gold, a measure of opportunity cost

If gold imports by India are going to be 1000 tons in 2015, at current rates it is worth $34.64 b or Rs.2,530 b, never mind the gaps in the exchange rate. I have argued in the past that it is not the brightest idea of investment. One has got to be inclined towards stupidity to spend that kind of cash in a commodity that the majority still considers to be the last resort. 

It is clear from history that whenever there has been a crisis and the consequent loss of faith in a currency, gold has been perceived to be the savior. May be because it glitters, or may be because it is finite, whatever the reason, people have held on to gold for protection. It could well have been some other item, not gold, but gold it is. 

I don't care what portion of those imports are meant for government reserves and what for public consumption. The fact is that much of gold has to be imported by India which puts a serious dent on its current account. At least we haven't got much choice when it comes to imports of oil, which is another item that affects the country's public finance. But, haven't we got discretion when we spend on gold? There is also depreciation of the rupee year-on-year, which affects the cost of imports. If only people had been a little more rational, both the country and themselves would be better off. 

Gold does not do much other than being stationary in as much time as we want to consider. Gold prices move such that only greater fool theory would fetch satisfactory returns for the investor. Apart from small doses for decorative consumption purposes for those who fancy, and some for industrial purposes, gold doesn't serve much purpose. However, the opportunity cost of gold imports is significant. The cash could have been used for purchasing any cash flow generating asset.

India's gold imports in metric tons from 2003 to 2015 are presented below.

The dollar values of those imports are staggering.

Let's assume that each year the Indians invested the cash, instead of purchasing gold, at an after-tax return of 5%. This is a dumb, low-return investment, even lower than the government treasury and inflation rates.

Yet, they would be smarter than their actual spending, because they would be sitting on a cash pile of $432.02 b as of now. There's more: This cash would earn that dumb 5% year after year.



There is a lot one could do with that cash. One could invest in treasury bonds, or some other instruments, or perhaps invest in a portfolio of stocks picked carefully.

Of course, there's more one could do. Smart people are capable of earning 15+% over the long term. The graph below shows what would be the value of the (cumulative) cash stream today if invested at various rates of return.




The graph not only shows the opportunity cost at various return levels, but also, it mocks people who did not invest in cash flow generating assets. And they did not.

Why they would not do it is a multi-billion dollar question. Don't you think? 

big boys, market and stories

It is no secret that market perceptions play a significant role in valuing firms. It is, in fact, the discounting of future stories related to a business by the market that reflects its current valuation. I mean, market valuation, not intrinsic valuation. 

These future stories are told as perceived, not as they actually unfold. That is why it is dangerous to accept market's views in the short term. Invariably, the stories are going to turn different. You cannot tell the story in zest; this is not the place to display excitement or dejection; investment decisions are done with real cash. Therefore, one of the key requirements of a successful investment operation is control over emotions. Put another way, the story has to be told not as likely to be perceived, rather, as more likely to develop. The probability of the story to become a reality should be rather high for an investment to bear fruit.

As noted, market valuations do not reflect those odds; this is true in the short term. However, in the long term, as the story actually emerges, the market adjusts the valuation accordingly. It is better to play the long term game for satisfactory returns. As much as the long term is uncertain, the investment returns are more predictable at least for certain businesses. 

It is true that intrinsic value of a firm is the present value of its cash flows discounted at an appropriate rate. Accordingly, the value is affected by cash flows, their growth period and growth rate. Once we have estimates of these numbers, the value becomes a function of the expected rate of return. 

The following is a snapshot of 3 big boys in the world of business. We have the latest annual revenues, 5-year average operating margins and 5-year average free cash flows to firm for each of the firms. None of the numbers are based on the trailing months. 

Based on the above information only, how do we value each firm? All of them have been around for a fairly long period. The business model of each relies heavily on technology for its success. Each of them has disrupted its market in a significant way. They are all being managed by competent people. One is in the retail business, the other is into computer peripherals (and more) and the last one is in the advertising business. 

As much as we would like to estimate the value of these firms, market as already done the work and given us its offer. Now it is up to us whether to buy them at those prices or leave for another day when the market is in another mood. 

While its cash is building up at a very rapid pace, we would like to know the reinvestment plans of Apple; how long its story is going to continue like it did in the past and what it is going to do with its cash are what determine its value. 

While Google's story appears to be more stable and credible, advertising market is not unlimited. It has boundaries and Google will have to operate within that. 

It is Amazon that amazes me the most. How long it is going to be until it really starts generating cash flows? The market has been very patient and is playing a very long term game. 

If we accept that it is the buy price that determines our investment returns significantly, we should be careful about what we pay; and this applies to Amazon, Apple and Google. 

morality of business

I have always maintained that one should carry out in a way that is within the legal boundaries set by the regulation and the moral boundaries set by the society. It applies to both personal life in terms of behavior and professional life. While it is easy to know the legal boundaries, checking out morality is not so easy. What is moral to one, might as well appear to be immoral to another. So, where do we stand here?

Is advocating Coke consumption immoral or is it tobacco that is bad? What about fried, packaged and canned food? What about environmentally unfriendly business? I can give more, but the line is blur. Yet, people always like to talk, or preach is the right word. Do as what I say, not as what I do, seems to be the cliche. 

I have not been a fan of Coke, and although I have said in the past that I won't buy Coca-Cola stock, I might buy it if the price is right, but not tobacco. When you attach big names to stories, they become more interesting; and that's what is happening at the moment. Wall Street likes to make it interesting. Someone says buying Valeant stock is immoral and some other says buying Coke stock is immoral. I liked the thud of that counter attack. 

I don't think any of these accusations are new stuff though. When it is never easy to draw the line of morality, opinions become personal not pervasive. If image-bashing is what attracts attention, people think so be it, and more. Now, is that moral? 

I don't think Warren Buffett has crossed any legal boundaries; I also find him to be very honest and ethical. His advice on investment management is the best one can take. No one has ever let out secrets of investment as openly as he has, and it is all free of cost. Probably, that's why they are not taken sincerely by people. Perhaps he should have priced his advice appropriately for its value to appear. As a matter of fact, I thoroughly enjoy his mocking Wall Street and the academia. Why not, when they fail to understand the difference between price and value, responsibility towards owners and are obsessed with personal gain? Yet, it does not mean that he is free of faults. He is a businessman and an investor. When he deals with other people's cash, he has the responsibility to maximize their (and his) returns. His actions are always within law, and what he considers to be within morality is up to him.

The accusations have been: He does not advocate use of derivatives, yet, he uses himself. He is an activist investor and uses his connections for profit. He advocates higher taxes, but pays the lowest tax rate. There are more. 

If he knows what he is doing, and his doing profits him, why not use derivatives? He is a businessman looking for profitable projects for his shareholders. His advice has been to avoid doing what you don't understand especially when it involves cash. Derivatives can be so complex that most don't understand the game, yet, play it, whereas, he is smart and plays it to his advantage; is that wrong? 

Activism and connections is a severe charge because it amounts to insider trading, which is illegal. Well, it is not proven as such. So people should be careful about what they talk. This one is ridiculous. If he found opportunities during the financial crisis when irresponsible firms were in trouble, why not profit from their folly? Did these reporters want him to look around and just feel sorry? It does not happen in business. 

He would be a bad businessman if he does not use prevailing tax laws to his advantage. He is in charge of shareholders' money where he has a fiduciary duty to make its best use. Did these characters want him to pay tax at say, 40% when as per rules it was only say, 20%? That math is crazy.

He is human too, and has his own shortcomings. Some may not find him to be the most adorable person due to stories regarding his family relationships. I too might have liked to advice him on a thing or two. We are all entitled to our opinions.

I would like to look at his positive side: He has taught people how they can lead a fulfilling life with lots of fun, and also make money by being honest, ethical and law abiding. Isn't that wonderful? 

His personal story may have been interesting for his biographer and others who enjoyed it, but I don't attach too much importance to it. I admire his simplicity, wit and wisdom. The guy is giving away almost all of his wealth. 

Charlie Munger can be the smartest guy we can find, and he is entitled to his views on morality of Valeant's business model. And so is Bill Ackman on Coke.

It is those storytellers who tend to attract attention with their so-called insights. They probably fail to look at the purpose of a business and decisions that maximize its value. To generate cash flows and growth, managers have to take good projects, finance them well and deal with excess cash appropriately. For personal charity, there is another platform.

precision castparts and berkshire hathaway

No due diligence, no advisors, no fees, no frills. That is how Berkshire Hathaway does acquisitions, and that's how it should be done as well. Of course, the due diligence part can remain a bit distinct. I like, however, the idea of not having any outside professional help; what do they do anyway other than making money for themselves? Berkshire has been an exception in an otherwise sticky framework for acquisitions. With its Chairman & CEO and Vice Chairman, it remains grounded on most of its business decisions. Warren Buffett and Charlie Munger can be as rational as we can expect in a corporate executive or a businessman. It is never that easy, but those men make it simple. Just look into eyes before dealing with people. It can't get better than that. One of the finest run firms in the world of business, Berkshire announced acquisition of Precision Castparts for $37 b including debt in August 2015 at a price of $235 per share in cash. Its has 137.59 m shares outstanding.

Interestingly, when it was announced the stock price of Precision jumped nearly 20%. So is this deal good for shareholders of both Precision and Berkshire? Precision managers consider that their stock is cheap at the price of $222.64, for that's what they paid when they bought back 7.21 m shares during the year that ended in March 2015. Later, they accepted the offer for the entire company at a premium of just over 5%. It appears that Berkshire got the better of Precision shareholders, unless, $222.64 a share was not cheap in terms of its intrinsic value, which then would mean their managers wasted $1.6 b in an expensive buyback. Knowing Berkshire's history, I am not surprised that they got a better deal; note that the price is 21 times its 2015 earnings. Precision's past performance and future prospects should tell us how good the deal is.

Precision's share price was as high as $275.09 in 2015 and as low as $47.08 in 2009. From its high market value of equity of $18 b in 2009, it has come a long way. Its revenues grew by 12.77% annually over the last five years; operating earnings increased by 12.86%, net earnings by 10.67% and earnings per share by 11.19%.

It did not have a particularly good year in 2015 though. $10 b revenues were not enough to show a good performance.

Precision's growth has come mainly through acquisitions. In the last eight years, it spent $9.78 b in acquiring other businesses, and recorded a goodwill of $6.67 b as of March 2015. Its net reinvestment in the business during that period was $13.13 b. Because of this, it never paid large dividends, and its free cash flows are not that robust. Surely, both its managers and Berkshire must consider Precision as more of a growth company. 

Its return on equity (13.44% in 2015) and after-tax return on capital (11.96%) have been declining over the years. This is because its capital efficiency has come down significantly, requiring larger reinvestment for generating revenues. Perhaps, managers and Berkshire must consider that results of reinvestment would show up in the future years. 

Debt of $4.58 b is not too much compared to the market value of its equity, which was mainly raised for the purpose of a large acquisition in 2013. It also has a small amount of lease debt. As in any manufacturing company, a good amount of capital is tied up in working capital requirements. I reckon, there might be some discrepancy between discount rate and expected return assumptions used in its pension liabilities.

If Precision were to grow at 12% annually in the next five years, and then slow down a bit to become a mature business by its eleventh year; if it were to become efficient in capital utilization (i.e. lower reinvestment to bring revenues), say, as it was in 2009; if its return on capital were to reach 20% during its stable growth period; if its operating margins do not deteriorate anytime; then the value of the firm would be a function of expected rate return of the investor. 

As you can see, I have not used conservative assumptions regarding growth rate and reinvestment. Nevertheless, I am not going to argue with Berkshire on its acquisition price. Precision, surely, appears to be a good business to keep for Berkshire. As much as it has grown in size and as much as its free cash available for use, Berkshire cannot continue to buy common stocks from open market and make any meaningful contribution to its value. It has been correctly pursuing an acquisition policy that suits its size and cash flows. 

shareholders or customers

Can someone run a business and become a billionaire snubbing investors? May be the title of the article is incongruous, or may be there is a real snub out there what with 5.80% return on equity.

Whatever that is, Mr. Kazuo Inamori must be a great guy with motives towards welfare of his employees. As per the story in the article, he was able to amass huge wealth focusing on making staff happy, let's call it creating employee value. He must have also created shareholder value in the process; he let Japan Airlines come out of bankruptcy. His lines: If you want eggs, take care of the hen; At times company management has to say no to shareholders' selfish requests. And the response from the shareholders was, we are shareholders and not selfish shareholders. Mr. Inamori apparently acknowledges that the companies do belong to the shareholders, however, he is quick to extend that hundreds or thousands of employees are also involved, and then he says, the hen has to be healthy. 

What I am not clear though is, who is the hen here. I would like to argue that if Mr. Inamori's businesses are any successful in increasing their long term returns, the hen would be shareholders, not employees. Mr. Inamori must have focused on creating shareholder value through the means of making his employees happy. Never mind if there has been some mix-up over who the hen is.

This brings us to think about the purpose of a firm. Although arguments on this topic are unresolved, the favorite choices remain: shareholder value, customer value and society value creation.

Here's my take. Any business, small or big, private or public, listed or unlisted, national or multinational, is started by the owners, with a combination of their own and borrowed capital, in order that they make money out of it. If this was not true, they would not be spending their time, resources and efforts. In an owner-managed business, the owner would both supply capital and operate the business. In a professionally managed business, the owners employ outside managers to operate the business as per their mandate; the managers would get paid for the services and final profits would accrue to the owners. The owners' goal here is not to make anybody but themselves happy, and happy they would be, if only they make money; otherwise they would do something else, not start a business. Of course, they would have to operate their business within legal boundaries set by the regulation and moral boundaries set by the society. If making money for themselves requires anything to be done, they would willingly do it. For instance, if happy employees would make more money for the firm, the owners would like to take good care of their employees; if it requires making customers happy, so be it.

What is important is to know the final objective of a business. The end is to generate cash flows, more the better, and there could be several means - making employees, customers and society happy. Therefore, creating long term value for shareholders is the only objective of a business. 

A business operates as a going concern, usually until perpetuity. It is clear therefore that the shareholders would look for long term profits and value creation rather than short term. It is true for a private business and also for a publicly listed business. For a listed firm, there are many distractions, the biggest one is the capital market. The market would like to grade the firm on a moment to moment basis, and at each quarter it is open to a harsh scrutiny. If managers and shareholders consider this as troublesome, they are not aligned with their thoughts. It really does not matter what happens in the short term, because there are always inefficiencies in that flawed process. What matters is the long term performance of the business. In the final analysis, stock prices follow earnings and cash flows. It is better for the business, managers and shareholders to focus on the long term than think about what would happen in the short term. 

In this respect, there is no need to reinvent the purpose of the firm as this report calls for. The article calls it the age of customer capitalism, as opposed to shareholder capitalism, and supplies a series of confused arguments. It gives example of four firms, Coca-Cola and GE as proponents of shareholder value, and Johnson & Johnson and Procter & Gamble as proponents of customer value. It argues that there is no sign that shareholders benefited more when their interests were put first and foremost.

My intention is not to disagree with the author personally, rather with everyone, who is from that school of thought. The article then goes on to say that to create shareholder value, you should instead aim to maximize customer satisfaction. Our response to that muddling is, who said no? Note that it starts the sentence with to create shareholder value, which means it implicitly accepts that the end is the creation of shareholder value, but fails to put it explicitly.

A CEO should do whatever it takes to ensure enhanced returns for the shareholders. If that takes making customers happy, the CEO should take it as a task.

Consider this: If happy customers do not translate into high return on the invested capital, why would shareholders continue to invest? It is called throwing good money after bad. Capital is not available free of cost. Let's take an example. Imagine that there is a business, which either due to being a monopoly or some other uniqueness has immense pricing power. Let's assume that because of this power, it is able to charge more than what its customers feel fair, and consequently it makes customers somewhat unhappy, and yet is able to make money. Would managers and shareholders think in these lines - this business is too good, makes a lot of money for us, but our customers are unhappy, we cannot see it, let's close the business or charge them less and earn less for ourselves - would they?

The article throws yet another argument: that the only sure way to increase shareholder value is to raise expectations about the future performance of the company. While it acknowledges that there is a behavioral aspect to this in the markets, it fails to bring forth the economic reasoning behind allocation of capital. The manager's role is to ensure that capital supplied by shareholders is suitably allocated to projects that earn more than their cost of capital. This is not an overnight's journey, but a long one. Those who are not tuned to this thinking, whether managers or shareholders, should rather stay away, and look somewhere else. 

I find the article's most flawed argument: Executives come to understand that shareholder value creation and destruction are cyclical, and more important, not under their control. How can we respond to this? If shareholder value creation is not in their hands, in whose hands are they? Why have shareholders picked these managers for? A CEO's job is to maximize the value of the firm, which requires obtaining a right mix of capital, allocating capital in the right projects, and paying out excess cash generated back to shareholders. These decisions are to be taken considering long term economic impact on the business and its value, not based on the dancing notes of speculators and traders. Short term gyrations are best to be ignored; when such alignment exists between executives and shareholders, shareholder value creation is warranted.

Value of a firm is the present value of its future cash flows. Managers can destroy value in several ways with short term tactics, which they often do - take projects that do not earn their cost of capital, pay too much for growth, take on excessive leverage - to manage quarterly earnings and increase immediate stock prices. This does not, however, change the objective of the business. 

Stock-based compensation is another aspect that is misunderstood. Stock options are given basically to align the thoughts of managers with that of shareholders. If managers are shareholder oriented and believe in long term economics of the business, they can buy stocks from open market themselves with their own cash. They need not rely on stock options for that. When we find top managers, who do not keep their stocks for long, it is safe to conclude that they are not shareholder oriented.

The article says that companies should seek to maximize customer satisfaction while ensuring that shareholders earn an acceptable risk-adjusted return on their equity. I would like to ask, what if companies are able to give an acceptable return on equity to shareholders despite making their customers slightly unhappy?

The article then promptly highlights Johnson & Johnson's credo, which according to it, gives shareholders last priority compared to the doctors, nurses, patients, customers, employees and communities. As I read the last sentence of the credo which states that when we operate according to these principles, the stockholders should realize a fair return, I find that again the primary goal appears to be shareholder value, if it was not, J&J would price its products at cost or below so that customers and society were happy. Whether CEO James Burke's recall of every Tylenol capsules across America, or more recent recall of Volkswagen vehicles across the world or recall of Maggi noodles across India, yes, it is about doing the right thing, but not for customers, it is for shareholders. If not, the long term brand image would be hit severely impacting long term profits; in such situations, it is better to take lower profits or even losses in the short term. This is again a shareholder oriented policy, not customer oriented.

The article mistakenly thinks that companies such as J&J and P&G are customer focused rather than shareholder focused, and therefore they are able to deliver impressive returns to shareholders. It is a flawed thinking. At the cost of repetition, I note that if maximizing shareholder returns requires customer satisfaction, the CEO should work towards it. However, it is a mistake to assume that customer satisfaction is the primary focus and shareholder profits are incidental.

A good CEO is one who understands shareholder value well enough, and runs the business accordingly. This involves taking investing, financing and dividend decisions in the best interests of shareholders. It is not about increasing stock prices in the short term, thus making way for managers and traders. It is about increasing long term economic value of the firm, which when done increases the stock price eventually. Investing in stocks, as opposed to playing in the derivatives, is not a zero-sum game. Here, the stockholders are rewarded for supplying capital to a well run business. This business, operating under free market environment, will be doomed in the long run if it continues with the policy of ill treating employees or charging excessively to its customers. The competition will ensure destruction of its image, business and eventually, value. The decisions taken here are business decisions which are shareholder oriented.

In conclusion, while creating shareholder value is the single objective of a business, creating employee, customer and society satisfaction is only a means to that end. If the primary goal is creating value to customers and society, the capital providers should look towards charity, not business profits. They are noble thoughts, but not ethos of business.  

apple in a decade

Shareholders' pride, neighbors' envy
Apple's market cap is $ $676 b now. It peaked at $750 b in 2015. The returns given by the stock are phenomenal by any standards. 

As we can see, even if we had purchased the stock at the high price in any prior year, our investment return would have been more than satisfactory. For instance, if we had picked it in 2005 at its high price for that year, the annual return would be 31.29%; that is our investment growing by 15 times. At 2010 high price, it would be 20.25%. We would not make much if it was bought in 2012 and 2013. 

If someone was a superb market timer and was able to buy the stock at the low price in any prior year, the story would be extraordinary. 

The entire company was available at $15 b in 2005; but, who would have turned it into $676 b by now? Not any of us. As near as last year, Apple was available at $397 b and that is a 70% upside now.

As they say, we don't need many stock ideas in our life time to become rich. Yet, not many would have the foresight, wisdom and belief in management. It looks like everything has turned out well for Apple so far; this is despite our asking the right question: for how long this magic is going to continue? Is many shall fall that are now in honor going to be true for Apple ever? May be it will one day. In the meantime, it is not inappropriate to ask, what makes Apple as a business so special?

The story that has been
Apple's revenues increased by 27.86% to $233.71 b, operating earnings by 35.67% to $71.23 b, and its earnings per share increased by 42% in 2015. This EPS is slightly different from the one reported because I have not used the weighted average number of shares outstanding.

What I find striking is that Apple has been generating cash year after year. My unsolicited advice to Apple in October 2014 for effective use of its cash went, not surprisingly, unnoticed; my consolation is that I usually write for myself, not for others. 

If the story continues the way it has been, Apple is going to outgrow and it will always be in honor. That kind of perpetual model has not been witnessed in the history of business. So it is appropriate to consider that one day Apple will face the reality and slow down. But, when will that be?

In the last ten years, Apple generated free cash flows of $235 b, significantly through its own capital. It has started raising debt only recently. It spent $59 b on capital expenditure, including acquisitions. Yet, its net cash spend was only $9 b in the last ten years. This was possible primarily due to savings from working capital and depreciation. I look at the story like this: $235 b of cash was generated with the help of $9 b reinvestment. Granted, Apple also spent $30 b in research and development; I am not sure whether innovation in iPhones, iPads or Macs in the recent years reflect that. It is not surprising that Apple has been operating with negative capital in its business. Its current cash hoard is $205 b, of which a significant part is trapped outside of US and is liable for additional taxation. Still, free cash net of tax liability is massive.

Valuation
To value Apple, we need to estimate how much it would need to reinvest in the business to achieve the expected growth rate. We know that growth is not free. However, as evident from its past, Apple has been growing without much help from reinvestment. How do we estimate reinvestment? We could use the industry standards; but, Apple has been defying it all the time. We cannot assume past reinvestment rate either, which is ridiculously amazing. 

If we assume that Apple's free cash flows are going to grow at the rate of growth in the US economy forever and use the expected rate of return considering our opportunity cost, we should be able to get a value. Two problems though: We are not sure whether even this low perpetual growth rate will be valid for Apple, because at some stage it will have to put in capital for reinvestment. It cannot continue squeezing its suppliers forever. Again, our opportunity costs differ. We could also calculate its cost of capital, but I am not interested. This is because I am more interested in how much I can make than how much Apple is actually worth.

I also used my estimates of growth and reinvestment in the next decade and made Apple a stable firm thereafter. I know my estimates are going to be wrong.

The questions to ask are: How much Apple is going to grow in the future? How much capital it is going to require to be able to show that growth? When will it stop growing and start behaving like a normal, stable firm? What is our opportunity cost at the moment? What alternatives do we have to invest our capital - treasuries, bank rates, money markets, bonds, equity market rates - how about Apple stock? Will Apple managers ever mess up?

Is there anyone who can take on iPhone? Will Macs continue their fancy? Will iPads follow the PC markets? Is there any product - it can't be watch or TV - in pipeline for Apple to hold its fort? Tough questions, which only time will be able to answer.

I come back again to that unsolicited advice. 

strategic buzzwords

Earlier it was China, quantitative easing and demand for commodities, which made firms, analysts and every other to justify their actions, whatever that might be, acquisitions or high valuations. 

Now it is the same, but in the opposite direction. It is China slowing down, low commodity prices, and the Fed quitting the easing. I wonder how some things just don't change. While there are still acquisitions happening around the world, the cues are about slowing down. 

What I have seen and remain confident about is that economists never concur on anything. You put several of them in a room and they will diverge in their opinions. Again, it is evident from history that any economy moves in cycles; we witness growth and recessions all the time, one after the other. 

My take is that no federal policy would be able to permanently change the path of a cycle. We might want to attribute the change to the government, but it is more due to the spirited free markets that eventually push for the change. This is because in a democracy and free markets economy, the government's role is limited, and should be limited, only to put the system in place and oversee as a regulator, and not meddle much. 

As the economy, including the government, is made up of humans, what drives it is the change in the behavior of the individuals. We know that they are not rational beings; therefore at any point in time, the economy reflects their moods. Higher value is driven by meaningful growth, which is reflected by increase in future cash flows, and cash flows are generated through investments. When they are optimistic about future, good investments are made, projects are executed well, and there is growth. Opposite is true when people become depressed and consequently, reluctant to invest in projects. 

Just like firms, investing, financing and dividend decisions of the country are dependent upon the behavior of the people. It is up to the government, as a manager, to take these decisions in the best interests of the stakeholders; probably the key function of the government is to lift the mood. I don't know why China is slowing down now when it was growing in earlier years. May be people are scared of its past financing decisions, or may be something else. I don't know why commodity prices are low now. Isn't it all good for the firms to buy them cheap to use in their production, and drive growth? Quantitative easing has been the savior for the US economy, but how much credit is due to it is something we need to ponder. If it was not there, what would have happened? Would markets have remained on the brink until now? I don't have an answer to any hypothetical question. Of course, sometimes things don't really work out for a long time just like it is the case for Japan, where they are clueless about what should be the way forward. I find that ironic.

Mostly, though, we are responsible for our own actions. If we remain positive collectively, work hard enough towards what we want, use only reasonable, not excessive, debt and execute our tasks well enough, we should be able to move forward. If that sounds Utopian even for a capitalistic economy, my advocacy is to hope for this during longer cycles. Wait, hasn't this been happening already? We have had more positive years than negative years in the past as long as we can go back. From stone age to here, we have moved far enough. That is going to continue long enough into the future. I see this as the bright side.

that fascination for gold

Indians buy a lot of gold is actually an understatement. They not only do it in truck loads, but also take immense pride in it. I am yet to find a reasonable answer to why would they buy 1000 tons annually spending $35 b. In Rupee terms, at a price of Rs.26,987 per 10 grams, the cost is Rs.2,698.70 b. That's the Indian enigma. 

For them, the opportunity cost of cash, stuck in this bad investment, is hard to contemplate. Yet, this cost appears to be much lower today because the prices have fallen in the last 5 years. 

The stream of cash flows, both in magnitude and consistency, they could have received in return from the investment made in any other (cash-flow generating) asset would have been impressive. It would have made them richer, and continued to do so. 

I have already mentioned how bad gold is as an investment earlier, and need not repeat it again. Nevertheless, it does not stop me from musing about it. 

value or growth

There is never a single approach to make money; this is granted. Each should embrace one that suits the temperament. Yet, there is only one way we can make money: buy low and sell high. Of course, we can sell first and buy later; however, the essence is the same. 

In investing, two types of approaches are well talked about. One is value investing, and the other is growth investing. Each camp is eager to take on the other. And boy, aren't those value investors too proud of their pedigree? 

I am going to keep a detailed post for some other time. At the moment, let's just highlight what the world thinks of these two approaches. Value investing is construed to be picking securities at low prices such as low price-earnings, low price-book values, high dividend yields. The key for value investors is bargain prices; they like to call it statistical bargains. Whereas growth investing is taken to be investing in stocks that have higher than normal growth rates. The key for growth investors is the growth rate, not price. 

I am not in either camp. It is better to be an investor than a value or growth investor. If investing is all about buying securities that are priced lower than value, that's all we need to think about. 

If what is given away is higher than what is received, it is not a business-like transaction. There are other places where such actions are applauded. That person will be well served if charity work is taken up; even here one can feel what is given away is lower than what is received; the pleasure of giving is beyond any pricing. 

In business and investing, profits are made by buying low and selling high. The focus therefore should be on the present value of cash flows and price paid. Four things are of importance here: There should be mispricing, which should be identified and then taken advantage of, and finally, the markets should correct that mispricing. 

In investing, the predominant factor is the mispricing of securities, not the type of securities or the period of holding. For an exceptional business, the longer the holding period, the higher the returns. For a low quality business, it is preferable to close out the transaction as soon as mispricing is eliminated by the market. When low risk arbitrage opportunities are available, the transaction period can be much shorter. 

All investing is value investing, for what is investing without value? Similarly, it isn't investing, if price paid for growth is higher than value of growth. It is a mistake to separate the two. And we know that if it is not an investment, it is actually a speculation. Heck!

m and a lessons

Firms can grow in two ways: By reinvesting their earnings back into the business. By using their excess cash or issuing stock to acquire other firms. Both represent reinvestment without which there is no growth.

Usually, firms start with organic growth. It is only when growth in their core business dries up, they look for other ways to grow. There is nothing wrong with the strategy, except that very few firms are good at identifying right targets at right prices. 

When managers stop getting projects that earn excess returns, it is wise is to accept the reality that the firm has matured and behave like one. Here, cash flows are more predictable, debt is more affordable, and dividends and stock buybacks are more value accruing for owners. Investing, financing and dividend decisions are less complicated. For a good business, continuing as a going concern, albeit at lower growth, works best. For a bad business, well, slow decline or liquidation is the preferred route.

There is a problem, though. It is not common for managers to exhibit common sense. As if to prove that common sense is so uncommon, they refuse to accept the reality. This leads them to do one of the two things.

They continue to believe that their business is always capable of earning returns that are acceptable. Attributing below par earnings to a temporary setback, they continue to pour cash into the business. Nothing is worse than dissipating cash, which rightfully belongs to the owners. This will only lead to the eventual value destruction of the business and consequently, poor returns for the stockholders.

If they realize that pouring cash back into the business is not a wise idea, they continue to believe that there are other ways to grow. They trust their hubris more than their capital allocation skills. The result is acquisitions. Most of the mergers and acquisitions around the world start with this framework. Firms need to grow; the bigger they grow, the faster they grow, the higher they are valued. It really doesn't matter whether just physical growth is good enough for the business and its owners. 

The rationale is the standard M & A lingo: Control and Synergy. Firms can be run better and the combined firm is always more valuable than sum total of the individual firms. In addition, operating, financial and tax synergies are quantified. Lo and behold, the firm with no growth becomes bigger and superior. There is more fun when stocks are issued instead of cash. Magically, growth is created without even using cash. 

What is lost somewhere is the fact that all growth does not add up. They are not created equal. There is a cost to the capital used. Again, it goes down to the basics. A business that lacks durable economic advantages is not worth buying, except as a bargain. A business that is unrelated to the core business of the acquirer is difficult to operate since there is lack of experience. In all acquisitions, the key question to ask is whether value of the business is far more than the price paid. Unfortunately, many acquisitions fail in all three counts: an unrelated business that is lacking durable excess returns acquired at an exorbitant price. Often, managers do not hesitate to use high leverage in buyouts. Even corporate cultures hinder otherwise workable mergers.

One justification offered in buying an unrelated business is diversification. A better idea is to let investors use their own cash in dealing with that issue. Owners give cash to the managers to invest in core business. Managers should rather stick to that instruction.

In fact, acquiring a business is no different from investing in stocks. All that matters is a good business bought at a reasonable price. 

What managers learn from history is that they don't learn from history. There is always more action in a vibrant market. While there are many acquisitions that have made sense, many more have not. Cisco did phenomenally well by inorganic growth in the past. HP did not.

The latest one playing the game is Anheuser-Busch InBev and SAB Miller. When price is at a 50% premium to the market value, and when we aren't even sure whether market value is lower than its intrinsic value, we realize the blame is on some one.

It is not that acquisitions are bad, it is only when asking price is way higher than the present value of cash flows that is available in return.

When price is high, no action should be the action. Like someone rightly said, all trouble starts when people are unable to sit quietly at a place.

indigo ipo

InterGlobe Aviation Limited is seeking to raise capital and accordingly, is filing its IPO in October 2015. There will be a fresh issue totaling Rs.12.722 b and an offer for sale of 26.112 m shares from the selling shareholders. Currently, there are 343.716 m shares issued and outstanding.

The promoters

The board

Managers

The objective of the issue
The objective of the fresh issue is explicit, while that of the offer for sale is implicit.

The story

InterGlobe Aviation operates IndiGo, India’s largest passenger airline, with a 37.4% market share of domestic passenger volume. IndiGo operates on a low-cost carrier (LCC) business model and focuses primarily on the domestic Indian air travel market. It primarily aims to maintain its cost advantage and a high frequency of flights - low fares, on-time flights and a hassle-free experience to passengers. IndiGo started operations in August 2006 with a single aircraft, and currently has a fleet of 97 aircraft all of which are Airbus A320. 

IndiGo claims that its market share has increased to 33.9% in terms of passenger volume. It has the largest market share in terms of top 10  metro-to-metro, metro-to-non-metro and non-metro-to-non-metro routes. Its maintenance costs are the lowest among Indian airlines. Its fuel costs are also among the lowest. IndiGo is the only airline that has been consistently profitable over the past seven years. Its order book currently is the largest with 430 aircraft. Average age of its current fleet is only 3.7 years. IndiGo's EBITDAR margins are the highest at 19.8%.

Extract from the prospectus:

One reason for IndiGo to remain profitable is that it uses only one type of aircraft (Airbus A320) with a single type of airframe and engine, which reduces its operating, maintenance and crew training costs; it also facilitates fuel efficiency.

IndiGo is strictly a no-frills product airline: It offers a single class of economy service, which allows for the maximum seating capacity of 180 seats. Unlike most full-service carriers, it does not offer a frequent flyer program, free lounges or include food and beverages in its ticket price for non-corporate passengers.  

Revenues increased from Rs.38 b in 2011 to Rs.139 b in 2015.

So far, it's been consistently profitable:

As of 30 June 2015, IndiGo had long term debt of Rs.35 b mainly aircraft related, and cash of Rs.22 b. There wasn't any short term debt. However, it remains to be seen how non-cancellable operating leases have been dealt with in the books. Any such commitment is a form of debt. 

The airline has been generating free cash flows:

Just that those dividend payouts appear to be special and intentionally managed.

Who are going to make money

There are others who too get to make money

What can go wrong

While the majority is gung-ho about this IPO party, it is worth knowing the risks highlighted in its Red Herring Prospectus. 

There are several legal cases pending against the company amounting to at least Rs.9,642 m. Of course, the final outcome depends upon the probability of ruling. The present value of the probable amounts will affect its value. 

The prospectus rightly notes that airline business is a low margin and high operating leverage business. Especially, aircraft lease and acquisition costs and engineering and maintenance costs cannot be postponed. The industry is laden with intense price competition. 

Aircraft fuel costs represent the single most significant cost item for an airline accounting for almost half of its total operating costs. Fuel costs vary in terms of fluctuations both in the international oil prices and in the US dollars exchange rates. For an airline, the ability to pass on increases in fuel costs to the customers is limited. Whether is worthwhile to hedge oil prices risks is open to debate.

IndiGo has plans to expand its current routes and also to other tier II and III cities in India, and later to look for expansion of routes in South East Asia, South Asia and the Middle East. How far it will be able to replicate its LCC model is the moot question. 

It has agreed to purchase a total of 430 Airbus aircraft under its 2011 and 2015 purchase agreements. This right is generally assigned to a third party lessor, and the company takes delivery of the aircraft under a sale-and-lease-back agreement. If the business faces adverse conditions or if the lessor defaults, the financing of aircraft would be in trouble. This will have the biggest impact on its ability to continue as a going concern. 

Extract from the prospectus:

The company is making some interesting statements about transactions with its related parties. Check out the risk factors # 4 in the prospectus. It is almost hinting that these transactions were not on an arm's length basis and might have adverse effect on its cash flows. 

The aircraft leasing and financing arrangements have restrictive covenants, breach of which might adversely affect its survival.

The company has acknowledged that there are lapses in its internal controls, and the auditors have qualified on the delay in dealing with certain statutory dues. This also speaks about the quality of management.

IndiGo has also acknowledged that it is seeking an implied valuation for its equity in excess of the international LCCs such as Air Asia, Cebu Pacific, Ryanair, Southwest Airlines, Spirit Airlines and Wizz Air. Higher issue price will adversely impact the return on investment for the IPO subscribers.

The company has been subjected to an ongoing investigation regarding competition and cartelization. 

The managers have intentionally turned book value of equity to negative by paying out special dividends to the existing shareholders. This speaks about the intention of both managers and selling shareholders.

While revenues are mostly earned in Rupees, a significant portion of costs including leasing and financing, engineering and maintenance and aircraft fuel are incurred in US dollars. There is a clear mismatch between the cash flows, which is rather difficult to fix unless the company uses derivatives to hedge its foreign currency exposure.

There is a likely dilution in equity due to 1,111,819 shares granted through employee stock options at an exercise price of Rs.10 per option. In addition, 578,746 options are proposed to be granted at an exercise price of Rs.10 per option, and 2,528,928 options are proposed to be granted at an exercise price per option equal to the issue price.

We can get to know more of the risks (there are 68 in number) highlighted in the prospectus. Check them out. 

IPOs are diced against investors

In addition to these, there are some obvious risks for investors in any IPO. Here are a few sellers who know more about the business selling shares to a large number of buyers who know much less (or mostly nothing at all) about the business, and these sellers have the option to choose the time to sell the shares to buyers having no such option and at a price implicitly chosen buy the sellers. 

What do we expect? Unless the sellers are dumb, they would choose a rising market and price the shares so that the collections are the highest. IPO is indeed a very good mechanism for promoters to get rich quickly. The dice is rolled against the investors; so it is always the buyers beware. There is no point in blaming the sellers. It is never a fair game. 

The kind of profits that are going to be made by the promoters can be noted from this:

The basis for issue price

For sellers, the determination of issue price is easy for obvious reasons, nevertheless it is noted in the prospectus in a manner that is to be noted. However, it will do well for investors to know that due to fresh issue of shares and through employee stock options, there will be dilution in both earnings per share and return on equity in the coming years.

It looks like IndiGo is better managed compared to any other airlines in India.

Extract from the prospectus:

I don't really like EBITDA as it is dangerous to assume that capex requirements are offset by depreciation and amortization.

Here's EBITDAR for airlines extracted from the prospectus:

No wonder then that IndiGo is seeking higher valuation compared to its peers. 

To be or not to be 

That is the question. I am not considering this IPO for two reasons: Airline is inherently a bad business. I am as biased as one can be towards an IPO, that is any IPO. I like to play the game my way.

You have your prerogative too. You can ask whether IndiGo is worth Rs.32 b.

when capital was free

The team was evaluating an acquisition for a large holding company. It was full of qualified professionals, CFAs, MBAs, lawyers, engineers and analysts; and certain areas such as market research were outsourced. In addition, there were top bankers as investment advisors, and two of the big four accounting firms carrying out financial and tax due diligence. In effect, you could not have asked for a better qualified analyst team.

The holding company (let's call it a private business, although it wasn't) was the investment vehicle for its owners. The capital, all equity, was supplied by the owners. The company was never short of capital as the managers asked and owners gave. The quarterly reporting was filled with colored graphs, charts and presentations, but devoid of any meaningful analysis and action. Nevertheless, it did not matter because such were the owners; may be it was in spite of the owners. Equity was treated virtually free of cost. No wonder then that performance of historical investments, spread across the globe, was not adequate considering the opportunity costs. None cared; whatever was earned on the costless capital was more than adequate. 

The target company was in the commodities business and was exposed to cyclical overtones. The historical performance was very good, and it was majority-owned by private investors. 

The sellers were more pronounced on two matters: Their asking price was fixed and not available for any negotiations. Furthermore, certain key information that mattered was not to be disclosed until the deal was signed. The double whammy was also conspicuous in its absence in the buyers' den. It wasn't laughable; remember, all capital was free. 

As I was discussing with an analyst in the team about how the valuation of the target was going to be done, his reply was obviously based on the discounted cash flows. When I asked what if the value came very different from the seller's price, the reply was that the team did not care about the seller's price and would ensure that their bid would prevail, and the buyers would be able to get a high return on capital. All I did was smile softly from outside and laugh loudly from inside.

The analysts and investment advisors took cash flows and growth rates, obviously supplied by the sellers, that were not only aggressive but also questionable. They were plotted on a complex model and presto, the value was exactly equal to the asking price. Wasn't that magical? Of course, there were meetings with the sellers, and lots of it, to discuss, question, demand and negotiate. Yet, the result was more predictable than any other.

In that paradox, the buyers spent a lot of time, resources and money, and then botched in the name of thorough analysis. They compromised the first principles of investment all through. It appeared that they did not understand the business, for they would not have accepted unrealistic cash flows. They went carelessly and desperately after the business that did not have any durable competitive advantages. It was prone to economic cycles. They did not have a clue about the intention of the incumbent managers, although, it was agreed that they would continue office after the take over on terms that were not in the best interests of the buyers. Finally, the price that was paid was quite incompatible with the value of the business.

What the owners got in the end was a commodity, cyclical business that had no competitive advantages, with debt disproportionate to the size of equity, and price that was outsized.

The epilogue was that cash flows did not meet the projections and goodwill was fully written off. So what, for the owners, this was only one more addition to the existing deteriorated investment portfolio of the holding company. After all, the managers and owners were consistent in their behavior, except that this particular acquisition was a bit heavy on their pocket book.