commodity, cyclicals, or pricing power

It's time for many to assess how they fared in the game of investing. I have selected some of the largest market-cap stocks from India, and some other randomly in order to check out their performance over the years.

The longer term
Since I usually do not look short term, let's start with the five-year period, where the markets returned 57%. Take TCS, India's largest company in terms of market-cap. It has returned 233% over the last five years, while Reliance lost money (negative 18%). However, it performed much better than NTPC which lost 40%; how pathetic, and how relative. So much for the previous government's promises of reforms, especially in the power sector. ONGC is up 16% in five years. Tata Steel is down 35% (blame it on bad acquisitions and more). And then there is Asian Paints, which returned 304%, and Nestle which is up 1019%.

A look at the picture below, and we get the picture, I reckon. 

I am not much interested in the year-on-year performance particularly, but some things do stand out, and tell us.

For the year 2014

For the year 2013

For the year 2012

For the year 2011

For the year 2010

The lessons
There are commodity businesses, and there are cyclical businesses, and then there are businesses which due to something about them that give them the pricing power. That is, they are able to increase prices of their products when they want to without worrying much about volume of sales. While the former categories rarely make investors rich, the latter category when purchased at the right market prices often rewards them sufficiently.

Obviously then it makes sense for us to watch those businesses which sell less discretionary products, have lower operating leverage, and not much of debt. These are the ones that have durable competitive advantages, and therefore, can sustain higher gross margins, and higher return on capital over a long period. Pick them at the right price (when markets have fallen off the cliff) in meaningful quantities, and wait for the price and value to converge. Have fun, get rich in the coming years ahead.

how instagram is worth more than $35 b

Instagram, an online photo-video sharing social media business was acquired by Facebook in April 2012 for $1 b in both cash and stock. Now it is being valued at $35 b. That is 35 times payoff in 2 years. 

Was the buy a bargain (sellers that foolish, and buyers that smart), or is this just another of analyst's fantasies?

With social media companies one cannot tell as the euphoria that was there during the late 1990s regarding information technology companies seems to be rubbing off regarding the social media companies now. Human behavior is the same at all times. Greed and Fear are the easy masks people like to wear.

I am not saying that Instagram is not worth $35 b; what I would like to ask is how do we know? It could be worth any value. There isn't any rational basis at the moment to justify with confidence that it is worth something.

We haven't got the revenues and margins; we don't know the growth rate; we haven't got the reinvestment that is required to sustain the level of growth that is expected.

We can definitely have a set of assumptions about these, and come up with a value. However, I can guarantee that the intrinsic value of Instagram as a business would be anything, but that value. The reason is simple: with technology businesses, it is almost impossible predict the future course. We might want to see a level of growth, but to achieve that growth, reinvestment of capital is required; information about market size and market share is required; we should know the sustainable margins which leads us to understand the market and predict competition.

One way to go around this is to have a distribution of assumptions and come up with probabilities, and then the expected value. Heck, it doesn't work that way. There could be probabilities, but then, in reality the actual value is not based on probability, but on a single set of fundamentals. Which of these assumptions will hold true, you never know. We can use probabilities only when there is a very high probability of an event occurring. Rest is pure academic.

Isn't then valuing a technology business a futile exercise? What is the point in valuing a business just for the sake of it? We should be able to make a buy or sell decision based on our valuation. If we are not able to do that, I find the exercise only academic. Not too bad for a class of students, though.

Hypothetically, if Instagram is worth $35 b, it is a better business than say, Hershey ($23 b), Sony ($22 b), ICICI bank ($33 b), Kellogg's ($23 b), State Street ($33 b), Southwest Airlines ($27 b), and Cognizant ($32 b). Is that so? I don't know. I am not saying that these market values reflect their actual worth. At least these firms have established revenue models.

Instagram does not have meaningful revenues at the moment. It might have a revenue model, but we are not privy to that information. I would argue that even the managers would be wrong in their estimates for a start-up business like this one.

Instagram's value could even be higher than $35 b. What I mean is that at this moment we cannot know this for sure.

With all this behind, I might as well give my estimates of Instagram.

If Facebook is worth $222 b and has 1.35 b users, we can use this information to price (not value) Instagram.

Here we go, Instagram is worth $49 b.

We can use price-to-sales ratio of Facebook to price Instagram to $53 b.

I can use a set of assumptions on revenues, operating margins, growth rate, reinvestment rate, return on capital, and use that to estimate the value of Instagram. But, I will keep that for another time.

I have had fun with these exercises in the past (TCS/Infosys, Facebook, Twitter, Twitter, Nokia, TCS, Blackberry, Google, FB/WhatsApp, TCS, Apple), but have never used that for any investing decisions. In fact, my concluding thoughts have been similar; we cannot value technology businesses accurately.

Yet, who stops us from having some fun? Let's play along...

oil buyer, or oil seller, that is the question

Back in 2012, I argued that value of an oil producing business depends upon two key factors: oil reserves and oil prices. While I wrote about the significance of being realistic about oil reserves, I did not much deal with oil prices as they are not within anybody's control.

Alas, we are left to deal with it in these times. With oil prices falling just like that, there are at least two groups who are affected. Those who produce oil, and those who consume oil. There is no prize for guessing in the current times who you would like to be. 

Naturally, oil producing businesses have been hit and oh boy. At less than $60 per barrel, suddenly the time is to be the buyer of oil rather than the seller. I wonder why then the stock buyers go gaga over rising stock markets rather than falling. That post is for another time though, let's come back to our current story line. 

Oil sellers

The right thing to do for the oil producers now is to cut back on production and let market prices of oil rise to the levels required to give them the required rate of return. Unfortunately, producers with lower financial flexibility (having high debt, and low debt capacity) should panic, and have higher chances of bankruptcy. These firms might not have time to wait for the prices to rise. A sorry situation reflecting probably poor managerial skills (financing decisions). Those who have the financial flexibility would be able to cut the production, and wait for the prices to correct. There is no time frame in this respect as the prices tend to be unpredictable, and to a large extent not controllable. 

Then there is another class of oil producers whose dynamics are decided by the state rather than the owners. Take the example of ONGC whose hands are tied regarding both production and pricing. Firms like this will have no option, but to rely on the state's (rather than the firm's) economic considerations. History suggests that the state has not taken the right decisions on behalf of the owners. Therefore, ONGC has not performed the way it would have if it were a private firm.

Oil buyers

The story is quite different for the oil buyers. Businesses who consume oil in large quantities as their raw material, and having pricing power on their finished products, are likely to be key beneficiaries of low oil prices. They should be able to increase their operating margins other things being equal. Businesses selling less discretionary products to the consumers are best placed to increase their value. 

Investors

Investors will be well placed to buy stocks of oil buyers having pricing power. And those interested in buying stocks of oil sellers should consider buying those who have low debt, large reserves, and control over the timing of production. Privately owned or publicly listed oil producers are better placed in this category rather than the state owned.

Needless to say that the price of the stock compared to its value should be the primary consideration before making any buy decision.