good investor

The long-term goal

Everyone's pursuit is to be a good investor; this is true whether that person's training or day's job is in the field of business and finance, or not. If earnings are not invested properly, financial security for the family will be at stake. That brings us to think about investing. 

There are certain things that I consider fundamental to investing and to becoming a good investor. It is imperative to be clear about those things before we start our efforts in building a secured financial future, i.e. by taking the right investing decisions.

Investment and speculation

The first thing is to understand the difference between investment and speculation. I see a lot of confusion, mostly subconscious, out there about this.  Investment looks at the downside first; speculation does not. Investment gives a reasonable comfort that the capital invested is protected, i.e. it will not be eroded, and the returns over the period will be more than the inflation rate. Thus, investment gives the consolation that purchasing power of capital is retained at a minimum. If analysis is done properly, investment can give higher returns, but that is only incidental. 

Speculation fails to do any of this. There are many activities which have the characteristics of speculation; one example is trading of stocks without business analysis. 

If one starts with a wrong footing, i.e. thinks investing when actually is speculating, or even vice versa, the results are not going to be pleasant. 

Price and value

As a corollary to the first one, this is another important aspect.  Price is what we pay and value is what we get, is a widely known phrase. This has to be taken literally when it comes to investing. Value is based on the fundamentals of a cash flow generating asset, such as a business. Value is mostly driven by changes in cash flows, growth and associated risk; any decision that does not impact these, does not change value of that asset. On the contrary, price is influenced by almost anything including the value drivers. Speculators get this concept wrong invariably; investors understand it well.

In the short term, the most common factor that changes prices, is the behavior of the market; fear and greed are the traits of the behavior that drives prices. Bad weather, headline news, political changes, stock splits, stock dividends, less-or-more--than-expected earnings, management's views, analysts' views, and you-name-it are examples that influence prices.

Most corporate acquisitions take place without understanding the difference; overpaying has become a habit the cost of which eventually is paid for by the providers of capital.

In the long term, however, prices usually catch up with the fundamentals, i.e. the value drivers. That is the presumption the investors hold on to in order to expect adequate returns on their investment; history is on their side to support this presumption.

If one is not able to understand the difference between price and value, the advise is to first grasp it before taking any investing decisions. 

Risk

The meaning of risk in business and finance is quite clear; risk is a downward movement in prices when long on securities, and upward movement in prices when short on securities. This is fine, we are all worried about downside risks, not upside risks. So far so good.

The problem starts when it comes to measuring risk. The common understanding of measuring risk is in terms of the volatility in the price of an asset. It is perceived that if the price swings too much, the asset is considered risky; if prices stay within range, it is considered stable, i.e. safer. Practically, this assumes that market prices are good enough to measure the value of the asset all the time. For someone who understands the difference between price and value, this is bull. 

For instance: The prices of the stock of a lousy business which has no takers could remain at stable, albeit lower, levels for quite some time, giving low volatility. A great business, having short-term problems, although nothing related to its long-term cash flows, growth and risk has changed, could trade at swings if markets do not factor its fundamentals, giving high volatility. A private business or a real property or a farm land may not have quoted prices, and hence have low volatility; yet, if analyzed based on their fundamentals, these may be independently viewed as risky or safer assets.

We can correct this mistake in measuring risk in an asset by knowing more about it. Like someone said, risk lies in not knowing what one is doing. This is apt; to measure risk, what one needs to do is to understand the asset more, i.e. to understand the factors driving its cash flows and growth. An asset is viewed safer, if its cash flows are more certain and growth is more reasonably visible. In other words, we need to look at the downside risk that is more likely to be permanent; short-term downside risks are temporary in nature, usually speculative, and therefore are not actually a risk in the investment.

The riskiness of a business depends upon - nature of the business, the products it sells and the regulation under which it prices it products, the managers running it, the corporate governance surrounding it, its operating and financial leverage, its capitalization, i.e. equity and debt proportion, and its competitive advantages - its long term prospects. The more we know about these aspects of the business, the less we feel uncertain about it, the less we speculate about it, and therefore, the less risky it appears to us if acquired at the right price.

Contrary to the common belief, risk cannot be measured in precise terms; it can only be perceived as a guide for the investor's analysis. It is possible that something that appears to be risky to one, may not be risky to another because of her knowledge on the value drivers.

Understanding the concept of risk is crucial for the long-term investment results.

Analyzing and valuing an asset

Analyzing value comes first; any asset is a buy or a sell only at the right price. Let's be clear that there is a business behind a stock or a bond. Consequently, when investing in stocks analyzing the business itself is important. Watching ticker prices is of no use; that is for the speculators. 

Accordingly, developing the skills for business analysis and valuation is vital to investing. Without this we will not know the real worth (intrinsic value) of the business. That said, it is not easy. The good news, though, is that it can be developed gradually. As the knowledge grows, so do the skills. Over the long period we should be better at understanding and valuing businesses than before.

However, it is important to understand that there is no such thing as a complete knowledge; it is a life-long learning process. 

The first step in this learning is to read about the business from the annual reports, quarterly reports, and manager press conferences. Annual reports of past years should supply enough information about the business, the managers, where investments were made, how these investments were financed, the quality of these investments in terms of return on capital, and what was done with excess cash, if any. As we read more about the business we should be able to understand more about it, and thus, feel less uncertain about its prospects, good or bad, to be able to value it. The numbers, i.e. financial statements, tell us the most part of the story we seek. Gradually, we will be able to gather which part of the annual report and other information is relevant to our analysis.

Then there is information related to the business, the industry, the economy, and other aspects of business and finance that should be read. Since accounting is the language of finance, it is advisable to have some knowledge related to accounting and financial reporting as well. Moreover, it is always good to read about the investment philosophy and methodology of investors we admire. It is amazing how interesting this process can be; accumulation of knowledge is a good stuff.

It is also important to know what not to read. Any views expressed by the analysts or even managers about the future prospects should be shunned. These are the personal opinions more often based on bias. So ignoring them is the correct thing to do.

Finally, it should be realized that value is only an estimate based on some analysis. For valuing a business, we need to estimate both cash flows until perpetuity and the right discount rate, which is never going to be precisely right. Therefore, it is prudent to keep the price paid for the asset fairly lower than the value estimated. This is to make up for the human error of judgment. Only hubris can come in its way; so it is better beware.

Behavior

In the meantime, we need to build the right behavior, not to be swayed by the whims of the markets. For that sticking to the basics is what is required. If the analysis is done right and an investment decision is taken, the short-term price movements, which are the doings of the speculators, should not change our decision. On the contrary, we can thrive on these price swings by taking advantage. It is clear that investors make money at the cost of speculators. 

Maintaining some discipline in investing is important. Fear, greed, and envy are to be avoided at all times; it pays to control that urge. 

Business of investing

There are no shortcuts to this process. If, let's say, we start a business today, we cannot reap rewards immediately. Any business, private or listed, has to operate for a fairly long period of time to give results. There are short-term investment strategies too where the price catches up with value sooner than usual. Usually, investing is a long-term process. We read, we analyze, we value and we buy; then we need to wait until our efforts fructify, which usually takes longer than we would like. It is best to view active investing as a business we operate.

There is no scope for part-time active investing. If we have no time or interest in this process, it is better to invest regularly in an index fund; over the long term, the return on investments should be fair. In the meantime, our time and efforts can be directed towards things we like, rather than being halfhearted or forceful on the business of investing. 

Limits to expectations

With all the time and efforts that we put in learning about business and investing, it is crucial to understand the limits to the expectations from our investments. There are no super-normal returns to be expected. Some exceptions could be there in the short term, however, over a long period of time, it is wise to have a limit to our expected returns.

Usually, the price paid becomes a key factor in determining the returns. Stating the obvious, the lesser the price paid the higher the returns. Nevertheless, super-normal returns over a long period of time are not only unsustainable, but also unreasonable. Both the long term macro economic conditions and the fundamentals of the business itself will ensure dilution of the competitive advantages attached to the business; at some stage, the competition, technology, or regulation will kick in such that the business will experience stable growth or even decline, rather than high growth.

Therefore, it is sensible to set the expectations to be normal; ideally, the rate higher than long term inflation rate plus a few points should be adequate to beat the broader index. Rest assured the amazing power of compounding should take care to create wealth. 

Humility
Finally, it will be good to have some humility in this whole affairs. If we attribute success only to our skills, it would be imprudent. For investment success, the market price should eventually catch up with our estimated value; if this does not happen, however good our analysis be, we will not be able to seek expected returns. For all the silliness, irrationality and inefficiency in the short term, we want the markets to become efficient at some point; and this requires both our efforts and a bit of luck. So let's shun that hubris, if there is any.

Plan for the coming years
Let us be the owner of the business of investing; let us put in our time and efforts to seek long-term financial security; And let us have loads of fun in the process, because it is actually a lot of fun.

Let's defy the markets.

decline of the firm

Declining revenue; no earnings; increasing losses; eroding equity; and increasing debt. If this is the story over the last five years, it should be reasonable to presume that either the business itself is lousy, or managers are not able to take the right decisions, or may be both. Such a situation should only result in destruction of value for the shareholders. 

And who are these shareholders? The government owns 56.25% and Life Insurance Corporation owns 18.81%, may be a forced buy for LIC. It is LIC's Fortune Plus Secure Funds that owns the shares of this firm; however, there is neither fortune nor secure in this investment.

What was selling for Rs.78 b in 2009 is now available at less than Rs.10 b.

While the broader market increased.

It is difficult to understand why the firm had to reinvest in its business; over the last five years, it has spent about Rs.87 b as net capex. It is not tough to realize that competition is killing its business.

The best thing to do in this situation is to gradually withdraw from the market or make an outright sale. The first claim on this value would go to the lenders; they cannot get their full Rs.115 b, though, unless the government decides to make payments out of the tax payers' money.

The current year to date performance is consistent with prior periods; it seems there are far too many problems for the firm. When the book value of debt is Rs.115 b and market value of equity is Rs.9.73 b, there isn't much left for the shareholders.

Yet, here's a buy recommendation for MTNL. By the way Sharekhan owns 1.19% of this business.

change in market value

How much can (intrinsic) value of a business change in a year? Unless, there have been significant changes to its cash flows, growth or risk factors, an analyst would say, not much. 

Now, how much can market value (price) of a business change in a year? The answer depends upon the extent of rationality prevailing in the market. If markets are efficient (are they?), the answer is not much. If there is too much fear or too much greed, the price would swing; then it becomes difficult to measure the madness.

Value of a business should change over the period; As it begins as a start-up firm, it is exposed to the growth period, then to the stable market period, and then eventually decline. At every stage, the fundamentals of the firm undergo changes, and so does its value. There could be exceptions, such as, a firm could see decline before it experiences the stable period, for instance. However, how soon a firm is exposed to these conditions depends upon both external macro economic factors and internal corporate finance decisions involving, investing, financing and dividend decisions taken by the managers. We can visit this subject some other time.

For the moment, check out the swing in the market value of equity of Havells India during the past five years:

I am amazed at the extent of swing each year, i.e. the difference between the high and low market value of equity in a year. I wonder if there were any significant decisions related to projects, financing or dividend payouts envisaged by the managers that were factored by the market; I doubt it. If we think rationally, we can figure out how crazy it is to view a business in that way.

I would like to find out the quality of investments made by managers, the financing arrangement (i.e. the way the firm is capitalized) and how the managers treat excess cash. These factors have direct impact on value drivers, i.e. cash flows, growth and risk.

Market behavior has nothing to do with the value of the firm, but influences price. Whereas, the business behavior impacts its value and eventually influences price. It is for us to decide where to invest our time and efforts.

valuing real property

I have posted on the property market in India before and have argued that prices appear to be too high to justify value. Well, some time has lapsed, and nothing much seems to have changed in the market. 

There are innumerable stories floating around how people have made money in the property market in India. This is one of them. Some of my friends have made a lot of money as well. While I have not been a party to it, they are amazed at that; they consider that I haven't been able to analyze the prospects of the real property. After all, typical Indians invest in two assets: real property and gold; they usually utilize black money for these purposes. Their argument that under current regulation they do not want to pay undue taxes on their hard earned money may appear to be a little far-fetched. 

That said, I have my views on both as investments: gold is a dead-investment; and it is difficult to find value in investment in real property. 

Let us come back to the real property. The investments could be in land or building; house or apartment; commercial or residential. I don't think that prevailing prices for these assets relate to their value. Valuing a real property is no different from valuing any other cash flow producing asset such as a business or a share in stock of a business. 

Thus, value of a real property is the present value of its cash flows over its life discounted at the right cost of capital. Rentals represent cash inflows; there are no other fundamental sources. Costs of maintenance, such as repairs, co-op society charges, municipal fees represent cash outflows. Estimating terminal value becomes a bit dodgy; nevertheless, it is imperative to estimate it based on perpetual rentals if there is a perpetual period; if there is a finite life, that issue is not there. However, the most bizarre thing to do is to use a terminal value multiple; it is like mixing coke with yogurt; yuck!

I find that prices are ridiculously far away from value. I can argue that either prices are far too high, or the rentals have not caught up with the present economic conditions, i.e. rentals are far too low. In the absence of any evidence, I would like to stick to the former argument. 

Why else would a sub-urban Mumbai apartment fetching annual rentals of Rs.300,000 should sell at Rs.12.5 m? Or the one with annual rentals of Rs.180,000 should sell at Rs.7.5 m? Remember, rentals are not free cash flows. A plot of land measuring about 1089 square feet in a remote small town currently sells at Rs.1 m; the price was about Rs.150,000 just about five years back; I don't see any significant improvement in economic conditions of that town or the residents to justify that price. The story is true in any part of India in the present times. 

The funny part is due to poor regulation and urge to accumulate black money, most transactions are registered at a price far lower than the actual transaction price. The result is lower rentals, lower taxes and further investment in real property with black money; a vicious cycle.

The property developers use high leverage and unidentified sources of capital to finance the projects, and play strange games to influence prices. No wonder the realty stocks have faltered; however, I don't think that the developers' personal wealth has. These developers, private or listed, are not monitored and regulated adequately.

The current news is that prices are under threat, and that inventories of unsold properties are piling up in major cities; yet, there are no signs of prices falling.

I haven't got any answer to the questions, yet. Despite that people have been buying, prices have been going up and people have been making money; Only that I have not been party to this party. 

Identifying the greater fool has been difficult so far. A bubble or a burst...you tell me.

coke's story 2012

I have posted about coke before; apart from its enormous brand power, I did not have much to appreciate about. As a continuation of the previous post, the following shows how coke has performed in terms of operations and market value.

The decade

Revenues increased by close to 11% p.a.; Operating profits by 8.25%; However, I have not noticed significant increase in free cash flows to firm. Of course, FCFF depends upon how we calculate it in the first place; I have used after-tax operating profits and past reinvestment in both capex and working capital. Acquisitions also represent reinvestment; in the last decade, coke has reinvested about $19 b in net capex and acquisitions.

Market value of equity is at $173 b now, trading at about 20 times earnings. Coke's high and low PE multiples have reduced over the years perhaps suggesting market's reluctance to accept coke like it did historically. If we compare high-to-high market values over five or ten year periods the return to the shareholders is pathetic. Even if we consider low-to-high market values the annual return over five-year period is about 11.51% and over ten-year period it is about 8%. Not great by any measure.

The most interesting aspect has been coke's deteriorating after-tax return on capital which stands at about 21% for 2012. Again, definition of return on capital is important here. If we consider only tangible operating assets return on capital is stupendous. I have considered both goodwill (about $12 b at 2012) and other intangible assets as part of operating capital. In 2010, coke acquired Coca-Cola Enterprise’s North American business, which resulted in additional goodwill of about $7.7 b. It depends upon how we look at these assets. Where a firm continues to overpay its acquisitions and recognizes large goodwill on a periodic basis, ignoring goodwill would be a mistake. Charging it to equity would increase return ratios; however, the damage would already be done. Coke may not be in that category. 

Over 60% of revenues come from North America, Latin America and Europe. May be there is scope for growth in the emerging markets.

All said, people still do recognize its brand instantaneously; I still wonder why, though.

markets on to something

The party
We have been seeing markets run-up all over. Dow is at 16020 and S&P-500 at 1805 now; BSE Sensex is at 21326 and CNX Nifty at 6364. All of these indices are on a high. What has changed to cause this effect is the sentiment. Emotions are flowing in such that an optimistic view is being painted all over. Fear is being folded for the moment and greed unfolded. In other words, the market behavior has changed. 

The right reason for indices to change should be based on the fundamentals, i.e. cash flows, growth and the related risk of the firms in the indices. In the long term that will take place, but in the meanwhile the behavior of the so-called players in the markets influences indices.

Instead of asking questions such as are businesses going to do well given the macro environment, efforts are being made to check out how soon prices can be moved upwards.

For an investor, though, such behavior is good news, for it will help him take the right decisions depending upon price and value. So cheers to pessimism and optimism, and cheers to fear and greed. Speculators and traders make decisions based on ticker prices; investors do that based on price and value. The more the speculation and trading taking place in the markets, the better the profits for investors with the right behavior. 

The past journey
The extraordinary extension for Dow and S&P-500:

However, over the five-year period the Indian markets haven't done that well.

Both Nifty and Sensex are back to where they were in 2008:

Mid-cap and Small-cap have been disasters:

So too have been capital goods and metals. Autos have done relatively well.

FMCG, Health care and IT have done well.

Oil and Gas, Power, Realty and PSU have faltered.

Not really a party
There are lessons to be learnt: when in a downturn go for the businesses that are stable in terms of demand for their products. Other things being equal, a business which sells less discretionary products is inherently less risky. Generally, a business which has lower operating and financial leverage is also less risky. 

Instead of seeking super-normal profits, it is wise to check the downside of an investment first, and then look for the upside. The magic of compounding does wonders for any investment if it is utilized well. Yet, it is not well understood by many; but then why do we care?

The right thing to do now

For the moment, it appears that buying time is beginning to get over for the investors. It is time to either hold on to good businesses, or sell those where prices have peaked.

The rest of the time is well spent just watching the fun of speculative trading from a fair distance, and more importantly, reading and learning about business, finance and investing.

Skills worth developing for an investor: to first understand the difference between investment and speculation, and price and value; second, to understand how to analyze and value a business; third, to have the right behavior, i.e. to try to conduct in a rational manner as much as possible. These skills are inculcated over a long period rather than abruptly.

It is a never-ending journey, but, surely an engaging and enjoyable one.

google, the third biggest

I have posted about Google before; some good, some not-so-good stories. The classes of shares and corporate responsibility were interesting, but its phenomenal growth has been more interesting. 

Since 2003, revenues have grown annually compounded at 48% and for the last five years they have grown at close to 25%. It had revenues of $50 b in 2012, book operating profit of $13 b and $48 b of cash; cool! Return on capital has been consistently high and there is negligible debt.

All this has translated into high market value of its equity of $350 b from $86 b in 2009.

It is only behind Apple and Exxon Mobil now in terms of market-cap. The run-up has been sharp if we compare the multiples over the period. However, we know that these multiples and market values are meaningless if we look from the point of view of investment (the intrinsic value). Business valuation is what matters then.

It has $10 b of goodwill sitting on its balance sheet which represents its faith that its past acquisitions are going to generate cash.

That brings us to question whether the current market value for Google is fair based on its future cash flows potential and risks.

Google claims to be a technology leader focused on improving the ways people connect with information; and aspires to build products and services that improve the lives of  billions of people globally. In this regard, it has significantly exceeded my expectations. Today, Google is an educational institution. Its search tool has been of great advantage as a lot of information and knowledge is gained through it by anyone sitting anywhere. With all the crap that is being taught at schools and colleges, formal education has become only a means to take up employment. Google has helped people pursue their areas of interest and passion; have fun in the process, and also make money. It is difficult to imagine life without the Internet and Google now. Everyone uses Google is an understatement.

Google's revenues comprise predominantly advertising, with marginal contribution from Motorola Mobile coming from 2012.

Google's value will depend upon how much of its online advertising market share it would have to cede to its competitors, more importantly to, Facebook, LinkedIn, Twitter and Yahoo, in future. As these firms become more prominent the obvious would be smaller pie for Google both in terms of revenues and margins.

It is anybody's guess, though, about the total market size and Google's share in future. Difficulty in estimating revenues and margins makes its valuation exercise futile. Nevertheless, I wanted to have some fun based on my estimates of revenues, margins and reinvestment needs to get its value. The value came far too lower than its current market value; I had a lot of fun, though.

Google will see significant reduction of, yet reasonably high, operating margins and return on capital in future. It is currently spending a large portion (13.5% of revenues) on research and development. We don't know what products are in the pipeline; but we do hope that they are as good as the other products have been and continue to be.

ambuja-acc-holcim make tripartite

Ambuja Cements is in the news for its supposed restructuring what it calls heading towards a more efficient capital structure. The company is entering into a share purchase-and-swap transaction with its majority shareholders resulting in merger of Holcim India Private Ltd. into Ambuja Cements.

As per the details of the scheme, Ambuja will purchase 24% of shares of Holcim for a cash consideration of Rs. 35 b; it will cancel 9.76% of its own shares held by Holcim; it will issue 584.44 m of its shares to Holderind Investments Ltd.; and by virtue of the scheme it will own 50.01% of ACC. 

The current shareholding of Ambuja is: Holderind (40.79%), Holcim (9.76%), minority (49.45%). Ambuja also has certain options, warrants and rights which are exercisable for the purpose of the scheme. Since Holcim is fully owned by Holderind, it gets 50.55% of Ambuja. Holcim also owns 50.01% of ACC. Holderind is part of Holcim, Switzerland.

The story goes forward: Out of Holcim's total of 5,690 m shares, 1,365 m shares are being purchased by Ambuja at a price of Rs.25.63 per share; and in exchange for the balance 4,325 m shares, Ambuja will issue 584.44 m of its own shares to Holderind. 

Post merger, Holderind will own 1,214 m shares in Ambuja resulting 61.12% of the fully diluted shareholding because of options, warrants and rights being exercised. The balance 38.88% will be left for the minority shareholders. 

The merger scheme required valuation of both Ambuja and ACC separately and as per the valuation made by the professional accountants the share swap is 7.4 and the implied price per share is Rs.189.66 for Ambuja and Rs.1249.02 for ACC. 

To evaluate how the scheme impacts both the majority and minority shareholders, let's first have a look at the implied market values: Holcim of Rs.146 b representing its ownership in Ambuja and ACC; Ambuja of Rs.293 b; and ACC of Rs.235 b. The implied valuations are not too far off current market-cap of Ambuja (Rs.275 b) and ACC (Rs.201 b). 

For the majority and minority shareholders, it would first appear that the difference in value is heavily tilted in favor of the majority. To see how, all that is to be done is to find out their value before and after the merger. 

The market value of Ambuja should go up post transaction from Rs.293 b to Rs.375 b because of the net effect of the cash payout and gain of share in ACC. This increase in value of Rs.82 b is shared by the majority (Rs.81 b) and the minority (Rs.1 b). Now it sounds like the real merger, with the minority defeated.

However, if we look at what happens to Holderind as a firm, the equation would be different. Holdeind will give up about Rs.148 b of its value in Ambuja and Rs.117 b in ACC; in exchange, it  will get cash of Rs.35 b and value of about Rs.229 b in the restructured Ambuja. The minority will give up about Rs.145 b and get Rs.146 b after the merger. Consequently, the net effect of the merger scheme is shifting of about Rs.1 b of value from, in fact, Holderind to the minority shareholders. The deal is now through as the required minority has voted.

All this is subject to the valuations being fair which I doubt profoundly.

Finally, this is how the companies have rewarded their shareholders in the past:

This is the problem with the cyclical business.

marico acquisitions - boost or boast

The growth strategy

The path for Marico has been clear: growth through acquisitions. Since 2005, it has made 10-12 acquisitions covering India, Bangladesh, Egypt, South Africa, Malaysia, Singapore and Vietnam. 

In a highly competitive market categories that the firm operates, one of the two strategies should pay: Increase volumes or increase prices, or may be a fair combination of the two. Since there is a limit to increasing prices and volumes of the current products, what better way than increasing the product portfolio? So does the management think and hence, these acquisitions. 

Acquisitions are good if price paid for these is fair in comparison to the future cash flows. Although, there are some exceptions, one of the parties to the transaction would have an edge over the other. This means, the value gained by that party would be at the cost of the other. That is how mergers and acquisitions function in the corporate world. Of course, most of them fail to create any value.

The historical performance

In this respect Marico has not done badly so far. Over the last decade its revenue has grown at an impressive annual rate of 20%; its operating and net margins have remained steady; but, return on capital and return on equity have reduced from high levels to reasonable levels.

The primary reasons for lower return ratios are the acquisitions. Its first major acquisitions took place in 2011 which included:

1) Singapore based skin care solutions business Derma-Rx for Rs.1.44 b; 

2) The Ingwe brand (mainly Caivil and Black Chic brands in hair care) from South Africa based Guideline Trading Company. Surprisingly, no information about the consideration and fair value of assets acquired is disclosed in the annual report. 

3) The 85% equity in International Consumer Products Corporation (ICP), a Vietnamese FMCG company having brands such as X-Men, L’Ovite, Thuan Phat in cosmetics segment. Here too, no information about the consideration and fair value of assets acquired is disclosed in the annual report. Instead, the resulting goodwill (which is the excess of consideration over the fair value of net assets acquired) of Rs.2.21 b is disclosed.

If we have a look at the fixed assets note and the statement of cash flows it appears that Marico's total cost of acquisition in 2011 was about Rs.4.62 b.

The stock performance in the past:

Clearly, shareholders have been happy.

The restructuring in 2013

Marico has undergone significant restructuring:

1) The divestment of Kaya Skincare business into a new (being listed) entity, Marico Kaya Enterprises Limited. As a consideration, the shareholders of Marico have been issued 1 share of Marico Kaya each (face value Rs.10) for every 50 shares of Marico (face value Rs.1), fully paid up. Because of this, Kaya skincare, including the 2011 acquisition of Derma-Rx, will be out of Marico's operations. 

2) In May 2012, Marico acquired the (Halite) personal care business of Paras Pharmaceuticals Limited from Reckitt Benckiser for a consideration of Rs.7.45 b. This is effectively for Set Wet, Livon, Zatak, Eclipse, Recova and Dr Lips brands.

The investments and free cash flows

Marico has made net investments of about Rs.26.28 b including working capital in the last decade. A large portion of this, about Rs.15.32 b, has come in the last 3 years. Consequently, revenues and margins will undergo some change in the coming years as the new acquisitions start flowing into the business. 

These investments have been funded by both equity and debt. If fresh issues of shares is used to fund acquisitions, there will be potential problems: It results in dilution of earnings for the existing shareholders; especially when the price paid for acquisition is not a bargain, it results in lower value for the business.

For the first time in many years, Marico issued new shares (apart from its annual employee stock options) in May 2012. It issued 29,411,764 equity shares on a preferential allotment basis at Rs.170 per share to two foreign investors - Indivest Pte.Ltd., an affiliate of Government of Singapore Investment Corporation (GIC) and Baring India Private Equity Fund III Listed Investments Limited.

The acquisitions on a regular basis have made sure that the firm has never had any meaningful free cash flows in the last decade. Its poor payout ratio reflects this.

The future performance
Marico owns brands such as Parachute, Nihar, Saffola, Hair & Care, Revive, Mediker, Livon and Set-wet (in India) and Fiancée, HairCode, Camelia, Aromatic, Caivil, Hercules, Black Chic, Ingwe, Code 10, X-men, L’Ovite and Thuan Phat (international).

Whether Rs.7.45 b for Set Wet, Livon, Zatak, Eclipse, Recova and Dr Lips brands is a fair price, time will tell us. However, considering their collective current revenue of about Rs.1.50 b, it will take significant growth in revenue and operating margins, and a high return on capital to justify this acquisition. 

After these acquisitions, Marico's book capital has increased significantly because of which there will be pressure on return on capital in the coming years unless higher operating margins are sustained.

As per its latest quarter's report the company has a target revenue growth of 15-20% and operating margin of 14-15%. Well, if I take their word for it and estimate the value of equity of the firm on a going concern basis it falls short of its current market value. 

Nevertheless, we have a precedent of two foreign investors buying shares at a price of Rs.170 per share in May 2012. The stock has run up 18% since then. 

You can bet on Harsh Mariwala and the CEO if you wish to; after all, the past is some indicator of the future, if not the best one. But then, it is your call on revenues, margins, cash flows and the risk.

ongc is not a fair game

Exploration business

Brent crude is now at about $108 per barrel. In fact, it has remained higher than this level for much of the period. Oil exploration companies are treading good fortune, one might say. 

Despite that, 2013 annual report of ONGC says that its net realization on crude oil was $47.85, and it was $54.72 in 2012. For the first-half of 2014 it has been $42.56. This is not new, it has always been like that for ONGC. What is going on here? 

For any exploration business two biggest risks are explorable oil and oil price. The former depends upon several factors including technology and cost. As for the latter, the higher it goes the better it is. However, for ONGC it is not. Funny though, it is in a weird situation. 

The regulation

ONGC is forced to sell oil at discount to oil marketing companies, its customers. The discount is pretty large as we can already see. 

This is how it works: The government controls retail selling prices of high speed diesel, superior kerosene oil and liquefied petroleum gas. The reason appears to be simple; non-subsidized votes from the general public in exchange for subsidized petroleum products. Consequently, IOC, BPCL and HPCL sell for too low and incur losses (call it under-recoveries). The story gets interesting from now on. As mandated by the government more than 90% of these losses are to be borne by the government itself (about 55%), and upstream companies (ONGC, OIL and GAIL - about 35%). And more than 80% of the upstream share is charged to ONGC. The government does not reimburse in cash, it issues oil bonds to the oil marketing companies instead. ONGC and other upstream give discounts to them. 

Value destructive

Some thinking and analysis would tell us that this policy has had enormous impact on the business and shareholder value. The cornerstone of corporate finance has gone bonkers. In the last ten years, total subsidy borne by ONGC is about Rs.2,163 b; it's massive. That's the amount of revenue lost by the company. The bottom-line impact on ONGC is lower than this because it has to be pay VAT and statutory levies to the government. In 2013 the firm lost Rs.421 b and in 2012 it lost Rs.378 b on net basis; that is, cash loss after paying taxes. The minority public (including institutions) have lost about 30.77% (their stake) of this cash on account of poor regulation. 

Lack of substance

I just don't understand why the math had to be like this; it is ridiculous. If the public has to be supplied with cheaper products, why not just reimburse directly to the marketing companies? Just collect taxes, levies and dividends from the upstream, and give it to the marketing. Or better yet, stop this nonsense and go for market-driven policies where everyone gets what he or she deserves. Create employment, private partnership and growth, and make people work to afford goods and services, however expensive they might be in the market. If they cannot afford it, people should learn to live without it; a fair game.

The hapless minority

This is how I see it. The average return on equity (also return on capital) earned by the firm has been more than 26% over the last decade. If the subsidy cash was reinvested by ONGC in the business and earned say 25%, the current value of that cumulative reinvestment would have been staggering Rs.2,635 b; compare this to the current market value of equity of Rs.2,400 b. The government has destroyed the firm's equity value by about 50%. In other words, the minority would have been richer by 100% if only those policies were not adopted. Alas, it was not to be. 

The following shows how the minority has been taken on a ride by the majority shareholder (at March 2013).

This shows value lost by the firm at different levels of opportunity costs. Even the no-brainer 8% rate would have increased market value by Rs.1,534 b.

In fact, the government too could have done far better without regulation. Its share of value including all levies would be much higher. But then, politics is not business and finance.

The deregulation...the value creator

In 2013 both return on equity and capital reduced to less than 20% for the first time in the decade. No wonder the chairman is worried. The production levels (both oil and gas) have not moved much for a long time; fields have become old and mature.

For the firm to create value in future a few things have to take place: Increase reserves acreage; improve technology to reduce cost of production; hope for steady oil prices; and above all, pray for deregulation. The production targets require sustained reinvestment which would be impacted if the current policy continues.

We are informed that in June 2010 petrol prices were deregulated (I don't see it explicitly though) and diesel is on its way to be deregulated. All this is to bring down subsidies and fiscal deficit; the current hot topic.

When or whether it will happen is left only to guesswork. What we learn is that we don't learn. That should not stop us from guessing.

socialist democracy

The outsiders' view
He is usually low on the US and Europe, and high on Asia and commodities; that is his view. I don't track Jim Rogers. I am not particularly interested in commodities as such, because for me they are subject to pricing mechanics, not value mechanics; and that is my view.

Nevertheless, I found his recent comments about India quite interesting. Some of his thoughts:

Well, these are his thoughts and views. How much of these are really true, it is for anyone to ponder.

The fish school
The government has been from the school of giving the fish, rather than teaching to fish thought. Free food, subsidized food, subsidized products, in exchange for non-subsidized votes, probably. Wouldn't job creation be better? Wouldn't partnering with the private be better if the state cannot do it alone? Tough questions I guess, but, is India really catching up with the world, is it behaving right? Imagine a state owned listed company looting its minority public shareholders in the name of general public subsidy.

An option to delay...for how long...
I do see opportunities for improvement, if only some questions are addressed properly. We need to first check what India has shown in the past several years in terms of employment, per capita income, and real growth; how easy it is to do business, both for domestic and foreign firms; what kind of infrastructure is in place; how flexible or stringent are the rules regarding capital, currency and profits to move. These are to be assessed on a relative basis, both what it was before and what it is now, and also how it compares with other economies. If other economies are better placed it is easy to tell that business, money and growth will flow there.

The advantage India has is that it is difficult for the world to ignore it; it is tough to shrug off a billion-plus people, the potential for demand is immense; consequently, there is colossal opportunity for doing business. It is up to India now to capitalize on this, or fall behind.

At this stage, though, it is tough to tell whether India is a democracy, or a socialist; or a socialist democracy, I don't even know what it means.

Right now for investors it is like an option to delay worth a very low value. India needs do everything to increase that option value.

value of a business

The essence

The crux of the matter when it comes to investing is valuation. Unfortunately, value is often mistaken to be price, and vice versa. Just as investing itself is often confused with speculation. Understanding the difference is far too important for an investor. 

Speculation, especially calculated speculation, is not bad as long as one knows that one is speculating, not investing. Similarly, estimating the price is fine for an investor or speculator as long as he knows that he is chasing price, not value. 

The value

Let's come to value. The value of any cash flow generating asset is the present value of its cash flows over its life. Obviously you need to discount these cash flows at an appropriate rate to bring them to the present value. Thus, estimating value poses twin challenges: estimating cash flows and using the right discount rate. 

The value of a business is, accordingly, the present value of the cash flows it is going to generate over its life. If the life is considered finite, cash flows are estimated over that period. However, often, a business has infinite life. Consequently, cash flows have to be estimated over perpetuity. 

The cash flows

When this is the case, the cash flows period is split into more than one. First is to estimate when the business will reach the stable growth. It can be in 5, 10 or any other number of years. The period until stable growth is the growth period. Then cash flows are estimated during the growth period using an appropriate growth rate over this period. Lastly cash flows are estimated during the stable growth period considering the fact that business has become mature. The behavior of the business is different during the growth and the stable growth periods. Naturally, you expect decisions regarding investing, financing and dividends to be different too. The key to estimating cash flows then is to understand the behavior of the firm under different conditions. That is to know that revenues, margins, reinvestment and return on capital change as the firm's characteristics change. As the behavior of the firms changes, their value changes.

The discount rate

It is the easiest when cash flows are almost a certainty.  In this case, you just use the risk-free rate to bring them to the present value. Heck, cash flows are never certain. Using the right discount rate then becomes more challenging. 

The garbage in

It appears quite clear that once you input cash flows and discount rate, out comes the value. This is easily manipulated if the analyst is exposed to bias arising either due to his own emotions, or market-driven conditions. Therefore, it is imperative that caution is exercised before estimating cash flows and discount rate.

What is not value

Every other method used to calculate the so-called value is actually not value. That may appear surprising to many since value is used so much loosely in context by too many on too many occasions.

The most popular method used is the multiples-based method. Here, multiples such as price-earnings, price-book, price-sales, or enterprise value based multiples are used to estimate value. In reality, however, what the analyst is doing is to estimate the price, not value. Fundamentally, he is assuming that markets are overall correct all the time, but on individual stocks they are often wrong. Therefore, under-priced and over-priced stocks are selected for transaction purposes. Income-based valuation is nothing but a pricing method.

Asset-based methods use either book values which is nonsense, or market values which is again pricing. 

Liquidation value method is a valuation method if based on cash flows, discounted when required, or is a pricing method if you turn to the markets for clue.

Then there is option-pricing model used to value an asset, especially out-of-the-money, as an option. When estimating cash flows as they are is not easy, estimating inputs used for option-pricing seems rather too uncomfortable. The only way I see it is that since the downside risk is fixed, an option gives just that, an option to buy or sell, which should be used with caution. Let's not get attracted to the fancy stuff; let's concentrate on how comfortable we are with the cash flows, although they are probable.

The explicit

It is quite clear that the only way you can value an asset is based on the discounted cash flows. Every other method is useless if you are trying to estimate value. Pricing is fine if you know that you are trying to price for the short term. Prices change too quickly while value does not. Therefore, a prudent long term investor would want to value the stock rather than price it. 

It is amazing that so many professional analysts get it wrong. They seem to know nothing about the difference between value and price, or they seem to ignore it. The result is that their reports use models to estimate price, which is unfortunate because these reports are pitched to the potential buyers.

Now, if the buyers are unaware of the difference, they will fall prey to the pricing pitches, and will be exposed to lose money.

Get it right

You will be alright if you know what you are doing, and more importantly, if you know what you are not doing. Understanding the limitations and constraints is the key. Behave right!

was it right for blackberry

The scary ride

It is not clear whether not going private was a good decision for Blackberry, or was it not being able to sell the business to potential buyers. 

Last few years have been daunting for the smart phone maker whose technology was once considered disruptive. 

As revenues and profits started falling, market value has also taken a dive. The latest quarter ended August 2013 was extraordinary as the firm posted a gross loss. Does this mean it sold blackberry phones below cost, and did not have operating cash to cover its research & development, selling, general and admin expenses? Well, it looks like it.  

Dwindling market value

The consequence has been value destructive for the shareholders. 

From $47 b market cap in Sept-2009 it is worth, as appraised by markets, about $3.4 b now. As much as we hope that nobody bought any stock in the last four years we can't run away from reality. There must be a number of investors who believed the firm would grow its market share and stock price and put the money only to see it vanish. 

The good and the bad 

I am not sure what is in store for it now. Nevertheless, there are investors who have shown faith in its business model, or some of its assets.

The good news so far has been is that it has not been burning cash, yet. Depreciation and change in non-cash working capital have been positive cash flows for the firm compensating for the negative earnings. In fact, Blackberry would have increased its cash over the last year if it had postponed its capex. It has over $2 b of cash and no debt now which can help counter the storm for sometime, although, withering some ego. It also has software and patents apart from devices and network assets; these must be worth something.

However, there is plenty of bad news. Revenues and profits have been falling; market share is probably at its lowest point now; cash may not last for too long. Yet, the most important negative has been failing business model. There appears to be lack of a clear strategy going forward at least as available in the public domain so far. Moreover, capex cannot be postponed for long if Blackberry wants to continue doing what it does. In fact, it spent about $7.5 b in capex in the last four years; and we know what happened in those years. Reinvestment has to show growth and value, otherwise, it is meaningless and wasteful.

The uncertain bet

I am sure those who want to invest significantly in the firm have got a plan in place, and more importantly have faith in place. That $1 b investment in the form of debt securities with an option to convert into equity at $10 per share shows that faith. 

Whether it will fructify is something we have to wait and see. These are the challenging times for technology firms especially those into making smart phones and tablets. 

The option to sell the business in parts, a form of liquidation of assets, is apparently not on the cards. There is no full sale or part sale, there isn't going private, there isn't a strategy going forward. So what is it for the current and potential investors now?

It is tough to tell. But, here is what I reckon. Today, the market is willing to give just $1 b for its operating assets excluding cash. Is it too little or too high? Investment in Blackberry now is like a blind date, like you wouldn't know whether it is going to be a fairy or a witch. It is a bet which might pay off or may not. Blackberry's patents, like options, could pay off for the investors, or they may not. All this, however, is full of uncertainty. 

Uncertainty is what Blackberry is seeking today with its intention not to sell. Just for math, the stock price has to jump over 50% for the lenders to be even with the strike price for conversion. To make money it has to jump several fold though.

They must know better.....They must know something I don't. Wishful or nonsense?

reflections of the market

Short term or long term: Price and Value

We have discussed in the past about historical values of markets and made some analysis on key pointers. Well, it's about a year since and I see it apt to reflect on where it stands now. 

The factors that drive markets are the same as those drive individual firms, i.e. cash flows, growth and risk. Since risk has direct impact on cash flows and growth it becomes all the more important how we see risk both in terms of intuition and reason. In the long term markets catch up with the fundamentals of the firms. 

However, in the short term that is not the case. Markets move up and down based on the expectations of short-term price seekers. Often, there is irrationality embedded in these expectations. The game of short-term players and long-term investors always renders moot. In the battle of price and value as I see it, eventually value will have the triumph. This is based on the premise that price has to catch up with the fundamentals despite odds and delays.

The year so far

Let's come back to the market and its moods during the year. It started with 5937.65 and closed at 6299.15 yesterday; that is about 7.3% annualized, not very exciting. 

The Nifty was at 5285 by end of August 2013, though; that is about 19% in just two months. You can try the annualized yield, but, the point is such things happen in the short term. The expectations drive moods and consequently, the stock prices.

In the past ten months, the PE has moved from about 15 to 19. The fact that current values are far different from the all time high-low values lets us an opportunity to make decisions. Clearly, the buy time was end-August / beginning-Sept. 

The dividend yield has never been great for the index. This should be because either the firms are in high-growth phase, hence low payout ratios, or there is over-estimation of growth in price. In a growing economy like India, the tendency is to assume the former; however, this should be done with caution. We see firms investing in mediocre projects when they have a lot of cash. This happens primarily when their core business is generating excess cash, and the managers try to extend their smartness to the area they are not good at, just to fill their ego. Instead of increasing dividend payouts they go about empire building. This is not smart corporate finance. When firms reach their stable growth period it is far better to accept that reality and behave like mature firms.

The PB ratio has moved between 2.62 to 3.26. How far one can pay over the book value depends upon the type of business one is looking at. For a capital-intensive business the PB can vary significantly based on the expected earning power of operating assets. For a financial firm the PB is more closer to the book, though. Collectively for the index, it is better to visit history to check the prices it has traded at, albeit keeping in mind the level of interest rates . In Sept-2001 it was 1.92 and in Jan-2008 it was 6.55. A grand display of the vicious moods of Mr. Market.

The Diwali bonanza

Now, the Nifty is trading at 18.18 PE, 2.99 PB and 1.46% dividend yield. In the coming days, there will be a lot of coverage on hot stocks for the season, for the next year and for the next few years. All I can say is, be wary of these talks for these are often loose. Think about this default reasoning: If anyone is good at picking stocks that person would not appear on media and talk about it, rather would concentrate all resources on those stocks and get rich. As a corollary to this, because that person is appearing all over and trying to sell ideas there is reason for us to ignore it. One should try to recognize the bias involved in every proposition.

The basics

The suggestion is to stick to the basics. If you have time and are interested in business, finance and investing, set this activity as your business (full-time or part-time) and make all the efforts in understanding the business and its valuation. Try to understand the difference between price and value. Pick stocks on a selective basis whenever there is price-value mismatches. 

If you don't have time because you enjoy a different activity, there is plenty to cheer than fear. It is best to stick to long-term investing on a systematic basis in a diversified index, let's say, S&P-500 or S&P CNX Nifty. Such a program should be continued despite low or high index values, or adverse economic conditions, and should be carried out for a fairly long period of time. With this strategy you would have beaten a large number of so-called professionals managing money. The rest of the time you can concentrate on your favorite subject.

For both the strategies to work, one aspect is far more important. That is the ability to control emotions, not to get carried away by markets, media, week-end parties, relatives or friends. The fancy word is behavioral finance, but, one need not get there if one has discipline and right behavior.

We all need to cultivate such habits, and thus create our own good luck. 

Finally, the decision to buy an index or a stock should come from the expectations of cash flows, growth and risk. Bear in mind that expected inflation and interest rates influence value at any point in time. Therefore, none of the market ratios should be looked at in isolation.

Let's go back to work, rather than hear the media on hot stocks. Flap!