

Analysts and brokers will have to come up with something which they do all the time. It is for the investors to be wary of these reports before their action. The maximum we can take from the analyst reports, if at all we have to, is the data compiled by them rather than their recommendation itself. The data can be useful for our own independent analysis or at least for some cross checks since these analysts are able to extract information from managements.

Most of the time, however, their reports have no added value. It is best to ignore their reports in full; use company generated (annual) reports instead. In fact, this should be the standard practice.

The first step in analyzing a business is to do it independent of any influence and bias. Beware of analysts' bias and selfish motives.

rcom: debt and lows com

The company made debut on the stock exchange in March 2006 with an opening market capitalization of Rs.35,000 crores. Market cap touched Rs.100,000 crores in Februrary 2007.

It made about Rs.4,800 profits in 2008-09. Then things changed.

With about Rs.45,000 crores cumulative put in by the equity owners in the company to date, the market value has come down to about Rs.13,000 crores.

Those who bought the stock at the peak in 2007 would have seen their worth eroded by a compounded rate of nearly 40% pa.

What next? 

oil is well only when it is there

How to value an energy business, especially the upstream? The two key components to be considered are oil reserves and oil prices.

While we do not have control over oil prices, it is possible for the companies to manipulate their oil reserves, thus misleading the investors.

Oil reserves are the total volume of oil in the oil reservoir. However, it is not possible to extract all oil that is there in the reservoir. Much of it depends on the reservoir characteristics and technology used. The simpler the reservoir characteristics and the more advanced the technology used to extract, the higher the possibility of more oil to be extracted.

Thus the reserves can be classified as:

1) Proven (1P or P90) reserves - have very high (at least 90%) possibility of recovery.

2) Unproven reserves - have lower possibility of recovery:

a) Probable (P50) reserves - have reasonable (about 50%) chance of recovery.

2P reserves represent proven plus probable reserves.

b) Possible (P10) reserves - have very low (at least 10%) chance of recovery.

3P reserves represent proven plus probable plus possible reserves.

Under these circumstances, the company is best advised to disclose only proven reserves to the investors.

It is not certain that the company will be able to recover its proven reserves in full in the first place since these are all estimates.

If unproven (probable or possible) reserves are disclosed, it will only complicate matters and mislead the investors. Market participants are ready to sniff anything that is given to them. Lest they go astray, it is well advised that the company does not go any farther than its proven reserves.

Estimates of unproven reserves should be an internal matter for the management for its decision-making regarding capital allocation.

If you attempt to value the business considering its reserves that are not yet proven, do it at your own peril.

implied market rates

There are various ways of valuing a security. The most acceptable one calculates value as the present value of all cash flows over the life of the security discounted at a rate appropriate with their riskiness.

If we consider equity, the value of equity then represents the present value of all cash flows from equity (including cash outflows) over the life of equity, that is, life of the business itself. Cash flows depend on the nature of business, its reinvestment needs, growth periods and growth rate.

Since values are only estimates, these are highly subjective and depend on the perceptions of the valuer. Hence, these will invariably differ when estimated by different analysts. Also, the value will differ at various points of time when calculated by the same analyst due to changes in perceptions.

We can also extend this equation to the entire market such as an equity index. The value of the index then becomes present value of all cash flows from owning that index over its life which is a very long period of time.

Since we know the present value of the index (which is its current value), we can calculate growth rates and expected returns (discount rate) implied in the index value.

We can calculate implied rate of growth by keeping the index value and discount rate constant or calculate implied discount rate by keeping the index value and growth rate constant.

Based on this equation, the implied rates of nifty as of 4 October 2012 (index value: 5787.60 with a dividend yield of about 1.5%) are as follows:

Note: We have to view the following in the context of high inflation and government bond rates.

A 5-year growth period is assumed.

1) Keeping discount rate of 10.50% and terminal (stable period) growth rate of 8%, the implied growth rate (growth period) is about 18%.

2) Keeping discount rate of 13% and terminal growth rate of 8%, the implied growth rate is about 37%.

3) Keeping discount rate of 13% and growth rate of 18%, the implied terminal growth rate is about 10.75%. This means the market is implying that the companies will be able to sustain a growth rate of 10.75% until almost infinity.

These implied values are indicative of what the investors, speculators, analysts and others are expecting from the underlying businesses.

We can change any variable and see how it affects other variables. It is an interesting exercise just for fun to see the ingredients in the market.

This is just a nice little game when you are in that mood; not to be taken too seriously.  Play it at your own risk.

quality of voting rights

It is not unusual to find companies issuing dual class of shares, one having voting rights and the other having limited or no voting rights.

Issue of non-voting rights shares breaches the fundamental right of the shareholders.  Equity investors are effectively the owners of the business having certain advantages over providers of debt capital. These include entitlement to: receive dividends, attend meetings, participate in new issue of shares to protect dilution, receive reports, residual claims (including undistributed profits) on the assets, and vote on the important matters.

If any of these advantages are taken away from the shareholders it will not be considered fair.  Imagine where a company issues new shares to some private institutions thereby creating dilution for the existing shareholders, or where (more serious) a company does not pay dividends to certain group of shareholders. When such things happen it is natural to question the integrity of the management. Despite this, plenty of instances, albeit of less serious kind, are available in the corporate world.

Let us concentrate on issue of non-voting shares. Just why the management would want to do this? The main reason as it appears is that the majority shareholders want to retain or increase their control in the business. Furthermore, they may also want to protect themselves from a (hostile) takeover by an outsider. It seems like a noble thought, but only if taken in the right spirit. It is one thing when there is a well run company which is under a threat of takeover and another thing altogether when there is a show of only the majority power.

Under the circumstances what should the minority shareholders do? Well, it depends on what they are looking for. Usually a company develops its own clientele when it comes to the type of shareholders. For instance, a high dividend paying company will have shareholders looking for stable income such as pension funds and retirees. A high growth company not paying dividends will have shareholders looking for long-term growth and capital appreciation.

Similarly, when a company issues non-voting shares it is conveying a message, and therefore it is appropriate for only those investors who are happy with the present management having control on a long term basis. 

Let us look at this way: Generally when you buy a stock, you are not going to look for having control and running the business. Instead, you will look at the business and management, and its past record and future prospects before the purchase. The right to attend meetings and vote on the important matters is only secondary as usually management will have a majority voting due to its higher shareholding. Therefore, the investor’s participation in voting does not matter much and the investor knows it. If the purchase of a stock is for the right purposes, that is, to participate in the business and its profits, the correct way to look at is to see whether you are comfortable with the present management and the way they have run the business. If not, there is no question of buying that stock. Why would you buy a share in the business if you are not happy with the way it is operated?

If this argument is true, why would you be bothered whether you have voting rights or not? Good management brings forth good results and eventually, good market value anyway.

In another situation, let us say, you are already a shareholder in a business and now note that the quality of management has deteriorated and you are worried about it. You have a few choices to make: 1) sell the shares – this depends on the prevailing market price versus the price you paid for the stock; 2) do nothing – but pray for the better sense to prevail upon the management; 3) do something to change the management so that the business is run more efficiently.

Now, if you have full voting rights, how can you ensure change in management? You have to hope that some hostile takeover takes place to overthrow the majority shareholders. However, for that to happen some shareholders will have to sell to these activists – majority shareholders (present management) will not do that. The only way is a large group of minority shareholders to sell their shares and exit. If that takes place you as the remaining shareholder will benefit after takeover and change in management. The question is – will you want that? What if all minority shareholders are like you and wait for others to sell? That is why those voting shares will trade at a premium over non-voting shares. The activists will be more willing to pay a higher price to acquire control. The higher the premium, the more likely that voting shares will be sold.

If we consider these arguments, the value of non-voting rights becomes a bit clear. In most situations there will be no difference between the (intrinsic) value of voting and non-voting rights shares; none. This is true whether the business is good or bad, or whether the management is efficient or not.

Only in those rare situations where there is a high probability that a change in management will take place and business is likely to be run more efficiently, the value of voting rights shares will be higher.

But the catch is, the shareholder having voting shares will be able to sell to the activists at a premium but will not be able to participate in the prospects of a now more efficiently run business. It is then the remaining shareholders – both voting and non-voting rights – who will benefit from the new management. From that point again there will be no difference between the value of both classes of shares.

Voting rights never matter to an ordinary shareholder except when those can be sold at a premium.

Assume this: There is a business with current market value of 10000 m. This value will change to 15000 m if it is run more efficiently. It has 250 m voting rights shares and 400 m non-voting rights shares. There is about 25% probability of change in management for better.

In this situation, corporate finance will give a control premium value for voting rights shares as follows:
Value of non-voting shares = 10000 / 650 = 15.38 per share;
Value of voting shares = 0.25 * 5000 / 250 + 15.38 = 20.38 per share

While voting rights share will have a premium, it will be difficult to calculate unless there is a high probability of change in management. A mere 25% probability will look good in theory; in practice, it will still mean a low probability of change. Only when there is a very high probability the voting rights shares should trade higher. If not, both classes should trade more or less at similar price.

When there is a very high probability of change the (maximum) value of voting rights can be in the region of (assuming business values are accurate): 5000 / 250 + 15.38 = 35.38. This appears very high compared to the non-voting shares because this example assumes far lower number of voting shares and about 50% higher new value of business.

To conclude, the investors should consider (of course among other things) only the quality of management before deciding to purchase any stock, irrespective of voting rights.

1) If voting shares of a good business (good management) are trading much higher than non-voting shares, it is far better to buy non-voting shares. 

2) It does not make sense to buy any shares of a bad business (bad management) whether voting or non-voting rights. 

3) A shareholder of a business with deteriorating management should estimate chances of change in management for better and if such chances are high, both voting and non-voting shareholders should do nothing.

Note that the change will happen only if some voting shareholders sell. They will need to sell (of course at a premium) to facilitate the change in management and increase the prospects of the business and its shareholders (both voting and non-voting) who did not sell.  

google's googly

From the first founders' letter -
“We are creating a corporate structure that is designed for stability over long time horizons. By investing in Google, you are placing an unusual long term bet on the team, especially Sergey and me, and on our innovative approach...

.....In the transition to public ownership, we have set up a corporate structure that will make it harder for outside parties to take over or influence Google.…

...The main effect of this structure is likely to leave our team, especially Sergey and me, with increasingly significant control over the company’s decisions and fate, as Google shares change hands…

Our colleagues will be able to trust that they themselves and their labors of hard work, love and creativity will be well cared for by a company focused on stability and the long term…

As an investor, you are placing a potentially risky long term bet on the team, especially Sergey and me. …. Sergey and I are committed to Google for the long term.”

From the 2012 founders' letter -
"...In our experience, success is more likely if you concentrate on the long term....We have protected Google from outside pressures and the temptation to sacrifice future opportunities to meet short-term demands...

...Today we announced plans to create a new class of non-voting capital stock, which will be listed on NASDAQ. These shares will be distributed via a stock dividend to all existing stockholders: the owner of each existing share will receive one new share of the non-voting stock, giving investors twice the number of shares they had before....It’s effectively a two-for-one stock split—something many of our investors have long asked us for.....

...In November 2009, Sergey and I published plans to sell a modest percentage of our overall stock, ending in 2015. We are currently halfway through those plans and we don’t expect any changes to that, certainly not as the result of this new potential class. We both remain very much committed to Google for the long term."

From the 24 July 2012 - 10Q
".... The amendments authorize 3 billion shares of class C capital stock and also increase the authorized shares of class A common stock from 6 billion to 9 billion. The amendments are reflected in our New Charter, the adoption of which was approved by stockholders at our 2012 annual meeting of stockholders held on 21 June 2012. We have announced the intention of our board of directors to consider a distribution of shares of the class C capital stock as a dividend to our holders of class A and class B common stock."

End of quotes

Corporate governance - control...more of it!
Presently, Google has class A shares which are traded and class B shares (having much higher voting power and mainly owned by founders) which are not traded.

Now the company has announced a dicey corporate governance structure which provides for issue of 1 class C share (new class) which will be traded separately against 1 existing class A (same for class B) share. Is it a stock split...or..a stock dividend? I don't know. Google calls it both, sounds weird? That does not matter in the larger scheme of things.

The fact is that the market value of the company should not change post this structure as nothing fundamental has taken place with respect to its cash flows, reinvestments, growth and risks, or so we hope.

But here is the catch: class C shares will have no voting rights, effectively cutting the existing voting rights by 50%! Not that it matters to an ordinary shareholder, for someone said, that is the most docile and apathetic animal in captivity. Shareholders' rights and powers look good on paper not in practice.

A shareholder who currently owns, for instance, 1000 class A shares of Google will get 2000 shares (1000 class A shares with voting rights and 1000 class C shares without voting rights). The market value is supposed to remain the same on a combined basis.

The board has not set a record date for the issuance of the class C shares.

The bully: management has announced clearly as before their intention to hold control and call shots whether a shareholder will like it or not. That is exactly what they want. Considering this it is doubtful if they will issue class A shares again.

Would it really matter to a shareholder?
Considering the ordinary shareholders' position, intent, time and power, it would hardly matter. The market value of the shares do not change and the shareholder does not care for vote anyway especially when the management already has majority control.

The change in voting power should look like this: Class A has 1 vote per share; class B has 10 votes per per share; class C has no voting power.


It's bonkers!


This is as per the present understanding. The real damage however depends on the total number of voting and non-voting shares in the business.

Because of lack of voting power the class C shares should be selling at a discount and class A shares at a premium. Whether they will, and if so, by how much, I will tell you once I know.

Clearly, Google stock is meant for those animals in captivity - take the piece of the meal thrown at, eat and enjoy, but dont' complain. In management's own words....you are placing an unusual long term bet on the team.....As an investor, you are placing a potentially risky long term bet on the team...

With all this, there is no denying that Google has in fact changed our lives significantly. It has become a free educational institute. To see why, just google it!

As long as management is doing a good job, that is, operating the business and allocating capital well, there is no reason to complain.

Here's what they have given to the shareholders, the meal...(source: yahoo finance):

Can googlies be good? Your call.

airline business: castles in the air

Where are the earnings?

 

 

Jet Airways - all debt

Kingfisher - piled up losses

Air India - ? Any other airline......? The story may not be very different.

Physical growth does not always mean maximization of shareholder wealth. The capital that goes into a business has to translate into cash profits at a decent rate on a long-term basis. If not, the business is destined to destroy wealth.

When you are in a business that is fundamentally uneconomical, it is not a good idea to continue to be in it.

what moves market

Nifty closed at 5,787.60 yesterday. Some rally was seen in the past few days due to positive news regarding the reforms by the government.

Historical values for nifty are shown below:

 

The nifty

What do you make of these? Nifty has had a steady rise since 1994; peaked at 6274 in January 2008; bottomed out at 2553 in November 2008; and peaked again at 6312 in November 2010.

 

In the interim many things happened - good news, bad news, good results, bad results - however, the march was on as we can see.

 

The biggest fall came in 2008 from the January peak to the October low (a fall of more than 3500 points). Compare this to the fall after IT bubble in 2000 where nifty fell from the peak of 1756 (February 2000) to the low of 1045 (September 2001).

 

As we stand now, nifty is not very far from 6000 levels; whether it will breach that, time will tell. While it is inching higher, the key question is how high it is now. Is it expensive or is it cheap? We cannot tell this by just looking at the absolute nifty values. We will have to relate these values to some other values, more prominently earnings.

 

The earnings 

If increase in nifty values are generally in proportion to that of the total earnings of the index companies, it should be fine. After all, businesses are meant to grow. If not, it tells you that there is a gap between the price and value. It could either be a buyer's market or a seller's market depending on the type of the anomaly.

 

The high points of price-to-earnings were at 28 in February 2000; at 22 in March 2004; back to about 28 in January 2008; and at 26 in October 2010. 

The low points were in May 2003 at about 11; in June 2004 at 11.62 and then again in October 2008 at 10.68.

This should remind us of the bubbles of 2000, global crisis of 2008 and the aftermath.
 

With the current multiple of 19, it is about 33% lower than its peak value. How cheap the value is depends on whether and how soon we will get to see the peak multiple again.

 

The dividends

Dividends after all are paid out of earnings. It is logical to relate dividends to earnings and hence, dividends to market values.

 

Dividend yields from nifty have never been great. In May 2003 a high dividend yield of about 3% was recorded; since that time it reached to about 2.6% in 2004.

 

Lowest yield of about 0.6% was in May 2001 although p/e multiple was only at 15; this suggests that probably the companies backed out from paying dividends during the period. The low point of the yield at 0.8% in January 2008 corresponds to the high valuation.

 

The current yield of about 1.4% is not very attractive either. If you are looking for good dividend yields, better look for specific companies having more stable earnings.  

 

Price-to-dividend multiple is the reverse of the dividend yield. Accordingly, the graph should be the mirror image. Just like p/e multiple shows how high or low valuations are compared to earnings, p/d multiple shows in relation to dividends.

The book
Price-to-book multiple compares the market prices to the book values. A high multiple suggests high valuations and vice versa. The differences between the market and book values are due to goodwill component of the business itself. This is reflected by the earning power of the business. However, if earning power is lower compared to the price attached by the market, it reflects something else - both p/e and p/b can be outrageous!

This multiple only reconfirms our analysis drawn from the earnings and dividends. Usually you see high p/e, high p/d, low dividend yield and high p/b going together.
 

With the power of hindsight the best time to pick stock was in late 2008, second-half of 2001 and of course just before the beginning of the bull market in 2003. If only we had the foresight!

All we can say now is that the market does not look very expensive as per the past records; it is not very cheap either.

If earnings and cash flows are likely to grow, and inflation and interest rates can be contained, the current valuations look good; if not, you know what I mean.