the story that ril has

Reliance Industries had a story to tell: its foray into telecom, and its declining returns. Now with the passage of time, the story seems to have changed, at least for the analysts. 

Reliance is yet to come near its historical high market valuation.

It had a high market capitalization of Rs.4,794 b in 2008 and Rs.3,705 b in 2015 (so far). At the current market value of Rs.2,835 b, it is about 41% lower than its all time high. There was a lot of optimism built into the high market prices in 2008 and 2009. 

Subsequently, it has had its share of issues to deal with, some external and some internal, due to which its return on equity and return on capital have been declining. 

Its investment in telecom has been significant, and it has a delayed return cycle. This itself is the biggest drag on its return on capital. Reliance has spent over Rs.2,000 b in capex since 2011 twice its previous 5-year capex spend. As of 31 March 2015 there were more than Rs.400 b of commitments outstanding. 

However, if we believe in the changed storyline there is potential for efficiency in capital allocation for the company as a whole. Its capital expenditure cycle is going to be completed soon. 

For a careful investor there were opportunities in 2012 and 2013 to buy the stock at much lower prices. I am not sure how many did though.

Yet, the next few years are going to be interesting for this business. 

when's the money amazon?

I like the business; I like the way it disrupted retail; I like the way Kindle revolutionized reading. For the year 2014, Amazon had revenues of $89 b. So far so good, and I thought about it as a firm with long term vision. But later I had to ask how long is this long term. 

Long term shareholders of this business have made money all along: In May 2010, it had a market cap of $56 b, and today it is $200 b. Just last year in Feb, it was selling for $159 b. Funnily enough, since it came out with its initial public offering in May 1997, it has never made any real money. 

Revenues increased 19% in 2014, and that's about it. Sure, Amazon is still in a disruptive growth mode, where you care about market share and then about making money. 

For its part, it presents the statement of cash flows first before statement of income and balance sheet. The reason appears to be obvious:

In claiming those free cash flows, it has conveniently forgotten that stock-based compensations are real expenses for the business.

Arguing that these costs are non-cash will be at their own peril. Otherwise, it would be much easier to pay every supplier with stocks and bring cash expenses to zero. This is for discussion another day.

It has also excluded acquisitions from calculating free cash flows, an error whether acquisitions are made through cash or by issuing stock.

At the moment, all I see is that Amazon as a business is yet to make real money. Usually, stock prices follow business profits in the long run. So far, the long run seems like too far away for Amazon because the stock prices are not reflecting business fundamentals.

There is another storyline for this business: Current earnings do not matter. What matters is the future earning power of the business. As long as Amazon is going to make disproportionately larger profits in later years, it is going to be fine. Market knows this, that's why it is factoring in the stock prices.

Which side of the story are you in? 

rate hike and markets

If the rate hike is appropriate this year and later, what should happen to the stock prices, and the market as a whole? Well, if cash flows are not going to change the prices should fall. At least, the intrinsic value of all cash flow generating assets should fall. If they don't, it would mean that prices are expensive for a buyer. 

While bond prices adjust pretty quickly to the changes in interest rates, it is not going to be as easy as it sounds for equities. This is because at least for individual firms the cash flows pattern and their growth rate could be different. There aren't fixed coupons to be paid out and the time line is perpetuity.

There would also be flow of capital from let's say emerging markets where interest rates are much higher back to the US. Since the rate hikes are going to be gradual, to come back to what we can call the normalized interest rate (and inflation) environment it could still take several years. In the meantime, currency-based investments may still not be the best option. So for investments in the US, equities should remain favorites.

Nevertheless, interest rate is an important factor in making decisions about allocating capital. It measures our opportunity costs in investment options.

are you a pe - squeezing the market

Value of a business is the present value of its future cash flows. For an investor it becomes difficult to predict cash flows and estimate the right discount rate. He struggles in that attempt all the time. What to expect of an investment, say, in a stock, is a pertinent question. 

While many analysts stick to the standard DCF model (of course, they do complicate it in the process is another matter), some loathe it citing reasons that it is difficult to predict cash flows. The latter take solace in applying multiples. And a few others use the combo - a mix of DCF and multiples. Really, there is no dearth of imagination when it comes to an analyst's emotions and his excel worksheet.

I can argue that it is possible to use DCF model in estimating an approximate (rather than precise) value of a business. I would rather keep that for another post.

The topic of this post is how venture capital and private equity firms earn their returns. They use different models to supply finance and acquire stake in the (often a private) business. The simplest form is usually the most sought after: Invest in equity of the business. Estimate the price (it isn't value) of the business 3-5 years hence. The pricing model usually is earnings-multiple, revenue multiple, or any other multiple. Have a minimum hurdle rate for the investment. Work back to calculate the price to be paid for the equity today.

If that means squeezing the present owners, so be it. In capitalism, it is fair. What is fancy in this investment model is that it is not fancy.

I want to argue that it is not difficult to use this pricing (not valuation) model for a small individual investor. It is actually a superior model to use for returns in excess of the market returns provided he is aware that pricing game is what is played here. The key to success with this model is of course the behavior of the investor.

Here's how it works:

The buy price depends upon the expected return:

As we can see for an investor who wants 30% return, the buy price has to be 47.40 which has an implied PE ratio of 13.54. This is about 52.60% down from the current price.

Is it possible to play this game in a publicly listed company? Of course it is possible because the market can be squeezed on occasion. For a patient investor there would be occasions to buy at his price. After all, the markets are inefficient, and a more-sensible investor can make money at the cost of the less-sensible one.

Two things hold out: Estimating future growth rate and PE ratio can be anybody's guess, and in addition, the emotions of the analyst can flow through to spoil the pricing game.

Nevertheless, thinking like a private equity investor is often useful. At least, it lets you to play the game on your terms.

shell's contradiction

According to the story, Shell is going to buy BG for $70 b. Shell is worth $199 b, and BG is worth $60 b. In July 2014, Shell had a market cap of $280 b, and in April 2011, BG had $88 b. Just a few days back, though, market cap of BG was $42 b. Well, the market has reacted to the news report.

I don't want to get into whether the acquisition makes sense in terms of synergy, control, and other benefits. I will also not comment on whether the acquisition is costly or a bargain for Shell. What I want to note is how Shell is funding its acquisition: It is a combination of cash (383 pence) and stock (984 pence) totaling 1367 pence per share of BG. 

In effect, Shell is paying $50 b in stock. My question is whether it makes sense to pay in stock at the current price. It usually makes sense to use shares as a currency when its price not cheap. In other words, if Shell considers that its stock price is higher than its intrinsic value, it can use it for acquisition. The expectation then is that it will get more value than what is paid out. 

Now let's come to what else Shell is going to do. It has committed to a shares buyback of $25 b in the coming years. There are at least two things to be checked before a firm can go for buyback of its shares: It should have excess cash; and its stock price should be cheap, or at least not higher than its intrinsic value. 

For acquisition to hold good, we have to assume that Shell, in fact, considers that its stock price is on the higher side, otherwise, it would not have used its shares for acquisition. 

Whereas for stock buybacks, we have to assume that Shell, in fact, considers that its stock price is and going to remain on the lower side, otherwise, it would not have committed to the buyback program.

Heck, too much confusion...for the Shell managers, I guess. 

ntpc bonus debentures, and some reporting

NTPC has given away bonus debentures to its shareholders on 23 March 2015. While the corporate action has resulted in a free debt instrument in the hands of its shareholders carrying a floating rate coupon payable annually, there has been some interesting reports about its mechanism. 

It is interesting to note from this report that the company will be able to hold on to them for expansion projects; and this report which says that NTPC has issued bonus debentures for funding its expansion projects. I am not sure whether we should blame them for misguiding the readers, or blame the company for misguiding them who were unable to understand the concept in the first place. Just have a look at what the company has to say about this:

What the heck is happening here, who has paid out cash, and who has received cash? No one; and if there is no cash, where is the question of funding the projects?

Because no one has purchased these debentures, no cash has been received by NTPC. What has happened is simply the transfer from its equity to debt, thus increasing its debt ratio. Needless to say, equity has reduced and debt has increased. The debt portion will start paying interest which will be tax deductible for the company and taxable for the shareholders (now the debt holders). The book entry has managed to let the transferred amount behave like debt from now on. That's about it. 

If the profitability is not going to be affected (because of the additional interest charge), NTPC's return on equity should improve. 

I have written about NTPC before; the performance has been poor, and the stock is actually languishing. 

For someone who invested in the stock in January 2008, we can understand the frustration. The investor should be saying this: It really does not matter whether it will become a 90,000 MW company or not, what matters is its operating performance. How will it fare with its invested capital? Will it generate excess returns on its projects? Should it continue to reinvest its earnings so that it will increase its firm value (and consequently, the stock price), or should it stop reinvesting and start returning its excess cash?  

Capital allocation skills are tough, and under Indian conditions, boy, it's a double whammy.

can you value any asset

I recently wrote about value investors, albeit, for different reasons. Let's spare them for now. How about those who are on the other side, those who claim that they can value any asset? 

There are many who talk about valuation skills, and proclaim that they are adept at it. I wonder whether those skills are restricted to talking and writing only. I wonder whether they are able to profit from those skills in the real world investing. There is a reason why I wonder.

Value of a cash-flow generating asset is the present value of all cash flows that can be realized over its life. Anybody can do valuation. It is that simple: you only need to estimate cash flows and a discount rate to bring them to the present value. 

But wait, there is more to it. Practically, no one can estimate accurately how much cash flows an asset is going to generate in future. That is simply a prediction, and humans are not good at it. Furthermore, no one knows which discount rate is the correct one to use. 

It is clear that any valuation that we do is going to be wrong. It is also going to be colored by so many other factors such as bias and emotions. In this context, how can anyone be able to value, and profit from it? To make profits, we need to identify gaps between value and price. If the price does not factor input estimates of the analyst it is virtually impossible to make money out of his valuation. Prices are set by marginal investors who are usually large institutions. Their input estimates are going to be very different from an investor's. If those estimates are not likely to converge, value and price won't either. 

There is a good news though, if we are prepared to adhere to a different mechanism. Why get into assets whose cash flows are difficult to predict? For instance, technology companies, young growing companies, distressed businesses. It is not possible to come out with a realistic estimate of cash flows for these businesses; not even the insiders can do it. So we cannot value them reasonably, except on paper. 

The correct thing to do is to rather ignore these stocks, and move on to those where we can estimate cash flows, albeit with less precision. There are certain businesses where we can do it. For instance, those with stable and consistent cash flows, which have demonstrated high return on capital and operating margins. It is better to pick those businesses for valuation. Estimate cash flows based on past record, and future prospects (which is a lot easier than for unstable businesses), and come out with a value. This value is more likely to be in sync with the fundamentals of that business. 

The irony, however, is that such stocks usually sell at high prices. But then, who says we have to buy them regularly? There would be times when the markets are going to be in a depressed state (due to crises, or other reasons), or the company's stock itself is going to be depressed (due to issues that are likely to be temporary). These will be the moments when we should be picking. Markets will eventually come back, and that stable company's problems will eventually be solved so that the prices will reflect its fundamentals. Look at history, and you will find that such opportunities were there on several occasions. 

Of course, there are other sound approaches to investing, some of which I do use. Nevertheless, I find that waiting for the right occasion to buy is the best one. Rest of the time, we can do a few things: keep buying the index; do whatever we want to do in life to have fun, and watch (from far) markets fluctuating by the minute.