where're the market fundas

Nifty ended at 7812 on 22 Sept 2015; It had a 52-week high of 9119.20 and a low of 7539.50. This is a broader market, and might appear to be a buying opportunity for those who feel that way. 

It is also trading at 21.65 times earnings and 3.15 times book value. The earnings multiple is higher than the long term average of 18.60; however, lower than the book value average of 3.56. Not a close call, though. 

I did mention in my previous post that the market at levels (7785.85) it was, did not interest me much. In fact, I found it to be expensive. How about now, after just a few days?

I will make it short. Value of an asset is a function of its cash flows, growth and risk in those cash flows. Stating the obvious, the higher the growth, the higher the value. It is not just the physical growth that drives value, but the excess returns from growth. Growth can achieved in two ways: through new investments and through efficiency in current investments. The former leads to higher reinvestment at current return on capital, and the latter leads to higher return on capital without additional capital. The current market fundamentals do not give a picture of better future: The growth rate of Nifty at the moment is less than 10%, which was never there in any of the last 15 years barring a few days in March-April 2003. The return on equity is less than 15%, which is also one of the lowest.

Considering the above, it is hard to conclude that the market is a bargain. This of course is the current view. If the corporates make an effort to increase earnings and return on capital in the coming years, the tag line of good years ahead can be apt; otherwise, we are going to have a period of wait.

too big to fail banks

The RBI has designated SBI and ICICI bank as (domestic) systemically important banks. This would mean if these banks fail, there would be financial crisis and chaos in the country, impacting India's economy and its growth prospects. Why only these two and not other big banks can only be answered by RBI which has done the selection based on the systemic importance score, which takes into account the size, complexity and alternatives in the event of a crisis. 

The consequence of designation is that these banks will have to maintain equity capital in excess of the regulated norms for other banks. This is 0.60% for SBI and 0.20% for ICICI bank to be achieved in a phased manner by April 2019. They will also be subjected to much closer supervision, whatever that is.

The minimum Tier 1 capital ratio to be maintained as per Basel III norms is 7% as of March 2015, and 9.50% as of March 2019. While this is the minimum requirement, a prudent bank would have higher (internally) regulated equity capital ratio. While some may argue that it comes at the cost of growth, we can counter that with: growth for its own sake is no good; this is especially so for a bank. 

ICICI bank is in a comfortable position even when we set the Tier 1 capital ratio not at 7.20% as required for being a systemically important bank, but at 9.70% that is required by 2019. As of March 2015, its Tier 1 capital ratio was 12.79%. With the assumption of this ratio reducing gradually to 12% in the next five years, risk-weighted assets moving from Rs.5.5 trillion to Rs.9.7 trillion by 2020, and return on equity coming down considerably from 16.02% to 11.01%, ICICI bank should be able to generate free cash flows and payout dividends without raising further equity. Of course, Ms.Chanda Kochhar has indicated that the bank is not expected to raise fresh equity for the next couple of years; this indicates that the growth rate she is targeting is higher than what I have assumed in my estimates. Higher growth rates require higher reinvestment, and therefore may prompt external equity. 

The same cannot be said of SBI, which is a much bigger and more important bank. Although, it has a comfortable Tier 1 capital ratio of 9.49% (March 2015), due to its higher assets base it would require immediate fresh equity if it aims for growth. With the assumption of Tier 1 capital ratio increasing gradually to 12% in the next five years, risk-weighted assets moving from Rs.16 trillion to Rs.26 trillion by 2020, and return on equity coming down marginally from 11.53% to 10.98%, SBI would not be able to generate free cash flows in any of the next five years. It has to aggressively seek fresh equity of Rs.180 b, or grow assets at lower rates. Obviously, SBI won't be able to payout dividends unless fresh equity is raised; and even that would mean you take from shareholders and give it back to them; not much fun. However, if one shareholder supplies capital, it would be welcome. For minority shareholders, equity dilution is better than their entire capital at risk. And the good news is that the government is planning to give Rs.50 b to SBI soon, and has plans of Rs.700 b of equity infusion by 2019 in public sector banks.

In fact, all banks are big enough to fail and cause damage. The key, however, is to operate such that assets wouldn't have to be categorized as non-performing or bad, or to be written off. We don't want banks to continue to be in that vicious cycle.

Current times aren't too good for banks. Bank Nifty has been hit badly.

And SBI and ICICI bank stock prices have hit 52-week lows. May be the shareholders can take solace in Horace and say, many shall be restored that are now fallen...

is it time to buy now

Markets have been crashing all over. 

We can probably talk more freely about one market than other. Nevertheless, I know for a fact that in the short term, markets make a lot of mistakes; call it irrationality, rather than efficiency; yet, in the long term, they reason, and prices move towards value. 

Therefore, before we ask ourselves what to do with the current markets, we should take a deep breath, if that's what makes us more comfortable, and then ask whether there is any value here. Value is driven by cash flows, growth and risk in those cash flows. So we should ask whether any of the events taking place at the moment would have a long term impact on cash flows, growth and risk. Generally speaking, when we talk about the broader markets, short term events do not have the tendency to impact long term events; that is to say, generally in the long term, markets move upwards because corporates and countries grow.

Considering this, investors can continue their periodic market (the broader index) buying operation; for not-stock-pickers, this should not be stopped in any event; they should continue this activity irrespective of market levels. However, when it comes to individual stocks, it is a different matter. The investors need to work on the long term economics of the business and its capacity to generate excess returns over long term. When they find significant gap between price and value, they should act with meaningful amounts. 

Let's come back to the broader markets again. Apart from the periodic index buying program, can investors buy into indices given that they are falling? The so-called experts have been doing the talking, since they like talking, asking either to sell for the fear of coming bears, or to buy for the pleasure of getting bargains. I wish they had sat quietly at their home and executed those orders for themselves, and made themselves richer; I guess, they are too scared to do that. Prediction is a game nobody is good at; yet not many are able to accept this fact; they want attention and activity in their life.

For the moment, let's check out the Indian markets. How good or bad are they for an investor? Both Sensex and Nifty have had a free fall since the last week of August 2015. On 3 Aug 2015, Nifty was at 8543.05; and on 1 Sept 2015, it is at 7785.85; this is a fall of 757.20 points.

In the usual talking terms, Nifty is trading at a PE of 21.57, PB of 3.13, and dividend yield of 1.52%. Current PE multiple is definitely higher than the long term average, although it has not reached the previous highs.

There is another variable that we can use to check where markets stand, and that is the equity risk premium. Based on this, although it is better priced than July 2015, I find that current market level is one of the expensive ones on historical terms. Of course, that it is not like Jan 2000 and Jan 2011 is a consolation.

In short, I would not want to make significant investment at current levels. I would like to see the fall of 757.20 points in the right perspective, i.e. an 8.86% fall; and it is not good enough to invest other than on a periodic index buying program.

what do you want - linear or non-linear

This is what we saw over the weekend:

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

This is what we are seeing now:

Investors are fearful about prospects in China.

And they are fearful about India too:

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

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

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

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

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

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

loans, dividends and dilutions at banks

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

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

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

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

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

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

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

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

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

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

marico's 5-pointers

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

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

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

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

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

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

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

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

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

dabur's $8 b portfolio

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

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

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

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

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

Consumer Care is FMCG business in India.

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

Dabur Health Care includes: Chyawanprash, Honey and Glucose. 

Dabur Digestives include Hajmola and Pudin Hara.

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

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

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

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

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

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

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

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

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

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

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

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

Simple, play the waiting game.