things burry cannot explain too well

Recently, Michael Burry made a comment which the investors seem have taken too seriously. The story is short, but has made the news big.

Burry rose to fame after he made loads of money predicting the crash of the housing bubble in 2008. He was made more famous by Michael Lewis through his book, the big short. So yeah, he is a great guy. 

But that does not mean whatever he says has to be sacrosanct. He makes mistakes too. In the story, he saying that index investing is proving to be bad. In fact, so bad that he is likening it to the subprime CDOs. 

I am not sure whether I have to feel sorry for him, or for those who believe him. There is one thing I have found short in the investors' mind: that they don't have their own conviction. That's a behavioral debt which often becomes too expensive. 

Well, Burry is saying that index investing is bad, because it does not support market price discovery. Because when too much cash chases the index, prices of all stocks - good, bad, and ugly - will shoot up. Because investors buy without any regard for the price and value of stocks. Because the index comprises of far too many small, bad businesses whose stocks do not have liquidity, and yet are priced high. And he says the crash will be ugly. 

Then he goes on to compare index investing with the synthetic asset-backed CDOs. Here I am not sure whether he is actually comparing the bubble to the bubble, or the index investing itself to the CDOs. If he did the latter, his blunder is more prominent, for the CDOs are based on disproportionate leverage, and the index stocks are not that much. So that aspect is never comparable. But let's give the benefit of doubt to Burry, and believe that he just said about the bubble, like any other bubble. 

Now coming back to his concerns regarding the bubble in the index investing, we all know that the economy and markets are like a cycle. They go up and down all the time. There are times when the prices shoot up so much that they have to eventually fall, and yet other times, the other way is true. When taken to extreme, the bubbles have to eventually lead to price fall, and the busts, price rise. And they always do. 

Also, the free market mechanism comes into play all the time. Let's suppose that the bubble crashes badly. When the prices of the index stocks go up disproportionately compared to their fundamentals, the crash is bound to happen. Remember the dot-com bust. After the crash, the good stocks represented by high quality businesses become cheap compared to their intrinsic value, and the bad stocks represented by poor quality businesses may remain somewhat expensive. The investors will shun the index and buy good quality stocks, and may even short poor quality stocks. The index will then eventually move towards becoming fairly priced, making the case for index investing. 

Let's assume that the index investors, after the crash, sell their index stocks and buy good stocks which became cheaper. After the continual demand, prices of good stocks will go higher, and value of the index will correct. Now we have the case for index investing again. Because of this free market mechanism, even those index investors, who do not sell after the index bubble and crash, will also benefit by staying put on the index investing.

In fact, that is the essence of index investing: to keep going during both good times and bad times, pushing the average price of index units lower, and getting a reasonable market return. I can even say that a good index investor can achieve a return slightly higher than the market by increasing buys during bad times. But that's another story.

The hedgers, speculators, and short-sellers are always alert in a free market, and they take advantage of all arbitrage opportunities ensuring that the price and value of stocks and, therefore, the index are never too far off, for too long.

I am surprised Burry missed this point big time. We should be asking him where else to put money if not the index. The treasuries and high quality corporate bonds yield much lower. Junk bonds are not an option for the real investors. We have two choices then: Pick the stocks, or go to the index. 

Picking stocks is not for everybody. It requires time, interest, skill, and behavior. Index investing is for everyone who cannot be a stock picker, for the investor is assured of the market returns. 

For someone who has at least a decade of investing ahead, index makes the perfect choice. Once the horizon becomes shorter, asset allocation will have to come into play. A right mix of the treasuries, high quality bonds, and the index should take care of the investor's cash requirements for the rest of life.

The fun part is that we are not even close to all-passive investing. There is huge money actively and continually chasing stocks all the time, and I believe that as much as we know of the human behavior, we have a very long way to go against it. The fear, greed, and envy will ensure that active investing will stay for a long time, and index investing will continue to give market returns for those who find it satisfactory.

It is far better to use common sense and wisdom than borrowed conviction. Life and investing then will be rewarding.

microsoft and a trillion

Microsoft Corporation share closed the day at $127.13 with a total market capitalization just shy of a trillion dollars. The entire equity of the firm was worth $245 b some time in 2008. The growth has been both phenomenal and unprecedented because of the products it was dealing with and sheer size.

Revenues in 2008 were $60 b, and comprised the following.

In 2018 as revenues nearly doubled, the segments have changed.

The intelligent cloud has been the savior for Microsoft which experimented with many things using cash flows from Office and Windows. The elusive growth has been restored at least for sometime. Operating profits and (pretax) free cash flows to firm were $35 b in 2018. The growth in pretax fcff was 8.5% and 12.4% during the last 5 and 10 years respectively. Pretty decent given Microsoft's size of operations.

There were at least 2 major acquisitions in the past decade. Skype was bought at $8.6 in October 2011, and LinkedIn for $27 b in December 2016. Taxes in 2018 were exceptional; Microsoft is capable of $25 b aftertax fcff each year. Is 40x fcff a fair price for Microsoft? I am not sure. Apple is making nearly twice free cash flows, and yet is priced similar to Microsoft. But then Apple is banking on just one product, iPhone. Microsoft has a better product mix; Office and Windows generate steady free cash flows.

Even with a 10% growth for the next 5 years, and then moving towards a steady growth state in year 10, Microsoft may not give 10% return. If you are going to be ok with that, you might as well be ok with the S&P-500 with a far lower risk.

Microsoft has done well, and it is likely to do well in terms of its business and operations. But the stock is also not coming cheap.

Let's see again the numbers coming up for the year ending June 2019.

axis and yes bank q4

Both Axis bank and Yes bank reported their financial year results, and here's the story. Axis reported Rs.50 b profits for the year, and Yes had Rs.17 b profits. 

Yes also had losses of Rs.15 b for the latest quarter weighing in heavy provisions. While people are fretting over those losses, they don't get that when an investment turns sour, it just can't be called sweet; taste it to know it. Postponing provisioning for non-performing assets doesn't make sense even when the regulator or laws allow it; that will be stupid. On that front, Yes bank has probably done the right thing. 

Yes bank's book value is Rs.116 per share, while that of Axis is Rs.263 per share. With these numbers, their stocks are trading 2x and 2.8x respectively. But that is not the way to look at it. They have more NPAs, including stressed assets, that are not yet provided for. Including them in book value will inflate equity. Adjusting for full provisions on estimated NPAs, the stocks are trading 2.68x (Yes) and 3.43x (Axis).

Both banks have decent regulatory capital ratios: Axis (12.7%) and Yes (11.3%) in Tier 1 capital. Loan book is growing for both banks. Axis has better CASA (44%) compared to Yes (33%). Axis also has lower cost of funds (5.69) and Yes (6.5%), and slightly better net interest margins (3.44%) compared to Yes (3.2%).

Yet considering the current stock price, for a return of 13-15% in the next 3 years, Axis will have to grow 20% and Yes, 15%. Of course there will be people who will shoot for Axis in terms of higher growth and better book. At its current price though, Yes bank could give a return of 8% with a 10% growth rate. This is based on the reported gross NPAs and stressed assets; any hidden NPAs should bring the book equity and returns lower.

There is also a good chance that the Yes bank stock will be hit hard in the next trading sessions, and that should give opportunities for better returns. Axis bank is also likely to do well, but its stock price as of now is a little on the higher side. 

tesla q1 2019

Tesla reported its q1 numbers, and are we in for a surprise, or we aren't? That question depends upon whether we are a Tesla bull or bear. Vehicle deliveries fell short, and apparently had to be shifted to q2. The company still stands by its guidance of 360-400 k vehicles in 2019 representing a 50% plus increase over 2018. With Gigafactory China coming up, the target is 500 k vehicle deliveries. 

There was a significant reduction in revenues compared to the previous quarter. Tesla had operating losses of $521 m, and interest charges were $157 m. Cash loss from operating activities were $639 m, and over $300 m capital expenditures meant negative free cash flows of nearly a billion dollars. Tesla also repaid over $500 m of debt. Because of these, closing cash position was $2.6 b compared to the opening position of $4.2 b. The company has a debt of $12 b, and in addition, also had operating leases which are in effect a form of debt. 

The management has a guidance of capital expenditure of $2-2.5 b in 2019. So we should expect the company to make cash flows of at least that amount just to breakeven.

To justify the market value of nearly $50 b - never mind the fall post results - Tesla should do a lot more than what it has in the past. 

coffee day

Coffee Day Enterprises operates in 6 segments: Coffee and related; Logistics; Financial services; Leasing of commercial office space; Hospitality services; and Investment operations. It operates Cafe Coffee Day chain across India. 

The total business had revenues of Rs.37 b in 2018, an increase of 21% over 2017. Revenues have been growing in double digits for the last 3 years, 2018 being the best year of growth. The financial services revenues were Rs.5.7 b and that of leasing were Rs.1.4 b. Investment operations were Rs.530 m. 

The company had book debt of Rs.50 b and operating lease debt of Rs.1.8 b in March 2018. Because it also operates in financial services business, I am not going to look at its operating profits. That will not be meaningful because for financial services, debt is like a raw material, and interest costs are part of its operations as opposed to other businesses.

Earnings for 2018 were Rs.1 b. But after adjustment for the exceptional item (sale of stake in Global Edge Software) of Rs.532 m, it is actually an increase of 13% over 2017. Earnings per share were Rs.2.51 excluding the exceptional item compared to Rs.2.28 of 2017. Return on equity is less than 5%. There aren't free cash flows generated by the business. 

But the stock is trading at Rs.291.75 implying over 100 times 2018 earnings. Who are its buyers? 

The company owned 28,056,012 shares in Mindtree representing 17.08% ownership as of December 2018.

Coffee Day Trading is a subsidiary of Coffee Day Enterprises. In March 2019, the news is that the company and its promoter have signed a definitive agreement to sell their entire stake (20.41%) to L&T for a consideration of Rs.32.69 b. The price per share works out to Rs.975; and the stock is currently trading at Rs.950. 

As per this report, the total investment in Mindtree was Rs.3.4 b: Rs.440 m in 1999 for 6.60% stake; Rs.850 m (5.57%) and Rs.400 m (2.05%) in 2011; Rs.1.71 b in 2012 (6.84%). 

If the transaction does go through, the company will have a cash flow of Rs.27 b, handy enough to reduce debt. And the promoter will reap over Rs.5 b.

Coffee Day came out with an IPO in October 2015 at Rs.328 per share, and the stock commenced listing in November 2015.

The stock is yet to recover from its IPO price. But the question is: Is the business worth Rs.62 b? 

lyft ipo

Lyft is coming up with an IPO at an expected valuation of $20 b to $25 b. Its previous private valuation was $15 b in June 2018. Now that it is coming out with a $2 b IPO, the market is going frenzy.

Here are the investors seeking a valuation as high as possible. 

And why not, when there are buyers at the price? But then pricing is a game played by the private equity and venture capitalists, and for the right reasons: They want to cash out. That's their compensation for taking risk.

What about investors who like looking at the business and numbers? I haven't got a story for Lyft, for it is beyond my imagination how far it can or cannot go. It could do very well, or it could falter. I am not sure. That's not my game. But I can lay down the numbers. 

Lyft had revenues of $343 m in 2016. They became $1 b in 2017, and $2.1 b in 2018. That's a massive increase. But the business incurred losses in operations: $693 m, $708 m, and $978 m. Markets say it is the nature of the business like any other high growth start-up. 

The business is not using much of capital. It had $3 b in cash, marketable securities, and restricted cash as of December 2018. But it will need a lot of capital going forward. Because it is losing cash every year: It has been losing over $500 m each year (2016 to 2018). For 2018, this is despite $625 m positive cash flows from changes in non-cash working capital.

We haven't got a firm hold of numbers since operating profits and earnings per share are both negative. It has had low capital spending: $71 m for 2018, and much lower during the previous two years. It acquired Bikeshare Holdings (Motivate) for $250 m, and spent $300 m on research and $352 m on advertising in 2018. That's a significant portion of revenues. There are no free cash flows yet. 

Where do we go? Easy, look at the pricing multiples. 

If we price Lyft based upon revenues: For $20 b valuation, it will be 10 times revenues. That will come down to 8x if revenues increase by 25% next year, or 6.67x if they increase by 50%, and so forth. Pricing always gets interesting.

If we choose riders: The price per rider will be $667 for the $20 b Lyft. The catch is Lyft had 18.6 m active riders. The the price per active rider will be $1,075.

How about pricing based upon bookings? 

Lyft at $20 b = 2.5 times its 2018 bookings. Cool.

There were 241.614 m shares outstanding after conversion of preferred shares as of December 2018. If we round off and consider 250 m shares, the expected IPO price will be $80 per share to get that $20 b value.

Then you can juggle, and include the options (6.828 m) and RSU (31.605 m) outstanding, and come up with 280 m shares; and the price per share will be about $70. If you include $2 b coming from IPO, the price will be $64 per share, with an additional 31 m shares being issued and totaling 311 m shares.

Lyft is a good business. But the question is at what price. That's the conundrum we face with every technology growth business, don't we?

real property, and tax

Here's the story. There was this ancestral land lingering for a long time. The house that was on the land was dilapidated. So the time was apt to do something about it. The family, finally after a long, long pause, decided to do something. 

They contacted a real estate developer, and agreed with the firm to release the land in their favor in exchange for a certain number of apartments. The developer would construct an apartment building both for residential and commercial purposes. Apart from the ones to be given away to the family all units would then belong to the developer. 

The family was keen to reduce tax, obviously. How the tax liability was to be estimated was a big question though. There was no specific reference to such transactions in the law. Neither was there any case study which was referenced in the past. At least this is what the tax consultants noted. Now what remained was how the transaction was actually interpreted: by the family, by the tax consultants, and most importantly, by the tax authorities for assessment. 

What occurred to be a simple and straightforward deal was made out to be complicated. What did actually take place? An implied sale of the land for the consideration of market value of the apartment units given in exchange. None would agree to this analysis, though, especially if the tax liability increased.

Let us elaborate. Cost of land after indexation was negligible. So the capital gain was almost equal to the consideration given. The market value of apartments given away was at Rs.3,000 per sqft. Meaning, if the apartments were sold immediately after possession, the family would get that rate. That's a deemed and implied sale. 

1) 3 apartments of 1000 sqft each: 3x1000x3000 = Rs.9 m;

2) 1 apartment of 5000 sqft: 1x5000x3000 = Rs.15 m;

3) 1 apartment of 3000 sqft: 1x3000x3000 = Rs.9 m.

That's a total market value of Rs.33 m; and a capital gain of Rs.33 m. At 20% rate, the tax liability would be Rs.6.6 m. Net cash flow to the family would be Rs.26.40 m.

Because the deal missed one step of the transaction, it appeared to be complicated. Consider this: Step 1 was sale of land; Step 2 was receipt of Rs.33 m towards sale of land; Step 3 was purchase of 5 apartments totaling 11000 sqft at the market price of Rs.3,000 per sqt; that is Rs.33 m. If these steps were carried out, the capital gains would be Rs.33 m. Just because Step 2 and Step 3 were bundled together, the fact does not change, does it? 

Of course, the family is eligible to take deductions on account of the purchase of one apartment to reduce the tax liability. Everything else should remain the same. 

No wonder there is this perverse human character that takes pleasure in making simple things difficult. 

coke and pepsi

Coke or Pepsi, which is better? Both are lousy as consumer products. But I mean, which is better as a stock? Coke is worth $191 b, and Pepsi, $161 b. The Coke stock implies nearly 30 times its earnings, the Pepsi stock, 13 times. Why should Coke trade at a higher multiple than Pepsi? Is Coke growing better than Pepsi? Which business has a better return on capital and return on equity? Or is there a bias?

Coke has a better operating margin (20%) compared to Pepsi (16%). But I don't care much about operating margin. What I do care is return on capital. Pretax return on capital for Coke is 25%, and that of Pepsi is 30%. These are long term averages. The most recent values are 36% for both Coke and Pepsi. 

And I care as much about sustainable growth rate. The 5-year average growth rate in revenues for Coke is negative 7.43%, and the 10-year average is 0%. It had revenues of $31 b in 2008, and they were $31 b in 2018. For Pepsi, the 5-year average growth rate in revenues is 0%, and the 10-year average is 4%. It had revenues of $66 b in 2013, and they were $64 b in 2018. Pepsi's revenues grew 1.79% in 2018, and Coke's fell 10%. So much for growth rates. 

They have products that are not healthful, and there is no growth in revenues. Do we really want to talk further? Both companies spend considerable amount on advertising. But it seems that Coke is more desperate, for its average ad spending is 10% of its revenues compared to Pepsi's 4%. Yeah, Pepsi has more diversified products. 

When we capitalize advertising costs, the pretax return on capital changes to 27% for Coke and 31% for Pepsi for 2018. I am using pretax return on capital because of strange things that have happened in tax rates recently. 

Both companies are mature businesses and payout significant dividends. The 5-year average growth rate for Coke dividends is 6% and 8% for Pepsi. The 10-year average is 7% for both. 

Let's look at free cash flows. Pepsi had $6.75 b pretax cash flows for 2018, and Coke had $6.1 b. The 5-year average for Pepsi is $9 b and $6.79 b for Coke. For both companies, free cash flows have not been growing. In fact, they are falling. 

So again, why should Coke be priced higher than Pepsi? Is it because a prominent investor holds it and backs it? That's appears to be a stupid idea. But then we are not dealing with rational people.

I will start with $6 b as aftertax free cash flows for Coke and $6.5 b for Pepsi. Never mind these are much higher for Coke compared to its historical numbers. With these assumptions and a growth rate of 5% leading to a cap on the growth rate after a decade, we get similar values ($85 b) for both at an expected rate of 10%. 

Based upon free cash flows at least, the market pricing for both companies appears to be on the higher side. But my point is that Coke should not be priced higher but lower than Pepsi. And this has not happened for a long time. In fact, most of the time, the yearly low market value of Coke has been higher than the yearly high market value of Pepsi. That is bias, Coke being accepted as a more prestigious brand. But then who cares for the brand when the cash flows behind it do not justify the price? 

I am no fan of either, for I don't like their products. But it is time that the market realizes the potential of these companies, and prices them accordingly. 

amazon march 2019

I have written about Amazon before, and as I have admired the company as a disruptive business, I have never been impressed with its lofty valuations. Value of a business, after all, is the sum of its cash flows discounted at an appropriate rate. It is not anything else. Markets may have been overwhelmed by Amazon, but at the end of it, its value is driven by its cash flows. 

In 2008, Amazon had free cash flows of $773 m. In 2012, they were negative $640 m due to higher capex. In 2015 and 2016, Amazon's free cash flows were over $4.5 b. Just when we thought the business will generate consistent cash flows, we had a surprise. In 2017, because of $13 b Whole Foods acquisition, cash flows were negative $11 b. For 2018, it had $9.8 b of free cash flows. They have been quite erratic as they usually are for a growing business. We have a conundrum: What are the sustainable free cash flows for Amazon? Last 3-year average is $1.1 b; 5-year average is $1.5 b. If we ignore 2017 as an exception, the 3-year average is $6.5 b. Heck, we at least need a starting point. 

I am not much of a story person. I need the business to tell me the story rather than me weaving one. The total market value of Amazon's equity is $820 b. Let's assume that investor's expected rate of return is 10%. I don't want that cost of equity shit. If I want 7% return, I will go to the S&P-500. With that out of the way, we need two more variables. One is the free cash flows, and the other is its growth rate. 

I will be an Amazon bull - which I am not - just for fun. Let's start with the beginning free cash flows of $9.8 b. Let's keep the growth rate high at 25% over each of the next 5 years, which means they will be about $30 b in year 5. I have estimated free cash flows aggregating to be $325 b over the next 10 years. For the record, they totaled $12 b in the last decade. Keeping the stable growth rate at 2.5% after year 10, I have put a break on optimism. Amazon had cash equivalents of $41 b and book debt of $32 b as of December 2018. But, it also had lease debt of $23 b which are off balance sheet because of some funny accounting rules. When I use these numbers as valuation input, I get a value of Amazon's equity much lower than its current market price. That's something to note because I have used high free cash flows as a starting point along with high growth rates.

May be one thing I missed was using high perpetual growth rate. Here's is the thing: If we used 6.5% as growth rate in free cash flows as perpetual, we get to its current market value of $820 b. The present value of Amazon's free cash flows at this growth rate is only 20% of its total value. The bulk of its value is coming from the stable growth (perpetual) period. If we start with lower cash flows as base, we will have lower value. Obviously if we keep the growth rates lower, we have lower value. 

I am amazed that Amazon continues to be priced by the market at such lofty expectations. You cannot buy an asset for its future price. The time value of money will tell you that. And yet...

Of course, when we do adjustments for lease debt, advertising costs, and technology costs, Amazon's operating margins, return on capital, and return on equity look good. But you need cash flows to value its business, and they aren't good enough at its current market price.

In March 2013, I thought long term thinking was doing good for Amazon (market value $120 b). But in February 2014, I asked, how long is long term ($160 b). In May 2015, the question was, when's the money ($200 b). In September 2015, I noted the price and value mismatch ($235 b). In July 2016, I compared Amazon with Berkshire Hathaway, and continued to ask, where's the cash ($347 b). In March 2017, I noted that when Amazon's market value hits $600 b Bezos will be the first $100 b person ($427 b). By August 2017, I talked about the hype ($474 b). In October 2017, I looked at Amazon's q3 numbers ($525 b). In February 2018, Amazon was worth $695 b, and Bezos $100 b. In August 2018, Amazon was worth $908 b as I compared it with Apple. 

Every time I try to value Amazon, I am far from meeting its market price, and I have been wrong in expecting its price to fall. Now Amazon is worth $820 b, and I say the same thing: that Amazon is expensive compared to its cash flows.

Amazon had revenues of $232 b for 2018, an increase of 30% over 2017. North America accounts for 60% of it, and Amazon Web Services, 11%. There was a marked improvement in operating profits for the North American (retail) segment though.

Nevertheless, AWS accounts for much of the operating profits, and the international segment continues to suffer operating losses. AWS has been very profitable and is growing faster than retail. As such, it would be better to look at AWS as a separate business, and value it independently.

There were 2 acquisitions in 2018: Ring for $839 m and PillPack for $753 m. Technology and content costs were $28 b. Amazon is still a growth company, and for that it needs a lot of capital. The key is how much free cash flows it will be able to generate in the next decade. It is a disruptive business, it is a fantastic business. But then it is also richly priced; and it has always been like that.

the tata group

The executive chairman of Tata Sons said recently, "we have moved away from fixing to focus on growth".  I have not dug deep into the context behind the statement. What I know is that just physical growth will not contribute to value. That has to be accompanied with consistent excess returns. Value creation to shareholders is the primary focus for managers of any business. Their duty is only towards their owners; everything else is incidental. But the chairman knows better than we do. 

The Tata group sells from salt to trucks, covering the entire gamut of consumption. There are 17 companies listed on the stock markets, and have a total market capitalization of Rs.10,401 b ($148 b). In addition to these companies, there are many private organizations - including not-for-profit - set up to serve the society. With more than 700,000 people, the group is probably the largest private employer in India. That is commendable. 

This post analyzes only the publicly traded entities within the group. These 17 companies have total revenues of Rs.6,496 b and total earnings of Rs.560 b (March 2018). That implies the group is priced at an earnings multiple of 18.55. Although price-sales multiple is not the best measure - enterprise value to sales is better - 1.60x seems quite interesting.

Yet when we look a little closely, we can note some peculiarities. Consider this: Just one company makes about 70% of the group's market value. With Rs.7,185 b market cap, TCS stands singular. It is a little hard to believe that the rest of the group - 16 publicly traded companies - are only 30% of value, and are collectively worth only Rs.3,216 b.

One of the most important measures of how well a company is managed is the return on capital, and TCS stands out with stellar performance. It also generates large amounts of free cash flows. Titan also has superior return on capital over the past decade. But then market's inconsistency in pricing equities is evident: TCS contributes (Rs.258 b) over 45% of the total earnings of the group and Titan (Rs.11 b) only 2%, and yet, TCS is priced 27x and Titan 81x earnings. This is not to say that only earnings matter for pricing stocks; what I mean to say is that Titan is richly priced as of now considering its growth prospects and return on capital.

Tata Motors revenues for 2018 were Rs.2,954 b (over 45% of total group revenues) and earnings were Rs.89 b (over 15%); similarly, Tata Steel too had significant revenues and earnings for 2018; but both are priced less than 6x their earnings. For Tata Steel it is understandable because it is in the cyclical business, and its average earnings over the decade have not been impressive, and we are never certain about timing of commodity cycle. For Tata Motors, the situation is different; having had some good times through Jaguar, Land Rover in the past few years, with slowdown in JLR business in its key markets, the business is faltering. A large amount of capital is required for its ambitious electric vehicles project, and it is not coming through easily. We are not sure if those revenues, earnings, and more importantly, free cash flows are going to be large enough to price its equity. At the moment, though, Tata Motors is worth just Rs.519 b. 

If return on capital is less than cost of capital over a long period of time, it is not possible to have free cash flows. No excess returns, no free cash flows. Tata Steel and Tata Power have failed in this test. Tata Communications is worth Rs.147 b, and its performance has not been impressive either. Tata Chemicals showing has been deteriorating over the past decade.

Tata Global Beverages and Tata Coffee, both, have not had decent growth. Their return on capital has not been good. Tata Global is priced at 24x earnings (Rs.119 b), and Tata Coffee at 14x earnings (Rs.15 b). They may well have potential going forward.

Voltas growth numbers haven't been good, but it is priced about 30 times earnings. We haven't got much to say about Indian Hotels which is priced rather rich and is worth Rs.165 b now. Trent has low return on capital and free cash flows over the past decade.

Tata Elxsi and Tata Metaliks are performing well, but aren't big enough to make meaningful contribution to the group; yet. Tata Sponge and Nelco are collectively priced only Rs.15 b, and aren't the best performers.

For 2018, TCS, Tata Motors, and Tata Steel contributed about 85% of the total group revenues and earnings. In July 2017, I noted what would happen if TCS falters and JLR slows down. Well a little over a year, and TCS is doing fine, but JLR is actually faltering.

Yes, the Chairman is right, the group needs growth. But growth requires capital for reinvestment, and more importantly, for growth to create value, it has to show excess returns. Superior return on capital and free cash flows.

Tata group, no doubt, is a significant contributor to the Indian economy and society. It intends well and means well. With the change in focus, we are confident that the group will emerge stronger than before. 

adag, and market inefficiency

reliance power

Reliance Power operates power plants and is also involved in distribution of electricity. In early January 2008, Reliance Power came out with an initial public offering primarily to fund its power projects across the country. In February 2008 the stock got listed, opened at a high of over Rs.500 per share, but closed the day at just over Rs.370. This was the largest IPO at the time which collected over Rs.115 b through issue of 260 m shares. During February and March 2008, the stock price saw a high of Rs.599.90 (BSE) and a low of Rs.303 (NSE). 

To make up for the loss, the company issued bonus shares to all the minority - that excludes promoters - shareholders in the ratio of 3:5. That makes the high price adjusted to bonus to Rs.375 and low price to Rs.189, and the market capitalization of the business to Rs.905 b (high) and Rs.457 b (low) in 2008. As of now, the stock is trading at Rs.10.75 and the market cap is Rs.30 b. That's a colossal loss. The promoters own 75% of the business, and over 80% their shares are pledged. 

It was generous of the chairman to give bonus shares to the shareholders when it was clearly not required. If the shareholders thought the business was good enough at Rs.450 per share, they would have got their expected rate of return, never mind the blip in the stock price. That the issue price was too high was something investors had to check for themselves. Even the timing of IPO wasn't considered right which had the makings of the global recession. However, the long term fall in stock price is not attributed to these events, but the business itself.

reliance infrastructure

Reliance Infrastructure is involved in power plants, metro rails, airports, bridges, and toll roads. The company acquired BSES in 2002 and sold its transmission business in Mumbai in 2018. In January 2008, its stock traded at Rs.2,485.75; that was nearly Rs.600 b for all equity. Now the stock price is Rs.112.30 and the market value of equity is Rs.29 b. Down 95%. The promoters own about 48% of the business, and over 80% of their shares are pledged. 

reliance communications

Reliance Communications emerged from transfer of telecommunications business from Reliance Industries on a going concern basis, and it shares were listed in early 2006. In January 2008, the stock was priced nearly Rs.800, and the equity was priced over Rs.1,500 b. It is trading less than Rs.6 per share now, and the equity is worth Rs.15 b. Down 99%. The company has filed for bankruptcy this month as there have been too many hiccups in its attempts to sell assets to repay its enormous debt. The promoters own about 53% of the business, and 30% of their shares are pledged. 

reliance capital

Reliance Capital is a financial service company operating in asset management, mutual funds, stock broking, wealth management, insurance, and finance. In January 2008, the stock was trading at Rs.2,762.60, and as I write this post in February 2019 it is quoting at Rs.136.50. The market value of its equity has fallen 95% from Rs.678 b to Rs.35 b. The promoters own about 52% of the business, and 75% of their shares are pledged.

reliance naval 
Reliance Naval & Engineering is into shipbuilding business. After Reliance Infrastructure acquired 17.66% stake in Pipavav Shipyard in March 2015 for $130 m, it came out with an open offer, and the ownership now stands at about 30%. The company operates as a part of the ADAG group.  In August 2010, the stock was trading at Rs.116.20 and in December 2015, at Rs.100.25. The market cap has changed from Rs.77 b to just over Rs.6 b. Down over 90%. All of promoters shares have been pledged.

reliance home finance
Reliance Capital owns 48% of Reliance Home Finance, and the total promoter holding is 75%. As it was spun out of Reliance Capital in September 2017, each share held in Reliance Capital got a share in Reliance Home Finance. The stock price has fallen from Rs.107.20 (September 2017) to Rs.24.30. That's reduction in market cap of 77%. The company is worth about Rs.12 b now.

reliance nippon life
Reliance Nippon Life Asset Management is owned by Reliance Capital (43%). In January 2018, the stock price was Rs.318.30. As of now, it is 50% down and the market cap of the company is Rs.96 b.

The promoters ownership has proportionately fallen to Rs. 115 b as of February 2019.

Like we noted the long term fall in stock prices is not attributed to any macro events, but the businesses themselves. For whatever reasons many of the businesses have been dealing with unmanageable debt, and as is their wont, the markets have also punished those that should not have been.

Nevertheless, such a steep fall in stock prices appears to be unwarranted, and this might be an opportunity for investors having faith in the management. A decade and more, these businesses should come out of their problems and emerge good. But then again such contrary views require bold moves, and also depend upon the opportunity costs. 

tata motors, and jaguar, land rover

The market value of Tata Motors equity was Rs.575.954 b as of yesterday. As I write this post, while markets are still open, it is down to Rs.472.066 b. That is an 18% fall. 

The company has two types of shares: 2,887.348 m ordinary common shares and 508.502 m differential voting rights shares. The DVR shareholders are entitled to one vote for every 10 such shares held and dividends of 5% more than that are entitled to the ordinary common. However in the absence of any dividends distributed to the ordinary, there will be no dividends for the DVR shareholders. 

In June 2008, Tata Motors completed its acquisition of Jaguar Land Rover business from Ford Motor Company at a net consideration of $2.3 b in an all-cash transaction. The acquisition was on a cash-free, debt-free basis, but, Ford contributed $600 m towards the pension plans. In November 2008, Tata Motors market cap was at a low of Rs.65 b (less than $1.5 b at the 2008 exchange rate). That itself should have made the consideration over the top. But the chairman had said it was a momentous time for all at Tata Motors. Another Tata company, Tata Steel, had just acquired Corus for $12 b (608 pence per share against the original offer of 455 pence) in 2007. So the group was in an acquisition binge.

But then in 2008, JLR was losing money. Surprisingly, Ford had failed to monetize JLR. The financial crisis and subsequent recession meant demand for luxury cars (Jaguar) and SUVs (Land Rover) was slowing down. Confidence in the credit market was the lowest. Borrowers struggled for credit, and lenders were worried about defaults. The combination was unusual because Tata Motors was in the mass segment and JLR in the premium segment, and the synergy seemed to be out of place. For the first financial year after acquisition (March 2009), Tata Motors posted a net loss of Rs.25 b. The company also ended up with debt of Rs.219 b. 

Raising cash was a priority for Tata Motors. The sale of 1.3% holding in Tata Steel to the parent, Tata Sons, for Rs.4.85 b and a rights issue of Rs.41 b was not much compared to the capital needed. A turnaround in JLR was what was required.

And what Ford could not do for years, Tata Motors did in two years. Earnings for 2011 were Rs.92 b; for 2012, Rs.135 b; and for 2013, Rs.98 b. The catch was that Tata Motors local business wasn't doing well. In fact, it posted huge losses in 2015 and 2017.

JLR was turned around all right. But there was a cost to it. A good business is one which earns a high rate of return on its capital employed, and does it consistently. In this respect, we don't think Tata Motors standalone has been doing well. Tata Motors consolidated earned about 15% on equity for 2018. But then that was largely due to contributions from JLR as we have seen. Both revenues and earnings from JLR have been disproportionately large compared to the consolidated numbers. Whether it will continue in future is a question.

Tata Motors has poured in billions of dollars in JLR since acquisition. Yesterday when it released its 3rd quarter results (December 2018), the markets had a surprise. The company said that the carrying value of its capitalized investments were brought down by 3.1 b euros ($3.5 b). When the assets are not expected to bring enough cash flows to justify their carrying values, they are brought down to the level equal to the present value of future cash flows, and such impairment is taken to the income statement. This is a non-cash adjustment that does not affect the statement of cash flows. Yet, the indication is the JLR business may not do as well in future. One of the primary reasons has been slow down in China which was its biggest market. Tata Motors reported Rs.269.61 b loss for the quarter. JLR reported a net loss of 3.1 euros implying no profits even before this one-time impairment loss. The standalone business reported a profit of Rs.6.18 b.

JLR has announced plans to come out with electric vehicles on all models. It will require a lot of capital for investment though. Tata Motors domestic business is doing better than before. Time will tell whether each business will be able to justify the capital invested. For that to happen they will have to show high return on capital and generate large free cash flows on a consistent basis. We hope that the group will be able to wither the past and come out on better terms.

the purchasing power, and its parity

The long term purchasing power of an individual depends upon two things: earning capability and inflation. The time value of money tells us that a dollar today is worth more than a dollar earned a year hence. There are at least 2 reasons for that: inflation rate and uncertainty. If you want to borrow a dollar from your friend, your lender friend will look for compensation in terms of inflation. If you go and ask money from the market, however, the lenders will look for compensation in terms of both inflation and uncertainty. They will perceive present as sacrosanct, and future as uncertain. And because their money is only going to come in future, they will seek compensation for that. Consequently, the interest rate implied on the debt will include 2 elements: Inflation rate and a premium for default which represents uncertainty risk. 

Inflation is an implicit tax on every person's cash flows. If $100 is kept under a mattress for a year, and inflation rate during the year is 5%, the purchasing power of $100 is reduced to $95. That is why mattress is not a great idea, and it is important for the investor to at least make returns equal to the inflation rate. This will keep the real returns (the purchasing power) in tact.

The same rule applies to the exchange rates under the purchasing power parity. The exchange rates of currencies are determined by markets based upon their demand and supply. Both demand and supply depend upon a variety of factors. As of now the Indian rupee is trading at about Rs.71.50 per dollar. By end of 2017, it was Rs.63.84. These are of course determined by the free market. 

However in the long run, fundamentals of the country will take precedence, and the exchange rates will settle based upon those factors. Under the purchasing power parity, the exchange rates are influenced, therefore determined, by the long term inflation rates in the two countries. For instance, let us begin with the 2017 exchange rate of Rs 63.84 per dollar. If the long term inflation rates of the US and India are going to be 2% and 6% respectively, in the next 5 years the exchange rate should settle at Rs.77.38. That represents the rupee depreciating about 4% each year against the dollar. 

As of now, the US is the biggest economy with a GDP of $20 t, and China is behind with $12 t. India's GDP is $2.6 t. But when we apply purchasing power parity to the GDP, the numbers change drastically. China becomes number one with $26 t GDP, then the US ($20 t), and India comes third with $9.5 t. That is because instead of using market rates, we apply inflation-adjusted rates to the currencies. 

The purchasing power parity theory compares the two currencies using a basket of goods and services, and concludes that the cost of an item in country A should be the same in country B in real terms. And the real values are calculated after removing inflation components attributed to them. The idea is to include a variety of goods and services, instead of one or two items, that are representative of the economy. 

If the price of a pizza is $10 in the US and Rs.500 in India, the PPP exchange rate would be Rs.50 per dollar, considering both pizzas of equal quality. While market exchange rates are also influenced by factors not fundamental to the economy, such as perceptions and bias, PPP rates are considered more intrinsic. 

As easy way to calculate the PPP rates between the two countries is to look at their PPP and nominal GDP. Here's how it is done: We know that India's GDP is about $2.6 t. At the prevailing exchange rate of about Rs.70, that is Rs.182 t. We also know that in terms of PPP it is $9.5 t. That means the implied PPP exchange rate is Rs.19.16. In 2017, it was about Rs.17.74; in 1990, it was Rs.5.76; that implies over 27 years the inflation differential has been about 4.25% which appears to be fair. 

One thing comes out clear: The market exchange rates are not useful all the time. 

index investing 2

Whenever I am asked for advice on investing, I recommend the broader index. I never suggest individual stocks to anyone. For the most, picking stocks is more of arrogance than of skill. Everyone is up to beating the index. Although many mutual fund managers in India have been able to beat the Nifty-50 index, they may not be able to sustain that performance over many years. Even otherwise, for individual investors a simple Nifty-50 index should be sufficient. 

Index funds have not been that popular in India mainly because at the moment many mutual funds have been able to beat the index. They aren't available at cost as low as they do in the US. Despite that I can argue, individual investors should do well if they stick to the index over the next decade or two, or more.

There are 3 things that one should check before one invests in the index. It should be liquid enough to be able to buy and sell at any time. For that to happen, the assets under management should be as high as possible. Their expense ratio should be as low as possible, and why not when there isn't much to do for the manager other than tracking the index? Finally, the tracking error of the fund should be low. The returns from the fund should be able to tell us how closely it is able to track the index. 

In India index investing comes in 2 forms: Index funds and Exchange traded funds (ETF). Index funds let you invest with the fund house, either directly or through brokers (regular plan). ETFs are like stocks traded on the index. You can buy or sell as low as one unit as you would buy or sell stocks. However, index funds usually have minimum amounts to be invested. 

I have listed down 4 ETFs and 4 index funds mainly based upon their assets size. 

These funds are compared with the Nifty-50 total return over the periods selected. Among ETFs, Niftybees offers better liquidity although SBI ETF Nifty 50 has much higher assets under management. Other than that all ETFs have given more than 15% over the 3-year period; more than 12% over the 5-year period; and Niftybees has given more than 16% over 10 years. More importantly, these ETFs aren't too bad in tracking the total return of the Nifty-50 index. The same is true with the index funds. 

Consider this: how many individual investors can boast of returns over 15% over the last 10 years? This boring strategy of picking the index and sticking to it has been quite good in the past decade. We cannot predict how much it will return in the next decade, but suffice to believe that the return should be quite satisfactory. 

What is imperative is to choose the index fund or ETF, and then stick to it for a very long time. Throw the money each month irrespective of the market levels. And this is the best part of the index investing: pe ratios or pb ratios don't matter; implied equity premiums don't matter; whether the market is overpriced or underpriced is irrelevant for the investor. As the investing horizon gets longer, the risk in expected returns gets lower.

Invest in the index, and move on with life. Do what you enjoy instead of fretting over expected returns. The index will take care of your financial needs. Isn't that cool?

biggest markets forecast

According to this report by Standard Chartered, emerging markets will flourish by 2030, and the US will be the third biggest in terms of GDP measured using the purchasing power parity.

As of now, China is the leading economy with $26 t GDP measured in terms of PPP, and the US comes second with $20 t. India is much ahead ($9.5 t) of Japan ($5.4 t). So the three leading economies will still likely be the same.

market exchange rates

The current GDP of the US is about $20 t, and it has never grown more than 3% since 2005. If we assume 2.5% growth rate, the GDP will be $26 t by 2030.

At the prevailing exchange rates, the Indian GDP is $2.6 t. If it grows at a respectable rate of 7.5%, it will barely reach $6 t by 2030. Even a 10% growth rate will not take the GDP to more than $8.5 t by that date.

Now for China, from the current $12 t, the GDP will grow to $21 t at a rate of 5% over the 12-year period. 

Based upon the market exchange rates, though, the US will still probably be the biggest economy followed by China and then India.

Someone said, it is difficult to forecast, especially about the future. Time will tell us the reality, but until then, what's the harm in fooling around?

indusind bank q3

IndusInd Bank has moved down more than 2% as I write this post subsequent to its December quarter reports. While I don't care much about the day-to-day market prices, let's us have a look at how the bank has performed during the quarter, and how I feel about the stock. 

With 602 m shares outstanding and the stock quoting at Rs.1601.75 as of yesterday, the market cap of the bank is Rs.964 b. It earned Rs.9.85 b during the quarter. The net interest margin of 3.83% has not changed much compared to the previous quarter; but it is way down from the March 2018 margin of 3.99%. The casa ratio of 44% has remained steady all through the quarters. The cost to income of 43.65% has improved; in March 2018, it was 45.65%. But the cost of funds has gone up to 5.81% from March 2018 (5.03%). 

The true test of banking business is its loan book, its growth rate, and quality of that book. IndusInd bank's advances have increased more than 19% from March 2018. That implies an annual growth rate of 25%. The bank had gross npa of 1.14% and net npa of 0.59% which is remarkable for the private lender considering the current circumstances. In fact, the net npa (percent) has remained quite steady during the last four quarters. Restructured advances were Rs.1.86 b as of December 2018. 

The book value per share stood at Rs.438.48. But that is not the correct measure of the bank's equity. After adjusting for all stressed assets, the book value is Rs.418.30 per share. Now to price the stock, we can pick a multiple; and the expected rate of return for the investor will depend upon that multiple. 

Let's keep the investment period of 3 years and annual loan growth rate of 20%. At a price-book multiple of 2, investment return over the 3-year period is going to be negative. The bank probably deserves a better rating considering its growth rate and quality of assets. At 2.50x, the expected rate of return is a little over 4% which is not much. At 3.5 times book, the expected rate of return is more than 16%, and at 4x, it is more than 21%. We can play with the multiple, but if we consider 3 times book as fair, the investors stand to make about 11% on the stock over a period of 3 years. Whether 11% is good or bad depends upon the individual investor's own opportunity costs. 

For any bank, capital is key to its growth expectations. Any increase in advances will have to be matched by increase in equity capital. IndusInd bank's Tier 1 capital is quite fine at 13.78%. A growth rate of 20% should not be too difficult for the bank considering the superior quality of its assets. The bank's return of assets and return on equity are pretty decent too. 

IndusInd is a well managed bank; but then to buy at its current price, the expected rate of return will have to be modest.