what do you want - linear or non-linear

This is what we saw over the weekend:

And we will see what will happen to S&P 500 today when the markets open.

This is what we are seeing now:

Investors are fearful about prospects in China.

And they are fearful about India too:

As we see both Sensex and Nifty are down over 5%, and individual stocks are hit more severely. 

The reasons reported include Oil prices, China slowdown, FII sell off, Fed actions and more. The biggest price-setters in the markets are the institutions, who are driven by the institutional imperative. Their life is measured in quarters; for them long term is a quarter; and they usually trade more often. It is natural for them to pull off if they sense any danger in the near term. 

What are investors to see in the current markets? There is never a linear movement in equity markets anywhere. They fall, they rise, they fall steeper, and they rise much higher; and over a long period, markets always move upwards. We can check it with the historical numbers. 

If equities are going to give returns much above inflation rates over long term, the compounded gains are going to be more than satisfactory. If we accept this argument, a logical action during market pessimism is the investor's optimism. Higher purchasing power during market downturns makes it easier for the investor to load up on quality stocks at bargain prices. I am not saying that a 5-10% correction from current levels would give us bargain stocks. At least it is going to make our research easier. 

Therefore, instead of following the herd and becoming fearful, it is wise to look at the long term economics of the businesses behind stocks, and then make a call on investment. 

If we ever want a linear return on our investments, we should be looking at bank deposits, and may be any fixed currency instruments held until maturity. Heck, this will not assure us of beating inflation rates and increasing our purchasing power. Equity investments are more likely to give us non-linear yet adequate returns over the long term. Think about it.

loans, dividends and dilutions at banks

Here's an interesting read regarding Indian banks. Indian public sector banks have been troubled by both bad management and government restrictions. Whereas, private sector banks are troubled by only bad management. Well, that can be a harsh statement. Let's read that to mean that when these banks are in trouble, we know whom to blame. 

Banking is not an easy business. A well run bank is one which lends prudently ensuring return of capital and adequate interest margin. If this is done on a consistent basis, banking can be a good investment. Unfortunately, we wouldn't know which bank is run prudently, until the tides go away. 

For banks, leverage is the way of doing business where debt-equity ratio is far too high. It seems natural because equity capital is not adequate to carryout lending operations. They have to borrow from depositors and bond-buyers in order for them to increase their asset size. As the asset size goes up, their operating income goes up. When net interest margins are good, return on assets increases, and because of outsized debt-equity, return on equity and earnings per share increase much higher. Therefore, managers aim to increase their loan book as much as possible. That is growth for them.

The story is good. But the problem is, not all banks are well run. If lending is not done prudently, the result is bad loans. However much they try to hide by either not disclosing or not disclosing fully, there will be the day of reckoning. The real bad news is when loans have to be written off. The effect is very harsh on equity; loan write offs can erode equity; in fact, because of low equity base, even a small portion of assets turning bad is enough to wipeout equity.

The second problem with banks, public sector banks in particular, is that they are considered as good dividend payers. We can argue that when equity is low, and bad loans are high, it may not be a good idea for banks to payout dividends. It is a simple idea: If there aren't any free cash flows, there are no dividends. Obviously, managers are aware of the fact that capital markets consider dividends as some sort of signals. When dividends are skipped or reduced, there is reaction to the stock price. Therefore, they continue with the mistake of paying out, or even increasing dividends.

The third problem which of course is a consequence of the first two is raising of equity capital through preferential buyers, or in case of public sector banks, through government capital infusion. Here's the irony: Chasing growth, managers raise more debt; bad loans reduce equity which is already low; and dividends are paid out when there are no free cash flows which bring equity even lower. The result is a very low equity capital base, and the need for capital infusion. The dilution in earnings per share is apparent. This is the-never-ending vicious cycle for banks.

The lessons: Managers should learn that higher coupons cannot make up for a bad loan. It is also obvious that the borrower should have demonstrated capacity to generate both adequate and consistent cash flows to cover both interest coupons and loan capital. For those that lack cash flows, equity financing is the only route. That is why, firms that are in start-up stage or even high-growth stage deserve only low-to-moderate debt-equity ratio. As firms become mature, their cash flows increase and become more predictable; and then they can take on higher debt.

The sooner managers and governments realize this, the better it is for the economy and the investors: If banks operate with a little prudence, and with an internally regulated maximum debt-equity ratio, there is no need to be worried about regulatory capital requirements of the Basel Committee. For banks, growth has to come with a cost; and that is higher reinvestment of cash back into equity in order to sustain the set debt-equity ratio. If there is no free cash, pass dividends.

Managers have never learnt lessons from the past, and the chances are they never will. All we can do as investors is be careful when investing in banks.

There is some consolation, though, in case of Indian banks; they have not indulged in destructive derivative instruments so far. 

marico's 5-pointers

Note this: Rs.100 invested in Marico at the time of its IPO in April 1996 would have turned Rs.9,314 by March 2015. Marico claims that it is a market leader in 90% of its current portfolio of products. Its operating margins have steadily improved during the last decade. Return on capital is impressive, and Marico does not carry much debt. Of course, it has been one amazing story of growth. It has expanded both organically, and through acquisitions. 

Revenues grew over 18% since 2005, and earnings per share over 22%. Equity dilution, if there was any, does not seem like it was there. Significant portion of growth has been due to the pricing power, rather than volume-driven growth. Marico's aggregate free cash flows to firm from 2005-2015 is Rs.1.43 b. Excess returns are clearly visible. But then again, we have to ask whether Marico will be able to stretch its competitive advantages period for long. The longer it stretches, the longer it will take to become a mature firm. 

So, what's in there now? The chairman gives 5-pointers: Innovation, Go-to-market (for higher penetration) Transformation, Value Management, Talent Value Proposition and IT & Analytics. The company has the medium term volume growth target of 8-10% which is of course much higher than the recent past. It expects overall growth to be approximately 15% in the medium term.

Outside of India, Marico has a significant presence in Bangladesh, South East Asia (Vietnam, Myanmar), the Middle East, Egypt and South Africa; and a revenue share of about 22%. Bangladesh is the single largest market for Marico outside of India with 45% (international) revenues. It is surprising to note that although 18% of international revenues come from the Middle East and Africa, the business has still not achieved profitability; the managers say, it will come. In India, revenues from the rural areas account for 33%.

As reported by the managers: Parachute is a Rs.15 b revenues brand now. Parachute and Nihar jointly have a market share of 57%. In the premium refined edible oil segment, Saffola has a market share of 58%; and in the Oats segment, Saffola has a market share of over 20%. Set Wet gels and Livon serums have been growing.

The CEO has received 346,600 stock options at an exercise price Rs.1 per option which have vesting period of 2 years. At the current price it amounts to Rs.147.30 m. The company also operates stock appreciation rights scheme for eligible employees which has 1.99 m grants outstanding with the grant price of Rs.208.96. The information in the annual report lacks details regarding how they are converted into shares issued to employees, if they do, etc. It is also not clear whether there will be any dilution in equity in the coming years because there is also a mention of employees getting cash representing difference between maturity price and grant price. Nothing is mentioned about maturity details. May be there is no dilution here as it is mentioned that a trust is formed for operating this scheme which will purchase shares through funds advanced by Marico, and then at the maturity date it will sell those shares and give the proceeds back to Marico. Nevertheless, the managers could have been a little more clear about the scheme.

None of the independent directors hold any shares in the company. As it is in other companies, key management personnel are happy increasing their holding only through stock options granted to them, and will probably look at market optimism while offloading them.

That's the story so far; how about the value of the business? I usually look at free cash flows to firm for estimating value. As noted, these have been phenomenal in the past. I have tried to estimate future cash flows based on revenues, margins, and reinvestment during high-growth period, and then cash flows based on the characteristics of a stable business. As usual, I arrive at a value that is far lower than the market price.

The current market price is at historical high levels, and I have no intention of buying the market's assumptions in pricing the equity.

dabur's $8 b portfolio

Dabur is worth $8 b. It is currently trading at about 49 times its earnings. In 2005 it was available at $0.50 b, or may be less than that. That's the magic of compounding, and wealth creation. It has been consistently earning high rates of return on its invested capital, sustaining its operating margins, and using very low debt. 

It has pretty solid brands, which have helped Dabur earn those excess returns. 

Vatika, Amla and Real brands crossed Rs.10 b in revenues. As reported by the managers, investment in brands, distribution network, new products and consumer connect activities continued building momentum for future growth. Dabur plans to expand its rural connection to over 60,000 high potential villages in the next 2-3 years. Managers point out that according to the World Economic Outlook update prepared by IMF, India is set to become the world's fastest growing major economy ahead of China in the next couple of years. Inflation is expected to come down, and India is expected to grow at a much higher rate in the coming years.

It is surprising, though, that none of the non-executive directors, other than the Chairman (of course by virtue of being a promoter director), hold any shares in Dabur.

Dabur's geographical distribution of revenues (March 2015) is impressive:

Consumer Care is FMCG business in India.

All brands are well known in the market and are doing good business. 

Dabur Health Care includes: Chyawanprash, Honey and Glucose. 

Dabur Digestives include Hajmola and Pudin Hara.

Dabur OTC and Ayurvedic Ethicals include Dabur Lal Tail, Honitus, Janma Ghunti, Dashmularishta, and Ashokarishta.

Dabur's Oral Care business is growing, and includes Dabur Red toothpaste (crossed Rs.3 b revenues), Meswak toothpaste, Babool toothpaste and Dabur Lal Dant Manjan powder.

Under Dabur Hair Care, Vatika and Amla are the strongest brands. 

Dabur Skin Care includes Fem (for fairness bleaches and hair removing creams), Oxylife (bleaches and facial kits) and Gulabari (for rose-based skin care).

Dabur Home Care includes Air Freshners, Mosquito Repellents and Toilet Cleaners. 

Under Food products, Dabur claims to be a dominant player with the brand Real.

Dabur's International Business is dominant in the Middle East and Africa.

It has manufacturing facilities in the UAE, Egypt, Nigeria, Turkey, Tunisia, Nepal, Bangladesh and Sri Lanka.

We are aware that Dabur has generated value for its shareholders. The question is whether it will continue to do so in future. Value is about future cash flows, and these depend upon excess returns, which are driven by the competitive advantages of the business. We can argue that Dabur has the capacity to earn return on capital in excess of its cost of capital. It is a high quality business.

However, can it deliver profits to the new shareholders? Would an investor be able to earn returns higher than market returns from Dabur at its current prices?

You could have bought Dabur between 11x and 52x in the past. Even when you bought at 52.62x in 2011, you could earn 14% annual return by 2015. Not bad. But then, can we replicate that by buying at 49x now? You tell me.

Based on its revenues, operating margins, tax rate, return on capital, growth rate, and reinvestment needs, my DCF valuation got the value of Dabur's equity much lower than its current price. So what do we do?

Simple, play the waiting game.