hdfc bank, where can it go

HDFC bank's market value of equity was Rs.367 b in 2007; it was also available for Rs.198 b in the same year. Now, the whole bank is worth Rs.4750 b. That's a massive change in fortunes. And there is a reason for that. Earnings per share has increased from Rs.7.15 to Rs.59.52 during the period, even after accounting for dilution. Check this out: the number of common shares outstanding increased from 1.59 b to 2.56 b, adjusted for a 10:2 split in 2012. 

Market share has been steadily increasing. More importantly, the bank has been managed exceptionally well by Aditya Puri and his team. Book value per share increased more at the rate of 24.42% annually during the last decade. Mere increase in book value is meaningless if do not consider how good the book equity is. And that is measured by the quality of its advances, which were at Rs.5854 b, and  increased at 28.7% annually. Gross NPA was 1.05% in 2017, and net NPA was 0.33%. Including restructured loans, net NPA was 0.43%; that is phenomenal. Compare that to ICICI and Axis in the private sector, have a look at the entire public sector banks, and we will get the picture. Its equity capital is healthy too, with Tier 1 capital at 12.79% in 2017. 

The bank has excelled in other parameters as well. Its return on assets was 2.09% in 2017. Net interest margin was 4.30%. Average CASA ratio was 48%, which makes its cost of funds lower. Cost to income was 44.50%. Return on equity was 20.53%.

The story has been so good for the bank that its investors have really reaped rewards. The low base of a newly incorporated bank, and the advantages of a superior management have been clear. But where does it go from here? Is there anything left for the new investors to achieve superior returns?

The problem is that a good quality company always commands premium valuations. HDFC bank's price-to-book was 5.71 (high in 2007) and 3.08 (low). During 2008, 2009, and 2010, it was available at less than 3 (low). Even during 2014, 2015, and 2016, it was available at less than 3 (low). The high PB was never more than 5 during 2009-2016. I am measuring the ratio based upon latest annual historical numbers, rather than projected book numbers. Now the bank is selling at 5.18 times 2017 book equity. From March to September 2017, the book value has increased making it lower than 5 probably.

With the mess that has been around in the public sector banks regarding low quality book, their need for fresh equity is imminent. And, with the digital push from the government, it is reasonable to expect that the market share of public sector banks will gradually diminish, and private banks will gain. HDFC bank stands to gain from two counts: one, because of the sectoral changes shaping the economy, and two, top class reputation. 

HDFC bank will grow; but we do not know by how much. It will also command superior valuations compared to its peers; but again, we do not know how much. The bank's stock was trading at a high value of Rs.1454 during the year ended March 2017. In eight months time, it is quoting at Rs.1854 per share, a gain of more than 27%. 

Should we wait for the declines, or should we buy in bulk for the next decade? Or, should be accumulate on a periodic basis, averaging out the cost per share? My guess in terms of the strategy and results, is as good as anyone else's.

amazon q3 2017

Amazon announced its third quarter financial results. And here's the thing:

For the nine-month period, revenues of $117 b comprise, $12 b of AWS, and $105 b of the regular Amazon. That is 40% growth for AWS, and 27% for Amazon. The operations include Whole Foods business post its acquisition.

Operating income was $1,979 m, of which AWS was $2,977 m. What's going on? Yeah, Amazon suffered an operating loss of $988 m. Ok, North America showed profits of $1,144 m, but with a margin of 1.66%. International operations have continued to lose; for nine months, it was $2.1 b. 

While revenues have been growing, its core operations have not been great, yet. I have to say yet, because, the markets are forever willing to bet on Amazon. Its stocks are trading over $1000 per share, making Mr.Bezos, the world's richest along the way. Amazon never ceases to amaze me. 

Let's move to cash, for that is what is counted. At the beginning of the period, it had cash of $19 b excluding marketable securities, and over nine months, it ended with a little over $12 b. That means, it consumed a net cash of over $6 b. This story is not that meaningful. 

So we go first to the operating cash. How much cash did the operations generate during the period? It was positive cash earnings of $6 b. So far so good; collectively, Amazon and AWS generated some cash. This cash belongs to both lenders and common shareholders. Before attributing it to the capital providers though, Amazon needs cash to feed its growth projects, and there are many of those. It consumed $7 b for its capital expenditure. Boom...that is all of operating cash, and some more; now it is short by $1 b. During the period, it also acquired Whole Foods for more than $13 b. Effectively, Amazon's operating business, which from now onwards will include Whole Foods, used over $20 b cash compared to $6 b cash accruals. That is a net negative cash of over $14 b. If we are willing to bet that Amazon will not venture into more acquisitions in future, we can exclude that $13 b as a one off item. The chances are that it will not be the case. Even when we spread that number over say, 3 years, it becomes $4.5 b of annual acquisitions cost. So average annual capital spending would be over $13 b. Put another way, Amazon will have to generate operating cash of over $13 b just to breakeven. To be fair, Amazon did generate $15 b and $17 b for the twelve-month period ended September 2016 and 2017 respectively. Also its earnings are understated due to expensing of its technology and content costs. If we adjust that, its earnings will shoot up substantially. I will come to that later.

But where do its capital providers stand then? Amazon has debt of $25 b on its books. It raised $16 b to fund Whole Foods acquisition. It had to, remember it did not have enough cash. It is another matter that for a growing company like it is, which does not have stable, sustainable cash flows to service debt, increasing debt is not a good idea. But, that damn thing called equity dilution is pervasive...

It is fair to say that Amazon does not have any free cash flows for its shareholders, yet. Yet is the word, for the markets expect the business to do extremely well in future.

There is a goodwill allocation of $13 b, which I am going to ignore despite the accounting anomaly, we have no other choice. And for discussions on how it is an anomaly, I will keep for another day.

Its operating business looks like this: Assets $92 b; liabilities $66 b; that's net assets of $26 b. Then there is cash equivalents of $23 b. Total capital is: $25 b debt; and $24 b equity. Annualized return on capital was 10%, and return on equity was a little over 6%. These are improved figures compared to the prior periods; so the Amazon story is building up, isn't it? 

Now, for equity investors the equation is like this: What kind of returns is the business going to give on its book capital of $25 b? For an expected return of 10%, Amazon operations should generate $2.5 annually, and growing based on retained equity. For 15%, it is $3.75 b.

These numbers are prior to the adjustments due to technology and content costs though. When this is done, both capital employed and operating earnings will go up, and therefore, return on capital will change. For Amazon, it should increase.

For new shareholders, it is a different question. With a total market capitalization of $525 b, what are the expected returns? Even when we apply 52.5 times earnings multiple, the business has to generate $10 b in earnings.

As noted earlier, there is one key adjustment to be made in all this analysis. Amazon spends tons of money on its research and development activities for which the benefits are going to accrue in future periods, but the entire costs are expensed in accordance with the accounting rules. It spent $38 b during the previous three financial years. For 2016, the technology and content costs were $16 b. These costs are to be capitalized ideally and a portion should be amortized each year based upon the number of years the benefits are supposed to accrue. Take your pick; but is Amazon really worth $525 b?

I come back to my original hypothesis: Is Amazon a hype, or is there something we have missed, and the markets have not?

quality stocks, what to expect

Recently a friend of mine forwarded a report presented by an analyst, who is quite popular in the investing community. It was about buying quality stocks and getting excess returns. The key points of the report were: Investors tend to use higher discount rates to bring the estimated cash flows to the present value. All high quality stocks trade at large premiums. And because of that, their expected buy price never comes across. As a result, they miss high returns over the long period. And therefore investors should instead use a lower discount rate. Then they will have a higher present value for their stock; and lo and behold, they can buy the stock, and make make higher returns for a long time. It appeared cool to many, and why not?

I was surprised after I read the report; it was an interesting thought indeed, except there was a catch. The whole idea of discount rate and expected returns was pushed apart, and how. I have written about expected returns in the past. Expected returns are never precise. The aim should be to increase the purchasing power over time, rather than asking for more than what is warranted. CAPM is great, but has its limitations. Although it starts with the right footing, it falters when we come to measuring risk in cash flows, and unnecessarily looks for precision. And so does the concept of margin of safety, which is both overrated and getting more due than it deserves. Perhaps I will have to do a more detailed post on both CAPM and margin of safety.

Value of any business is the present value of its cash flows over its lifetime. We need two things: Cash flows for the entire period; and a discount rate to bring them to present. Simple, profound, but a complicated affair. How do we know what cash our favorite business will throw until its liquidation? The size of cash flows and their timing have a significant effect on present value. Therefore, our estimation task is futile to that extent. This is one reason why it is prudent to stick to businesses which are more likely to be stable over the period of our investment. Stable businesses tend to throw out stable cash flows; so our work is that much easier; but not as easy, because it still involves estimation.

If our cash flows estimation is getting difficult because the business is complex, or is subject to disruptions, or because of some shit, we cannot compensate it with either higher margin of safety (which all value investors do) or higher discount rate (which all other investors do). It doesn't really matter whether you try to eat shit with a spoon or hand, you are still eating shit. Most value investors don't get it.

Once we have our estimated cash flows, we need a discount rate. CAPM provides some framework on that, which is still the best tool available with us. It requires one adjustment though. Let's start with a risk free rate, and say that our investment returns will have to be higher than that. How much higher, is a great question. It is not volatility as measured by beta times equity risk premium. It should rather be based upon qualitative analysis and our own expectations. Short term volatility is investor's best friend for it helps in picking stocks at the right price, and then proves that often markets are inefficient. And yeah, beta is shit; period.

When our expected returns are 15%, we discount cash flows at that rate, and our expected returns will be 15%. In reality though it could be 10% or 25% because of at least two things: One, our estimated cash flows are wrong always. Two, markets can be more pessimistic or optimistic than our own estimates. The key point, however, is that when we expect to make 15%, we discount the cash flows at 15%, not 10%. This is the flaw in the aforesaid report of the analyst.

The guy is making a point that we should discount the cash flows at a lower rate so that we can make returns higher than that over the period. How profound...

What I would do for a quality stock is what I do for not a high quality stock too. A business that is not high quality may have cash flows that are visible for a short period of time. Why shouldn't we use those cash flows and discount them based upon our expected returns over that (short) period? Why should we use lower discount rate for a high quality business when we want much higher returns?

The analyst missed another key point. It is to be able to play the waiting game. What you do is analyze the business, and have a rate of return expected from the stock; and then wait for the markets to offer you a chance to get that. If that means waiting for more time, so be it. There is another way to play this as well. If you think that markets are not willing to give in, and your patience is running out, you can lower your expected returns, discount the cash flows at that rate, and see if the stock can be bought at that price. Again, these decisions are made based upon quality of business and interest rate environment. When risk free rates are 5%, your expected returns can be lower than when they are 10%. Long term interest rates change the course of our expectations.

A better game to play is to check the implied rate of return in the market price, and see if that is suitable for us. If not, we have to play the waiting game, and rely on the market's histrionics. I do know that there are times when markets are too kind to us; and a better investor waits for such times of cuddling.

For quality stocks, we can use lower discount rates for minimum acceptable rate of return, and then say that anything higher is icing. What we cannot do is, use lower discount rate, and then say we want returns higher than that.

The truth is that markets set higher premiums for stocks as long as they remain high quality. That means what we should be doing is look for those stocks that are high quality in terms of business and management, and then discount the cash flows, which are usually large and growing, with a rate, which is higher than risk free rates. And, how much higher is again a great question...

investment in property

I have noted how property prices are a delusion as prices were firming up in 2012. Later in 2013 prices appeared too high compared to cash flows associated with them. And in 2016 I noted that rentals were not aligned with prices in India. Recently, someone asked me why I do not invest in property. This is what I said: 

There are two caveats before I begin though. First is that I am biased towards equities. Naturally, I will banish everything else. But then so is everyone; aren't all biased too? Second, I don't have an edge in the game. My knowledge on property market is limited; and I neither fancy nor am I interested any further.

There are at least five reasons why I don't deal with the property market. 

1) I buy assets based upon an intrinsic valuation that I carry out. For a real property, say an apartment in a building, the cash flows are rentals net of maintenance costs. As noted in my earlier posts, rental yields have been too low in India. With a 2% yield for instance, the investor will have to say a prayer if the expected returns, including capital gains, are to be reasonable. I do not indulge in hoped-based-only instruments. Of course, we need hope all the time in life; we always hope that everything goes well. But while investing, I feel better when the probability of earning expected returns, based upon analysis, is higher, and then coupled with some hope that prices will come along with value at some point. There is always some meaningful work behind hope. 

Dividend yields on quality stocks in India aren't too high either; less than 2%. Yet, I prefer stocks. The reason is that mispricing in equity markets helps us pick stocks at prices we like. I don't find such privilege in property markets. Inefficient equity markets are investor's friend. 

2) Investing in real properties is highly concentrated with no regard for diversification. Usually for me it is not a problem when I have to buy stocks because of the comfort level I get based upon my analysis helped by the price I get to pay. Absent such comfort, property market becomes even more dangerous. For instance, with say, Rs.20 m, I would rather pick five stocks than throw the cash for one single apartment. The hope-based investment becomes prominent, and you will have to desperately seek a greater fool for your expected returns. 

3) The liquidity in equity markets is another reason why I prefer them. It takes time to first find a seller, and then to find a buyer in order to complete a property transaction. Heck, it is too much of a hassle. 

4) Tax regulations are too kind to equities in India, where as of now, there are no taxes on long term capital gains. And dividends are, generally, tax free. The difference could be enormous compared to the property especially when the transaction value is usually large. 

5) Then there is the fifth reason why I don't deal with the property market. I do not know it yet though.

Beware that you can defy equity markets; property markets have the capacity to defy you. The game is on.

d-mart, goldman, and idiots

Goldman Sachs, recently, recommended Avenue Supermarts as a buy and set its target at Rs.1,586; it currently trades at Rs.1,086 per share. That's an upside of 46%; want it? 

The stock was priced at Rs.299 per share when it was offered for public listing in March 2017; but the euphoria was evident as it closed the day at Rs.641.60. Well, the exuberance has not evaporated, yet. 

At the time of the offering, the company was priced at Rs.187 b. At the listing date, it was priced at Rs.400 b. As of now, the market price of the company is Rs.678 b. And now, Goldman is pricing it at Rs.990 b ($15 b). 

When EBIT grows 13 times, and EPS grows 30% annually over 10 years, magic happens. Euphoria combines with exuberance. 

Let's do the math. EPS for the year ended March 2017 was Rs.7.67. I don't buy the shit about weighted average number of shares, and Rs.8.48 EPS as reported in the financial statements; those are as per the accounting standards. 

When EPS grows 30% over the decade, it will be Rs.105.75 in 2027. So, if we expect 12% return on investment, the stock has to trade 32 times its earnings in 2027 as compared to 141 times now. But who wants 12%? Let's ask for 15%; for that, the stock should trade at 42 times. For 20% expected return, the multiple rises to more than 63 times. For 18%, it is 54 times. We are nearly there; in a decade, the stock will have to trade at 54 to 63 times its then earnings in order for the investor to earn a decent return. 

It's a simple math; but where's the catch? Retail is a tough business. We have seen in the past how Walmart killed other retailers, and how the current times are so testing for its own business. Online retailing, and ecommerce are set to takeover in future. Can d-mart survive it? Nobody can tell now, but with some rationality, one can say that over 50 times earnings is too much to ask from a retail business. 

D-mart reinvested Rs.20 b in the last three years. If it has to keep pace with its growth estimates, reinvestment has to continue. When stories about the Indian demography, consumption, low base, high growth and so forth are told, the growth story has to be matched with the reinvestment story. During the last six years, the company has not had positive free cash flows to the firm; in fact, it had a cumulative negative FCFF of Rs.12 b during the period. Is that a surprise? If you want to open stores, you got to put the cash back. And if you fall short of internal cash earnings, you got to look outside for cash; and if that happens for too long, it is not going to be good. 

So how do we value d-mart based on its cash flows? As of March 2017, d-mart had Rs.19 b cash and Rs.15 b debt. Let's assume its after-tax EBIT (March 2017) is free cash flows; wishful thinking, but hold on. Some more wishful thinking: Let's say FCFF grows 30% annually over the next decade; and let's assume that it would reach to Rs.75 b in 2027. We will then have to value it based on an expected rate of return. 

If we use these high cash flows over the decade, and then apply a perpetual growth rate set equal to the stable growth rate, and discount them at 15% rate of return, we get a value of Rs.314 b for the entire equity. At 18%, it is Rs.217 b; and at 20%, Rs.177 b. 

Instead of using the perpetual growth route, if we apply a multiple to the 2027 free cash flows, we get a value of Rs.400 b for the equity when expected rate of return is 15%. At 18%, it is Rs.318 b; and at 20%, Rs.275 b.

Now compare the values to the Goldman's value of Rs.990 b. Also remember that we have had a fair dose of wishful thinking. We have plucked cash flows from nowhere. We have assumed high growth rates in cash flows for a long time. These two assumptions are quite powerful, and quite exuberant. And I have not even considered dilution through options, for d-mart has some options outstanding.

Will they all hold? I mean, come on...

But then again...if the stock can trade at 141 times earnings now, it can also trade at that multiple ten years later. So there is a strong case for the stock to trade close to Rs.15,000 per share in 2027. How about that? All the stupid men and women, hurry up, the stock is a screaming buy now...

value investors, india

I don't like value investors, and I have made it clear. I don't like money managers too, and I have made it much clear. There are self-proclaimed value investor communities in India, and do I have to say more about how much I loathe them?

There are groups of course, and each has sort of a leader, whom the members look up to and say, awesome every time the leader spits out something whether spoken or written. They tell stories, write blogs, and thus attract naive men and women. And then they find ways to make money for themselves by asking money from the naive to manage or through conducting teaching sessions, or something else. 

They talk about teaching investing to the public, and their own portfolio is created through mutual funds. Oh yeah, some of them are so sloppy about their work that they discount earnings. Can't tell the difference between EBIT and EBITDA; don't understand that depreciation is a genuine expense. 

Many of them are SEBI registered investment advisors. Man...if you are good at investing, can't you stick to your philosophy and invest your own cash, and be an honorable person? Do you have to use someone else's money to pay your bills? Some of those, who don't invite cash for investment, charge fees for their gibberish. Man...can't you just be honest about the fact that you ain't no good for the investment game, and therefore need cash to pay your bills?

Man...you discount earnings? whatever happened to depreciation, capital spending, and working capital requirements? You guys talk about CAPM and its evils, yet, use higher discount rates for riskier cash flows. You harp about margin of safety, and yet, implicitly use a method to protect your follies in estimating cash flows, which is another way to say that cash flows are riskier. 

You make a living out of Graham, Buffett, and Munger, and some lesser mortals. Some shame guys, before you tell stories to idiots, who are incapable of knowing that they can earn market returns very easily without any efforts. 

I admire those, who use their own money to invest, or even borrow to invest, which means two things: one, they are confident about their skills, and two, they have skin in the game; they eat their own cooking. And there is the third, they are confident of paying their bills through their investing skills, not through fees generated from either managing money or teaching lessons. 

Twitter has made the game much easier to play. It's a pity that the public is stupid enough to be gamed. 

earnings growth, expected return

Nifty tanked 157 points yesterday, which is a 1.56% fall from the previous day. This happened after some time, and especially when people did not expect it. The market euphoria seems to be there still, although the index trades close to 26 times earnings now. 

What people do not understand is that there is a business behind every stock, and therefore, the index is nothing but a giant conglomerate comprising of 50 or more businesses. We cannot view the prices in isolation, for if we did, we will have esoteric numbers, which otherwise will be difficult to explain. 

A better way is to think about what we can expect from the current prices. If we expect Nifty to give us an annual return of say, 12% in the next 5 years, we will have to think about two numbers: earnings at year 5 and a multiple to apply at the time. Let's use a multiple of 20, which itself is not pessimistic, and 5 years from now the expected Nifty will be about 17500. So far so good. The catch, however, is that to achieve that the earnings will have to grow at 18% annually over the period. Is that doable? Yes, of course; but I always like to think in probabilistic terms. So how likely is that to happen? Well, a lot of things will have to fall in place before that can happen. It's been quite long since Nifty clocked that kind of earnings growth; very long. 

That is for Nifty. How about individual stocks? If the index can give a return of 12%, we would like returns from stocks to be at least say, 15%. Let's stick to that. The Nifty-50 stocks have been trading at different multiples, mostly unsustainable over longer period. If we can normalize the multiples, and then check how much earnings will have to grow to achieve our expected return of 15%, it should make sense. 

So here's the story for the 50 stocks within Nifty.

The blue line shows the current PE of each stock; and the red one shows our expected, a little more reasonable multiple. I have been careful not to assign a too low multiple. So I believe that the expected growth rate is on the lower side, rather than higher. Let's take for instance, Eicher Motors, which is trading at a PE of 50, and I have assigned an expected PE of 30. We can see how much the blue line is off the red line. 

When I analyze stocks, I pick all numbers from the reports published by the company. However, here for this exercise, I have relied on the external sources to pick current earnings and multiples. To the extent that it might have errors, the numbers could be unreliable. Yet, I believe that this should give us a fair idea about whether the growth in earnings is probable. Although book multiples are better suited for the financial stocks, we get the idea for them too.

Now we move to the expected growth in earnings:

As we can see, most of the companies will have to grow their earnings by more than 20% annually over the next 5 years in order for us to give a return of 15%, based upon our expected multiples. ACC, for instance, will have to grow at 47% annually; and Cipla, 37%. I have ignored Tata Steel, which has negative earnings, and the multiple did not make sense. Still, Tata Steel stock price will have to move from 654 to 1316 to give us our expected return. How likely is that? Or how likely is that these Nifty companies will be able to grow their earnings as pointed out by the chart? Will Zee Entertainment be able to grow its earnings by 24% annually?

PE multiples are also based upon the fundamentals of the business, which is driven by the cash flows, growth, and risk in those cash flows. The higher the operating and financial leverage, the higher the risk, and the lower the multiple. The more consistent the cash flows, the higher the multiple. But there is a limit to the multiple assigned because it is mostly dependent upon the growth in earnings and cash flows. The earlier we get it, the easier it becomes for us to check the market. 

If we are too quick to assign future prices to the stocks at present times, naturally we will have to tone down our expected return, which is what has happened now. Blame it on the guys on the street.