ideas to have fun, make money

The Indian stock market ended 2016 at 8185.80, which is just 3% ahead of last year.  

The returns from stock markets are not linear. You cannot expect fixed stream of cash flows from equity; for that you have to go to bonds. Alas, returns from bonds are almost always lower than equities. And in present times, man, it is going to be just equities, if your aim is to make money. 

What amazes me is that people expect stock market returns to be always, always positive. That shows lack of knowledge about what really equities are. 

When you start a business, you are ready to wait for years to make it worthwhile for you. You are aware that some years will be good, and some will be not as good. Yet, you expect the business to be viable in the longer run. When you are a businessman, like many that I know, you are also a highly concentrated investor; that is, most of your wealth is tied to your business. It is because you know that you are making a career out of your business, and want to stay that way for a long, long time. That is great. 

But then, why do you see your stock market investments any differently? When you buy a share in the stock of, say, Nestle, why do you expect it to increase in value every day, week, month, quarter and year? Do you think the value of Nestle as a business should change significantly by the day? Just like your private business, Nestle is also in a business, which is going to be good some years, and not as good in some. This is the crux of investing. The earlier you get it, the wealthier you get in life. 

People who invest in properties do not check price quotes on a daily basis, do they? They are crazy, if they do. There aren't quotes anyway, unless a transaction takes place. Just because there are quotes for your stocks, you are tempted to check. That's crazy too.

The resolution for the coming year is about taming your wild behavior. Stock investing is as much about human emotions as it is about intelligence. If you are not dumb, and are in control of your emotions, you are more likely to be a winner in this game. 

I have four ideas to share which are just enough make someone have fun, and make money at the same time. Don't forget to enjoy life. 

Hate those guys; the crooks

Stop listening to the pundits. Oh yes, stop listening to all those self-proclaimed value investors who write blogs, make up stories, quote Buffett and Munger, and then charge you for their offerings. They quote some philosophers as well just to spice it up. Know that they cannot teach you anything about stock market investing. If they knew, they would have invested for themselves and made money. There would be no need to charge you for their products. I know some of them who also invest in mutual funds; which means they give their money to others to manage. How ironic for someone who claims having knowledge to teach people about equity investing to trust someone else to manage money? It is because they have to pay their bills, they have the need to coin stories to tempt the gullible. Don't get swayed by their morally corrupt thoughts.

Don't care market prices investing

Invest in equities on a periodic basis. The best way is to invest in a broader index in good times and bad. Buying the index each month either in fixed units or fixed currency is good. Here you are not bothered about market prices because the prices average out in your favor in the long run. 

Market prices are the key investing

Then wait for the right opportunity to invest in individual securities. If you think that Nestle is a good business, you analyze the business and come up with a value. You buy the stock only when price is much lower than value. Here you do care about market prices. Your returns are directly proportional to the price that you pay. 

Caution: You cannot play this game if you are not interested in equity analysis or simply have no time. Then you are much better off investing in the index itself. You are guaranteed to earn returns equivalent to the market returns. You would be crazy again if you consider that is not enough. Equities outplay all other investment alternatives if played long enough. 

Control

The promise you have to make is to have a check on yourself, always. Control your emotions: greed, fear and envy. You will not only be having fun in life, but also be wealthier than you ever think you will be.

Speculate in moderation

On a side note, I am also an advocate of speculation. I am aware of the kick it gives; so some more fun is alright. But it should comprise an insignificant portion of your net worth. So if you are so keen, play along. 

8% government bonds

With interest rates falling, and projected to fall in the coming months, for investors in debt instruments, it has become a matter of importance. The 10-year government treasury is now at 6.46%; and 1-year treasury is yielding 6.32%. Bank deposit rates for one year are currently less than 7%. 

When safer debt instruments are below 7%, you tend to check out debt funds, which can probably give returns in the range of 8-9%; not assured though. 

There is one more option for the investors seeking risk-free debt. That is the government's 8% bonds. These were issued in April 2003, and yield a return of a little more than 8%. The catch, however, is the lock-in period of 6 years. 

With the brokerage fee of 1% on purchase, the pre-tax return on cumulative comes to 7.98% and on non-cumulative, 7.94%. At least, these are assured returns. If you estimate that inflation and therefore interest rates are likely to be lower during the period, these are better options compared to bank deposits, especially if you are in the lower tax rate.

For someone, who is in the tax rate of 0%, the returns are not bad to lock-in for 6 years. But then of course, all depends upon the opportunity cost of the investor. 

value of property

Many financial advisors consider that house property where one lives is not an investment. This is because the house is not going to be sold at all as the family lives in it. Great. They also advise that since the property has annual payments such as taxes and maintenance to be made, that should be included as a liability. Super. The value of the house would not be part of one's net worth. 

What if there is an investment made in an equity instrument, which the investor inherited from parents, and does not intend to sell ever, but wants to pass on to the children? Going by the earlier logic, the investor who owns shares of Coke, which are planned to be passed on to the next generation, should not include them in the calculation of net worth. 

Let's fix that conception. Any item that has value in the market should be included as part of net worth. Even car, expensive watch, etc. can be included. However, as a cautious analyst, I do not include any asset whose value depreciates over time. So the car goes out. I don't like the idea that an expensive watch has any meaningful value. I don't have the stupid habit of buying watches anyway. The more assets without having cash flows one owns, the more speculative the net worth becomes.

Back to the property. Even when the investor has only one house property where the family lives, and intends to live forever, there could be occasions where the family may decide to sell. This may be due to cash problem, or may be due to the idea of cashing in. When the property price becomes quite high in the area, the investor may decide to sell and move to an area where the price is low. Of course, house property is part of your net worth. 

Value of the property: Most buyers of house property do not think about its value. For them, the value and price of the property are just the same. I don't blame them per se, especially in India, where if someone really looks at the value of the property, it is difficult to buy at all. Nevertheless, it makes sense to at least understand the gap (the premium) that is being paid when it is bought. 

Value of any cash flow generating asset is the present value of all cash flows discounted at an appropriate rate. House property is not an exception. The cash inflows are rents, and cash outflows are taxes and maintenance. The value of the property is then the present value of annual net cash flows attached to the property. That is true even when the family intends to live in the house because if not, the investor would have rented the property. 

Let's consider an example. An apartment with annual rentals of Rs.360,000 has a market price of Rs.17.50 m in a suburban Mumbai. The annual costs are minimal; so I will ignore them in the calculations. That is a rental yield of just 2%. What the market is saying is that any expectation above that rate should come from the market itself. The 10-year government treasury has a yield of 6.50%. So to match that, the market price has to appreciate by 4.50%. It is a bit simplistic because there is growth in rentals too. Yet, if the investor wanted 6.50%, government treasuries would be the option, not house property. The expected rate of return for the property is some points above that rate. 

Assuming that rentals will grow at 7% annually (they may not if inflation remains lower) for the next 10 years, and after that they will grow at 5% on perpetuity (they may not), we have all the cash flows available to bring them to the present value. The value of the property now is a function of the expected rate of return. 

At the market price of Rs.17.50 m, the investor will get 7.562%. If the expected rate of return is 10%, the buy price has to be Rs.8.83 m, a markdown of 50%. There is no question that the market price would go that far down in Mumbai. At least they have not so far. That is why I consider that rentals and property prices in India are not aligned. To have an expectation of a reasonable rate of return, either the rentals will have to go up, or the prices will have to come down. Neither has happened in the past 20 years or so that I have seen. 

So what will the investor do? Owning a house is always a dream; so it is easy for the investor to make the decision. Just look around and track a few properties. Buy the one that is most liked in terms of its design as a trade off with the market price. The investor and the family moves in. There is no time to think about intrinsic value of the house property. 

There is another way of calculating value of the house property, It is how most equity analysts calculate the value of stocks. Take the cash flows for 5-10 years, and plug a multiple for the stable growth value.

This is how it works for the house property. All cash flows for the 10 years remain the same. Year 11 value is the expected sale price of the property. The value (is that price?) of the house property then becomes a function of both the expected rate of return and the expected sale price at year 11. 

If the investor reckons that it will be sold for say, Rs.27.50 m, the value of the property becomes Rs.13.70 m at 10% expected rate of return. At the market price of Rs.17.50 m, the investor will have to sell the property for Rs.37.34 m in year 11 in order to get a rate of return of 10%. With all the speculation about market prices after a decade, it becomes murkier. 

There isn't much choice for the investor. A better gamble would be this: Buy the property at the market price, with limited application of timing (i.e. buy when the prices are generally lower); live until the working life; upon retirement, sell the expensive property and move to a place where the prices are more reasonable on a relative basis.

dosanomics and financial independence

Raghuram Rajan's dosanomics became quite popular; and he is a smart person. Nominal rate is the sum of real rate and inflation. Therefore, if you take out inflation from nominal rate, what remains is the real rate. 

And real rates are more important than nominal rates. For instance, if you earn 10% on your investment, and inflation during the period was 10%, you have not moved forward; it is a status quo situation. However, if inflation was 11%, you earned a negative return. What it means is that looking at only the nominal rate of return in isolation is not a good idea. Inflation is an implicit tax on your returns. Ignore it at your own peril. That is why we like returns that beat inflation, rather than those that beat a benchmark such as the market index. If we are not able to retain our purchasing power, there is no point in harping about beating the index. If anything is worth doing, it is worth doing well.

So how does the dosanomics fair in terms of our wellbeing?

Mr. Rajan's thoughts:

He explains further:

Is it really so? Let's check out, especially for a retired person.

Let's have a retiree whose annual expenses are Rs.720,000 and assets are worth Rs.10 m. When interest rates are 8%, the retiree earns Rs.800,000; however, with a tax rate of 10%, the net earnings are Rs.720,000. 

Now, if interest rates come down to, say, 6% because inflation moderates to say, 5.52%, the financial equation for our retiree changes. After-tax earnings will be Rs.552 k with a lower tax rate of 8%. Annual expenses will be, nonetheless, higher than Rs.720 k; with 5.52% inflation, they will be Rs.759 k, leaving the retiree with a hole of Rs.207 k. 

Note that for the working people, with active earnings capacity, this may not impact much since annual earnings tend to compensate increase in costs, albeit at different levels.

It will get interesting next year. Even after assuming no change in rates, the hole gets bigger. The assets will be worth Rs.9,531,107. The retiree is clearly worse off.

There are two solutions to this: One is that the retiree should have had much higher assets to start with, which is to say, not to retire so soon. Another is to find an alternative source of income while retired; I guess that happens only by working again. 

This is exactly what someone asked Mr. Rajan:

And this is what he got:

The retiree with annual expenses of Rs.720 k, and with inflation of 5.4%, will have annual costs of Rs.1.2 m in ten years. How much will the earnings be by that year for someone who had assets of Rs.10 m? Not much compared to the costs.

Of course, there is a third solution to the retiree. That is to increase the gap between after-tax earnings rate and inflation. If after-tax earnings are say, 12%, the retiree should be fine. That would be possible only when assets are invested in equities rather than bank deposits. The problem here is that equity returns are not linear, because of which annual drawings may obstruct growth in equity in future years. You cannot rely on only equity returns for retirement, where you require stable earnings.

There is yet another solution: Reduce annual costs. That may be possible when the retiree chooses to live in a smaller, low cost place. 

Whatever the options are, dosaonomics may not be suitable for a retired person. Retirement is a key decision, and it is worthwhile to think about how much assets one should have before taking the leap.

Interest rates are moving downwards.

I would like to call it financial independence, rather than retirement. Whether it happens at 30, 40 or 60, the idea is to have sufficient passive income to be able to finance living costs. Working then becomes optional: you can sit on couch or beach, or take up work that interests you. You can even choose to be busy breathing in, breathing out. Earnings, if any, from such activity then are only incidental, not a requirement. 

troubled twins

To make money in stocks, usually, one has to stay focused on the story for a considerable period of time. The story is linked to the business behind the stock, not to the ticker price. So here it goes: in the short term, you do not know how the market prices will react; but in the long term, the prices are more aligned to the business performance. If the business does well, the stock prices go up. 

The risk in the business then depends upon the type of the business, the operating leverage, and the financial leverage. For instance, you take on too much debt, the business becomes that much vulnerable. 

Both Rcom and Rpower seem to have failed the investors big time. Unless one has played the game of high-and-low prices periodically, which is never easy, these businesses haven't given adequate returns to the investors.

Rcom is worth Rs.87 b now, from its peak of Rs.1742 b in 2008. 

Rpower is worth Rs.110 b now, from its peak of Rs.813 b in 2008.

Both businesses earn poor returns on capital employed. I wonder when they will be able to turnaround. 

demonetization, digitalization, and the windfall

The demonetization
The government announced on 8 Nov that by midnight of the day high value notes of Rs.500 and Rs.1000 would no longer be legal tender. It also noted that all cash holdings should be deposited into the bank account of the owner of cash by 30 Dec 2016. 

Well, the responses thereafter have been mixed; some in favor, and some opposing. That is obvious in a democracy. And that the news media is busy tackling the matter in a way that suits their ratings and increases advertisement revenues is another matter. That is obvious too because they are running a business, not public service; never mind the moral grounds, have they ever? As mentioned, that's another matter.

India is a country where most of the transactions take place in cash; it could be as much as 70-90% as pointed out by some sources. Therefore, cash is an essential commodity for the most. The digital currency has been picking up only recently. The idea is to move towards a cashless economy, where most (and all high value) transactions are carried out in an electronic form: net banking; debit cards; credit cards; and other e-platforms. This is good for the long term. 

How about the short term? There are consequences of course, especially for the poor, and emergency situations. And discussions about this galore. The purpose of this post is to check what is in place for the cash that is hoarded in India. 

Cash is held by the businesses, in the normal course, which is scheduled for depositing the next day; cash is held by the working individuals, in good faith, to carry out their daily affairs; cash is also held by housewives as part of their routine savings. These are all, may be, after-tax rupees. Besides, cash is also hoarded by these businesses and individuals as evasion of taxes; black money. 

The action
All genuine cash holders might takeout cash, and deposit in their bank accounts as authorized by the government. If the tax officials find any mismatch between the cash deposited and income tax returns filed in prior years, there could be tax and penalty levy. Despite this, genuine cash holders would be better off by declaration and deposits. 

However, the guilty would have to think before any action. They have a few options:

Option 1: Declare the black money, and deposit in bank accounts. Be open to scrutiny, and pay taxes and penalty. This could open up their box of...; be prepared for that.

Option 2: Do not declare, which is to say that take the cash and burn it. Let the smog be; let this be their festival of firecrackers without noise pollution. The loss is equal to the value of cash burnt. Move forward with life. 

There is another option for them: Donate the cash (without expecting anything in return) to as many poor as possible, with each poor person getting a very small value in cash, which can be deposited in that person's bank account for use. This will yield the cash hoarders good wishes from the poor. This option is not as ethical as option 1; yet.

The consequence
Nevertheless, it would be interesting to find out how the whole thing is actually going to play out. Here's the RBI's balance sheet as of June 2016; it had Rs.17,077 b of currency notes issued. 

We also note from its annual report that the RBI had Rs.16,415 b of currency notes in circulation as of March 2016.

How much is the black money held in cash? Let's take Rs.17,000 b as the value of notes. Of this say, Rs.15,000 b is from high value notes of Rs.500 and Rs.1000, which have ceased to be legal tender. Now, it is anyone's guess that how much of this Rs.15 t is held in the form of black money. For the sake of arithmetic, 25% comes to Rs.3,750 b. Too high? assume 10%; too low? assume 40%. The fact is that we do not know yet.

The windfall: Any cash that is not deposited in the bank account will become worthless. When it becomes worthless, the RBI will have that much lesser obligation to honor. People have been speculating about this proportion of lower liability, and about the likely use of that windfall: It could stay with the RBI as part of its reserves, which means lesser currency in circulation; is that lower inflation? It could be used to issue additional currency notes of equivalent value without impacting inflation. It could be paid out to the government as dividends. It could be used as a special equity boost to the public sector banks. It could be used to extinguish the government debt. It could be...blah blah blah...

The fact is that we do not know: 1) The size of cash that will be trashed; 2) The likely action by the RBI - to print new currency of the equivalent value, or to not to print at all; and 3) The likely use of the windfall.

As a consequence, though, at least some part of that parallel (black) economy will be gone. In the short term, these informal small businesses and real estate operators will be hurt, and will be forced to either close their operations or become part of the formal (after-tax) economy. In the long run, the share of the formal economy is likely to increase resulting in higher GDP. 

However, the value of black money is much larger in the form of gold and real estate as compared to cash holdings. Hoarded gold and unaccounted real estate are much difficult to crack. That said, going forward, even these transactions will be difficult to deal with before-tax cash. 

The idea of a digital economy is tempting. Let's wait and see how it will play out.

it ain't about how hard ya...

Markets are spooky these days. Nov 8 has been quite eventful what with elections in the US and demonetization in India.

From Nov 1, the index has fallen 6%. Much of that (5%) came after that eventful 8th day of Nov. 

Other things remaining same, investors go where there is less risk; perceived risk that is. Foreign investors could go to the US perhaps; but for how long would they remain there? Domestic investors could go to government bonds (would they?), or gold (again for how long?). They could go to real estate, may be, but chances aren't that high.  

Investors often fail to ask a question fundamental to their financial wellbeing, has anything fundamental to the business changed which is likely to remain for long?

With US not growing as much as it would like to, Europe and Japan, not anywhere, Latin America struggling, and China trying to check where it is heading, I reckon eventually a good portion of global money has to come to India. I mean it is for their own good, if they want better returns. And domestic investors will not like to sit and watch others party. So there is; the Indian equity markets are not going to be short of cash.

Short term fluctuations in the markets are routine. In fact, these are the opportunities to act. Real money is made when invested for long term. That is why investing calls for proper analysis and homework before action. Without analysis of facts there is only speculation; and one should speculate at one's own peril.

Often, men and women, tough and weak, smart and foolish, are all brought down to knees by the markets. What's to be done, take the hit and go back? In these times, investors should go to Rocky Balboa for advice, rather than to the so-called experts. 

Yeah, it ain't about how hard ya hit; it's about how hard you can get hit and keep moving forward.

diwali top picks worth Rs.13 t

Each year, India celebrates Diwali with much fun; and why not with so much mythology behind it. Also each year, Indian talking heads talk about top stock picks during Diwali. There's one here; but they are there everywhere. Each has his/her own picks, and no one is spared from hearing it, unless of course one switches off financial media during the time, and stops commuting altogether for you find talking heads in Mumbai suburban trains too. 

There is so much fanfare in doing it that for normal humans, filled with the spirit of greed, it is quite difficult not to listen and act. And act they do; every time, each year. 

I usually do not give a damn about what these pundits have to say, but sometimes, it is sheer fun to mock them; and I enjoy that immensely. I have so much regard and respect for them that I only just fall short of shorting their buy recommendations.

This year, instead of asking how much money the festival would bring to the investors, I thought of checking out how much money it would take away from them. The festival has its own charm, but people who celebrate it have some perverse attitude, which I attribute to the natural human behavior: being stupid of course. Here's how. 

People celebrate the festival by bursting firecrackers. Never mind, there is both noise and air pollution; let's leave that discussion for some other time as I take up bashing one at a time lest I too go berserk. The firecracker industry is estimated to be worth Rs.100 b. So in our analysis, it amounts to taking out Rs.100 b each year and burning it; you hear that noise and smog? I do, but I also see the potential financial loss it brings upon those who burst. 

The stock market has the potential to grow more than 12% in the next decade. Then there are dividends. The rate of return is less important (we can choose any rate) compared to the potential financial impact. Let's just use 12% as the opportunity cost. I picked equity markets rather than bank deposits or bonds because these people choose to burn the cash anyway. If this cash was put in equity markets, just the market index, instead, 12% was a probabilistic rate of return. 

If we assume Rs.100 b is the market for firecrackers, the cash flow would be worth Rs.1,700 b in 25 years at 12%. The cash flow would earn dividends each year, and also grow further.

Rs.1,700 b is the cost of just one year's stupidity. We know that stupidity carries through the years; Rs.100 b is burnt each year. So the future value of that annuity would be Rs.13,333 b in 25 years. And I have not even considered growth in stupidity, that is, Rs.100 b is not going to stay constant; it is going to increase year after year; think about a perpetual growth rate, and the potential financial loss is staggering.

Sure, we can celebrate the festival softly with family and friends, and have as much fun. I wonder where else we could find a combo of increasing noise, polluting air and losing Rs.13,333 b.

being right

To make money in investing you have to be right about what you do. To be right there are at least a few things that have to work out in your favor.

The first is your premise that the stock that you bought or sold is priced differently by the market. That is, the gap between your value and market price is large enough to give you profits.

The second is that your premise has to be correct. That is you are right, and therefore, the market is wrong.

The third is your premise that the market will recognize its mistake and correct itself.

The fourth is that your premise has to be correct. That is your are right, and therefore, the market eventually corrects itself yielding you your profits.

This is a simple model of investing which in short implies that you buy low and sell high, or sell high and buy low. Yet, not many are able to succeed consistently at this game.

Nevertheless, this does not stop people from barking. We get to hear,

10 stocks that will make you rich,
15 stocks that will be multibaggers,
20 stocks that should be in your portfolio,
12 stocks to buy this yearend and hold until the next,
Blah, blah, bark, bark...

Any rational individual (is there one?) would think, if it were so, why these idiots are not doing it themselves?.

As of now, Nifty is quoting at 8691.30, and has these attachments: PE 23.23, PB 3.29, and Dividend 1.27%. Do you want it? Since individual stocks make these numbers, by and large, both the market index and individual stocks carry these strings. Sure it is pricey.

If you buy the index, you are looking at 1.27% in dividends, and whatever else in capital appreciation. If you are playing the short version of the game, you are bound by the hands of luck. You could make money or lose depending upon your stars in the sky during the time. Or may be the fault will not be in your stars, but in yourself because you chose the shorter version. It is a difficult game to play because you are never certain of the outcome. However, if you are playing the longer version of the game, you could score some points. You could collect those dividends each year, and then be somewhat certain that the market is going to march forward during the years ahead. You understand that some years it may fall short or lag behind, but overall, it will be way ahead compared to what it is today. The game is better played continually rather than at a time; this will lower the average cost of buy. There is far little stress and far better result compared to the talking heads. You are more likely to be right than wrong.

If you are willing to make investing your business, there is a much higher probability that you will be able to make more money. This is how it is played: You ignore the outsider's opinion on stocks, business, and on anything. You focus on the annual reports of the individual companies of your interest. You attempt to value the business, and compare the value to its market price. If the gap is large enough (you are not interested in small gaps to allow for your errors), you either buy or sell. Usually you buy and wait for the market to correct its mistake. You would lose money on some, but on average, your collection of stocks would yield you profits when played over a long duration. Again, you are more likely to be right than wrong.

The ideal strategy would be: Set up a program wherein you buy the index on a regular basis irrespective of, and despite, the current news. You buy individual stocks based on value and price analysis as and when you deem fit. And you play the longer version.

Of course, you remain a student of the game all through. The game will teach you important lessons on life: greed, fear, envy, and happiness. Eventually though, if played well, you are more likely to be right than wrong.

bayer-monsanto

Bayer has agreed to acquire Monsanto at $128 per share valuing its equity at $57 b in an all-cash transaction. To finance the deal Bayer intends to raise both debt and equity. If the $19 b mandatory convertible bonds are the only debt to be raised, it appears like the entire acquisition being financed by equity. Then by implication it is not an all-cash deal, but an all-equity acquisition. For that to happen, Bayer must consider that its stock is overpriced. That is the first explanation that Bayer needs to give to its shareholders, although the major equity increase is through a rights issue.

Bayer must also consider that value of Monsanto's operating business is higher than $66 b. But is it? 

Monsanto is a mature business. Its revenues have not moved much in the past three years. And it has been generating steady cash flows. How much its revenues could grow in the next 5-10 years? Perhaps they would grow at a modest rate which would also be its perpetual growth rate; Monsanto is not a high-growth business. As of May 2016, Monsanto had $10.56 b of debt and $1.37 b in cash. 

If we consider operating margin of 25% and return on capital of 20% as sustainable for a foreseeable period, we can make value of Monsanto's business a function of perpetual growth rate and expected rate of return. 

For the analysis, I have not adjusted research and development expenses that Monsanto charges to its income statement. It would be much better if that is accounted for as an asset and amortized. 

The perpetual growth rate should be sustainable and reflect its mature business profile. Expected rate of return, which becomes the cost of capital, should be based upon the opportunity costs available at the time of acquisition. Of course, it should reflect the riskiness of cash flows; but how risky these cash flows are is a matter of perception. Rather than relying on CAPM, to supply a cost of capital, I would rather use a rate that I see is suitable for the acquisition. After all, if Bayer has opportunities to invest in a business that has an expectation of 10% rate of return, why should it invest in a business that can give 7%? As of now, the 10-year treasury has a yield of 1.69%. Obviously, Bayer would like to beat it, but by how much? 

If revenues grow at 3%, Monsanto will generate free cash flows of $2,134 m. Value of the business now depends upon the expected rate of return on cash flows. 

It looks like at 7% rate of return, Bayer is expecting value increase from control and synergies of 22.39%. This is to say that Bayer expects to increase growth rate in revenues, increase operating margins and increase return on capital after the acquisition is complete. How feasible is that? I am not too sure of growth rate, but if Bayer achieves an operating margin of 30% on a sustainable basis, it appears to have nailed the deal at 7% rate of return.

If the expected rate of return is higher, obviously Bayer has a tough job ahead.

To justify the acquisition price without benefits from control and synergies, Monsanto needs to grow at a much higher rate on a perpetual basis. 

At 3.73% growth rate, Bayer should expect a rate of return of 7% on the acquisition. Any higher expectation would put Monsanto under immense pressure to grow. It looks like a rate of return of 10% is not feasible.

If Monsanto grows at a much lower growth rate of 2% (operating margin of 25%), Bayer will have a lot explain to its shareholders. 

That is even when Bayer manages to increase operating margin to 30%. 

Such is life even for the corporates. It is both uncertain and filled with probabilities. By the way, Monsanto is still trading at a 20% discount to the acquisition price. Investors, who have faith in this acquisition and Bayer, still have the opportunity.

questions to buffett, 3 and another

I have always wanted to ask Warren Buffett a few questions, which have been in my mind for quite sometime. I have 3 questions for him, and another as a bonus question.

why back out of own path
Buffett was quite cool when he said what he said in 1955 as a 25 year old.

I was blown away when I first read the Forbes article. Here's someone, barely 25, talking about retirement in 1955. He did not mean to retire, retire like everybody past 60 does. He was talking about teaching and reading, and yet, confident of becoming rich managing his own cash. That's not retirement, but financial independence as we see it now. He did not want to be part of the rat race. He neither had plans of a partnership, nor taking up a job. For me, it was a profound statement because personally I could very much relate to it.

So then why did he choose to form the partnership?

Why did he himself offer to form the partnership when he thought he was going to be quite happy (and also rich) doing what he wanted to do, i.e. be on his own not being accountable to someone else?

why manage other people's money
Buffett is arguably the best investor the world has ever seen. I don't think there can ever be another of his kind. His ability to pick stocks is not matched by anyone considering consistency and duration.

If he had not formed the partnership, and opted to manage his own capital instead as he wanted to anyway in the first place, he would as well have achieved superior results. Perhaps, over the long period, the rate of return might have been higher because of the lower base. When he closed his partnership in 1969, its assets were $100 m, and Berkshire today has billions of dollars to manage. Both at their respective times are large numbers to invest.

Buffett's actual performance on Berkshire market price is 20.9% over 51-year period (2015), and 30% over 25-year period (1989).

If Buffett had listened to his heart in 1955 and chosen to manage only his capital of $127,000, its value would have been $11.2 b by 2015 considering 20.9% return. If we consider 25%, the capital would have grown to $82.8 b. No wonder compound interest works like magic; I dare not think of 30%. He is worth $67.6 b as of now. But that hardly matters, does it? He would be worth $1 b at 16.1%; a piece of cake for him.

Beyond a certain point, all dollars are directed righteously to charity. His frugal lifestyle hardly requires much cash; most ordinary people could have a similar lifestyle, but alas, they don't; that's a behavioral pattern, which I reserve for another day's discussion.

My point is whether he would be worth $11 b, $82 b, or $67 b is irrelevant. The question is why did he choose to manage other people's money? I don't consider taking cash from others and being obligated to the responsibility of keeping them informed of all times in terms of targets, key information, explanation for gaps, positive or negative, between actual and targeted, is a good idea. Definitely not for someone who is as smart as Buffett is. Perhaps, he wanted to get rich a bit quicker collecting performance fees, did he?

why close partnership and then start allover
In his 9 October 1967 letter to his partners, Buffett first mentioned about change of investment environment and personal factor. He noted that he did not want to form habits that ceased to make sense. Change of heart, so to speak.

He said he also wanted to do things which were non-economical, rather than only chasing the biggest point gains in his economic activities. He said he preferred, but did not say he would, to own controlled businesses that let him be with people he liked and have a life personally enjoyable.

Finally, he informed his partners in his 29 May 1969 letter of his decision to quit.

Much the quantitative guy that he was at the time, under the patronage of his mentor, Ben Graham, Buffett noted that good investment opportunities were lacking. Stock prices were very high; value did not seem to make sense.

He formally informed them that he wanted to retire. He did not mention what he meant by retire, though.

He mentioned quite frankly that he did not understand the investment environment, and did not hope to get lucky with other people's money.

Yet, he did not have a plan for the future; but he did mention that his priorities at 60 would be different from those at 20. I thought his remarks in 1955, 18 years prior, were more clear.

He was worth $25 m at that time, and could have chosen the path he had seen in 1955. If he had, his capital would have been worth $65 b in 2015 at 18.6%; $15 b at 15%. So he would be easily worth between $15 b and $65 b today had he chosen the path of a 25 year old.

So again, why did Buffett, despite all his aspirations to detach himself from economic only activities, continued to engage and immerse himself in only business and investment? Perhaps, he thought advance premiums from insurance operations were sort of free capital (when managed well like he did) compared to his partners' capital which had a cost, did he?

why coke

My final question, and I cannot resist this. Why coke?

the tap dance
Buffett could have done this or that. In the final analysis it really does not matter. In fact, from my personal point of view, and I am sure from world's point of view, it was good that he did what he actually did. If not, we would not have got the Warren Buffett; we would have missed his philosophies, his thoughts, and his wit; and that would be a big loss for mankind.

It gets better from his point of view because he really seems to enjoy what he has been doing for years. No wonder he tap dances to work.

Yet, if only he could answer my questions.

tata coffee: not much to take out

Tata Coffee's market value increased from Rs.5,074 m (high) in 2006 to Rs.23,533 m in 2016. It was as low as Rs.3,117 m in 2006. One would have earned 16.58% or 22.4% depending upon when one bought it, and if one had bought it. Not bad. 

Nevertheless, in 2016 the investor would have made 3.23% based upon the high price and 29.11% based upon the low price in 2011. The disparity is because of the double whammy presented by the market itself: a high PE of 27.67 and a low PE of 9.04 for the stock in 2011. 

In the last five years, revenues increased by 6.28%, yet earnings per share increased by 10.18% helped by other income and exceptional items. The average operating margin has been approximately 14%.

The return on capital has remained low, and was 9.1% in 2016. The company's annual average spend on reinvestment was Rs.278 m in the last five years. 

The alarming part though is that Tata Coffee's incremental return on capital has deteriorated. 

For any business to be successful, the key is to have the ability to generate a very high rate of return on its incremental capital. Unfortunately for Tata Coffee, the historical return on capital is already low, and its incremental return on capital is worse. 

With 19 coffee estates measuring 18,273 acres, instant coffee capacity of 8,400 MT; 7 tea estates measuring 6067 acres; and pepper vines, I need to estimate the growth rate, which if I use what I reckon is reasonable takes the value of Tata Coffee to a very low number. It's a struggle to find the growth rate.

The company has identified volatility in the international coffee prices, currency rate movements, high, price-sensitive competition, and dependency on nature as key risks involved in the business.

It has Rs.11,344 m of goodwill on the balance sheet; its subsidiary, Consolidated Coffee Inc. earned Rs.804 m of which, Rs.402 m was attributable to Tata Coffee. Consolidated Coffee owns Eight O' Clock Coffee Company.

The good news is that there has not been any dilution to equity. However, Tata Coffee should strive to have the ability to take sufficient cash out compared to what it has put in its operations. Can the company pull it off?

sovereign gold bonds, not colored

I have already displayed my dislike for gold for investment purposes; I don't like it for decoration either; wasteful altogether.  It is like when there is demand, supply shouldn't stop. To say that Indians are fascinated with the yellow metal is an understatement, what with 1000 tons of annual consumption. In a country where foreign exchange is precious, the dollar spend on gold never ceases. There isn't any appreciation for the lost opportunity; and the cost is massive.

After the government came out with the sovereign gold bonds, has the equation changed for gold buyers? The short answer is: No for those who love decoration; and may be for others. 

Before we go further, here's the brief.

• Bonds held in demat form and traded on the exchanges.
• There will be no physical gold.
• Time to maturity is 8 years.
• Interest is paid semi-annually on the investment at 2.75% pa, which is taxable.
• Redemption proceeds are calculated based upon units held at the prevailing market price.
• Capital gain on maturity is not taxable; before maturity is taxable.
• Minimum investment is 1 gram and maximum is 500 grams.
• Units held are protected; however, there is no protection against capital loss due to price fall.

At least there is no physical trace of gold; and with no foreign exchange involved makes it interesting. The government is not going to deliver gold upon maturity; all that is involved is, cash in and cash out. There isn't any yellow to be seen; and this might make the majority of Indians go gaga. Never mind, the few remaining will have reasons to think more rationally. 

These bonds are sort of derivative instruments, whose price would change based upon the price of the underlying, i.e. the gold. How likely are these prices to go up? If history is any indication, there might be a little scope to make these bonds good enough. From 1969-2012, the prices increased by 9.25% annually; from 1992-2012, 7.77%; from 1997-2012, 10.15%; from 2002-2012, 17.91%; from 2007-2012, 17.85%; and from 1969-2005, the prices increased by 7.57%; however, from 1980-2012, it was -(0.55)%. What is our fallback time period?

Now that the new tranche of September 2016 is coming up, the investor's prime concern should be where the prices would be in September 2024; and then marginal tax rate of the investor; all the rest can be safely ignored. The gold price for the September 2016 investment is fixed at Rs.3,150 per gram.

In the last 7 years, gold prices have increased annually at 10.65%. If this is any indicator, the bonds are going to be fabulous. Alas, that may not be the case; that is called the risk in the game.

Whether these bonds are any good for investment purposes depends upon the expectations of the investor. 

Let's start with the base rates. If the alternative is to keep the cash in bank deposits, the opportunity cost is about 7.25%; the long term government bonds trade at 7.12% today. This is the pretax rate of return. Since capital gains on the bonds are tax free, we need after-tax rates. For someone who is at 20% tax, the after-tax rate of return is 5.70%. 

So how much the gold prices will have to increase for the bond investor to match the government bond rates?

For someone who is in 0% tax rate, it is going to be 4.78%. That is to say, the gold prices will have to increase from Rs.3,150 to Rs.4,238 per gram by September 2024. 

For the 20% tax rate investor, the gold prices will have to increase by 3.78% annually until September 2024 to match the government bond rate of return.

Since I believe that investment in gold is based upon the greater fool theory, gold prices can be anywhere in September 2024. For each, the hunch is unique; yet, the hunch it is. 

For the 30% tax rate investor: If the price remains at Rs.3,150 in 2024, the rate of return will fall to 1.92%. To make it a little more interesting, to get 0% return (i.e. just the capital is protected) over the 8-year period, the gold prices will have to fall by 2.07% to Rs.2,665 per gram.

The gold bond investor would obviously expect more than the government bond rates. What if the investor expects 10% after-tax return?

Well, the investor at 25% tax rate would have to see the gold price increase by 8.46% annually over the 8-year period to get 10% after-tax return on cash flows. I come back to the hunch.

the timken story

The company makes tapered roller bearings (71%) and AP cartridge tapered roller bearings (21%), and it also trades in other types of bearings. The traded bearings are sourced from its group companies globally. The company also provides maintenance and refurbishment services.

Its growth largely depends upon that of manufacturing and infrastructure sectors. It has manufacturing facilities in Jamshedpur and Raipur which mainly cater to medium and heavy trucks, off-highway equipment, railways and exports.

As per management, the current size of anti-friction bearings market is approximately Rs.95 b, of which automotive industry has 45% share and industrial sector has 55%. The company had revenues of Rs.10.62 b for the year ended March 2016. So there is space to grow. 

The management also notes that low quality and counterfeit in the market and volatility in prices of metal components (main raw materials: steel, rings and accessories) as major threats to its business. Yet, it appears to be excited about the government's planned expenditure in building road and rail infrastructure corridor, private participation in defense and allied sector, and electrification drive.

Timken India is currently valued by the market at Rs.38.57 b. Timken Singapore Pte holds 75% of shares in the company; the ultimate holding company is The Timken Company, USA, which is worth $2.69 b as priced by the market.

Timken India pays royalty to its holding company; for 2016 it paid Rs.222 m, which is approximately 2% of revenues. It also pays inter-company service charges to the group companies.

It has 68 m shares outstanding. Apart from the institutional placement of 4.26 m shares at Rs.120 per share in 2014, the company has never diluted its shares. The placement had to be done to bring down the shareholding of the parent to 75% to adhere to the regulatory guidelines.

The company never dividends until 2012 when it made a hefty payout of Rs.1.27 b. Then in 2014 it paid dividends of Rs.6.50 per share (remember dilution of the holding company's equity); for 2016, it paid Rs.1 per share. Timken does not have a reliable payout policy yet.

What is interesting is that the market has steadily increased its expectations about the company and accordingly, its price over the last decade.

At the current price of Rs.569.65, the stock is trading at over 42 times its earnings. Although the PE multiple is a pricing measure, it can also be analyzed based upon the intrinsic value of a business. What we get out of the exercise is the implied PE multiple. For instance, if the value of the business is 100 and its earnings are 5, the implied multiple is 20. 

So then there had to be some fundamental change in the business affairs of Timken India for the multiple to expand.

Revenues grew at a cagr of 18.06% in the last 5 years and 12.37% in 10 years. We can choose to ignore the minor variation caused by the change of its financial year end from December to March from 2012 onwards.

Operating income grew at 20.64% and 10.43% during the respective periods; and earnings for common grew at 12.48% and 9.20%.

EPS grew at a slightly lower rate due to the institutional placement in 2014; it grew at 11.03% annually in the last 5 years and at 8.49% in the last 10 years.

That's the past. What we are really interested in is the future story for the business. How much can the revenues grow in the next 5 years? For the moment, let's expect to grow at 20% per annum. During the stable growth period the business cannot grow at a rate higher than the long term growth rate of the economy; therefore, let's set the perpetual growth rate to reflect that.

Operating margins started declining since 2006, but have increased in the last 2 years. Let's expect Timken to better its margins in the future and reach to 15% as a stable business. Note that this margin is expected to be perpetual and therefore sustainable.

2012 had a triple advantage: 15-month period; higher revenues and operating income; and lower operating capital. Therefore the return on capital was much higher. From 2012 onwards, the company spent approximately Rs.3 b in reinvestment; higher capex for expansion projects and also higher working capital requirement. In the previous 6 years, the aggregate reinvestment was Rs.602 m. Let's hope that Timken will be able to maintain a return on capital of 25% as a stable business.

Revenue growth rate of 20% is not going to come easy and free. There has to be right amount of reinvestment. Timken has already planned capacity expansions for railway bearings at Rs.1.24 b, and for tapered roller bearings at Rs.643 m, both at Jamshedpur plant. At 2.33 times capital turnover, the reinvestment is going to be there each year. Let's expect Timken to reach the stable growth period after 10 years of high growth.

Timken has generated free cash flows to firm of Rs.1.55 b in the last decade.

Where does it all end? Based upon our expectations, the projected numbers show that the invested capital is set to grow at 15.21% in the next decade compared to the historical rate of 12.73%; operating income at 16.70% compared to 10.43%; and FCFF at 37.96% compared to 29.96%.

Timken had excess cash of Rs.334 m as of March 2016 and investments in mutual funds of Rs.384 m, the market value of which should be higher. It had debt of Rs.63 m including interest-bearing deposits from dealers and distributors. It also had contingent liabilities (sales tax, income tax, excise, customs and other claims) of Rs.219 m; how much of this is going to be cash outflows is left for us to estimate.

Now the value of Timken's operating business becomes a function of our expected rate of return. If we accept that our expectations of 20% revenue growth, 15% operating margin and 25% return on capital are sustainable, the stock is currently priced (at Rs.569.65) by the market to give a return of 9.23% in the long term. Is that rate of return reasonable?

I would rather ask, is 15% operating margin sustainable for the business? Timken has never reached that in the last 10 years. I would also ask, can it increase its revenues by 4 times its current revenues by 2026? Will the market be able to accommodate that? Then there is the philosophical question, what happens if our expectations about the business and market turn out to be all wrong?

How about some sensitivity? If we tweak a little bit and change revenue growth rate to 15% and sustainable operating margin to 12%, the expected return falls to 7.65%.

If we consider that intrinsic valuation through discounted cash flows is too complex involving estimates of cash flows and growth rates, which we are incapable of being correct, we need not tread that path. We can bring the number of years far less than perpetual and try to price the stock.

Timken earned Rs.13.52 per share in 2016. The price of the stock becomes a function of growth rate in earnings, the multiple at which we expect it to trade and our expected rate of return. Conversely, we can keep the current price of the stock constant (the less we argue with the market, the better) and calculate the expected rate of return.

If we expect earnings per share to grow at 12% in the next 10 years and the stock to trade at 40 times, the stock at its current price would give an annual return of 11.42%. If growth rate is 15%, the rate of return is going to be 14.40%. That's a profound story, isn't it?

So what if earnings grow at 10% and the stock trades at a multiple of 25? Do we like to earn 4.40% in the next decade? At 11% growth rate, which is the last 5-year average, with a multiple of 40, the rate of return is going to be 10.42%; at 8.50%, which is the last 10-year average, the rate of return is 7.93%. Such is life.