nifty: what can it do for you

Nifty closed at 9217.95 on 24 April. Can investors continue to buy the market at this rate? If we are talking about periodic investments in the index itself over a very long period, my response is always yes. There is no need to play the timing game here, for we are never good at it. Periodic investment of a fixed sum usually takes care of pricing per unit, which tends to average out. This is a low risk investing strategy resulting in very close to market returns. 

Absolute investment in Nifty today is a different matter. That's 23.41 times earnings, and 3.52 times book equity. At least two factors affect investing in the index now: Earnings (actually cash flows) and market pricing at the time of exit. How much can earnings grow from here in the next 5, 10 or 20 years, and what pricing would it deserve at that time determine your return over the period. 

It is easy to remember that the higher the expected earnings growth, the higher the multiple accorded. Yet, there are other factors affecting this pricing. In fact, there are mainly three: cash flows, growth rate, and risk in cash flows. When expanded for instance: Higher payouts usually result in higher multiples. It is also true when the business earns a high return on capital. When interest rates are low, stocks are priced higher. High debt ratio brings down the multiple. Stable cash flows bring it up. Then there is the ubiquitous market bias. 

Instead of being part of the euphoria surrounding market, it is better to have a look at what has happened in the past, and think about what will trigger future. Usually, intrinsic valuation based on cash flows and growth rate is the best way to look at value. However, estimation errors are pretty significant there, so let's settle for what would be the implied rate of return. 

Over the last 10 years, Nifty earnings grew at an annual rate of 8.39%, and for the prior year it was 7.10%. As we can see in the chart above, the 5-year earnings growth during the last 10 years was between 6.05% (for the year 2016) and 11.77% (for 2014). In fact, for the preceding year, the growth rate was the lowest. Are they ready to rebound?

If I want to look at investing in Nifty for the next 5 years, I will have to estimate earnings for the year 2021. What is the reasonable rate of earnings growth in the present scenario? Of course, there is the India shining story, but what if it does not turnout as expected? We can use a range from say, 5% to 15%. Then we need an exit multiple for the earnings. I will use 15, 20 and 25. 

At 5% growth rate, I don't think investing is worthwhile even at a multiple of 25. Unless you consider that a post-tax return of 6.53% is difficult in alternative opportunities. Even when earnings grow at 15%, but index priced at 15 times earnings, the implied rate of return is less than ordinary. 

It is only when Nifty earnings grow at 10% in the next 5 years, and it gets a pricing of 25 times earnings, or grow at 15% and priced 20 times, the implied rate of return is close to 12%. Do we want it? Of course, there is an additional 1.25% dividends. When earnings grow at 15%, and the index is priced 25 times, the implied rate of return magically increases to 16.67%. This is definitely not bad considering available opportunities at the moment. 

Yet, the pricing multiple is subject to heavy bias. We are not sure of a higher multiple five years hence. At least that much risk is inherent in our expected returns. 

My thoughts are with the conservative investor who wishes to remain in the investing game, but does not want to take undue risks. We are thus back to, our favorite, index investing. Keep throwing cash beginning of each month to buy available units of the index. When done over 15 to 25 years, there should not be much reason to complain, provided our conservative investor has had fun doing things that are preferred in life. 

the conundrum of sell

Investors often consider that decision to buy a stock is the most difficult one. It is; when price and value gaps are to be analyzed. Yet, the decision to sell a stock becomes, probably, more difficult when dealing with human behavior. Investors sell (or don't sell) a stock due to various reasons, some right and some wrong. Let's cut to the chase, and come to the point. There are only four times when a long investor should sell a stock. 

The first is obvious: When you realize that you made a mistake in assessing value of the business; wrong earning power estimation or wrong growth rates. This is assuming the mistake is on over valuation. The quality of the business, after all, was not good enough compared to the price you paid. The second is a followup on the first one, and is more obvious: While your initial buy decision was correct because you found a reasonable gap between price and value, due factors not within your control, the quality of the business deteriorated over a period of time. This could happen because of poor management decisions on operations and/or capital allocation, or because of macro factors. For whatever reasons, the initial assessments of cash flows and growth rates are no longer acceptable. During both occasions, one would be at one's own peril if thumb-sucking is preferred to action.

There are at least two reasons for not selling here; this is when investors are not able to see the obvious: The first is when you don't realize the change in circumstances; i.e. you fail to assess the quality of the business compared to the price paid. The second happens when you are in excessive losses and therefore, hold on to your bias that things will improve; or even when you are in excessive profits and therefore, hold on to your bias that everything is alright. These are the real thumb-sucking situations. That is why behavior is of utmost importance in investing.

The fact is that whether you are in losses or profits is irrelevant. If market conditions are good, you would be lucky to get out of the stock at the first opportunity in profits. If you aren't lucky to see market optimism, it is also rational to sell the stock despite losses. In investing, we cannot leave entirely to the luck factor. A fair amount of analysis and thinking is required. The decision to sell is not easy mainly due to psychological factors.

The third time you should say time to sell is when you find a better investment opportunity. After all, investing is based on picking the best out of one's opportunity costs. If the stock that you bought has the potential to give you a return of say, 15%, and you find yet another stock, bond, or any other investment opportunity that has an expected return of say, 25%, it makes sense to sell one to make way for the other. The damage from inaction, though, is less here compared to the two reasons to sell noted earlier. The quality of the business has not deteriorated, its value has not changed significantly, and a relatively lower expected returns isn't troublesome. We need not be part of every investment opportunity.

The final time you should sell stocks is when there is emergency. Although you cannot invest short term cash in equities, sometimes one finds oneself in a situation where long term funds are to be liquidated for short term needs. These will be extraordinary times, and are therefore only rare.

There may be one more occasion when the investor may decide to sell. That is when you see that the gap between price and value has reduced significantly. Selling the stock is wiser especially when the business is not a high quality one having long term competitive advantages. Stocks of less than high quality businesses can be bought and sold more frequently purely based on price and value gaps. However, it is much wiser to hold on to the high quality businesses if the investor really wants to reap benefits of long term compounding. Wealth creation is always more imminent in a buy and hold strategy than in frequent trades. 

infosys: what next

I noted in February about how an investor could make close to 35% on Infosys stock. All I did was pick management's target of $20 b revenues and 30% operating margins by 2020. Well, targets could not change in a month's time, could they? 

Infosys reported revenues of $10.2 b (Rs.684 b) and net income of $2.1 b (Rs.143 b) for 2017. Revenues grew 9.68% and net income 4.93% compared to last year. Management expects that revenues might grow 6.5-8.5% next year. 

To achieve the target, revenues will have to grow more than 25% annually in the next 3 years; is that possible? Of course, anything is possible. But before it becomes possible, it has to be probable, or even plausible. That's something we need to ask those who set the target. 

Yet, what seemed like a target now seems like a moonshot. If not in 3 years, when is it going to be, 5 years? Even for that to happen, revenues will have grow more than 14% annually. If revenues grow 8.5% next year as expected by management, they will have to grow close to 16% per annum in the next 4 years. Yeah, it ought to be an aspiration.

It's not wrong to aspire, though. If not 35% return, what can Infosys offer now? Let's start with keeping management's targets. Revenues of $20 and operating profits of $6 b. Assuming Infosys will continue to keep $6 b in cash earning 5% and a tax rate of 28%, its net income will be $4.5 b (Rs.317 b) whenever that happens. 

That's a net margin of more than 22%. Based on its current valuation of Rs.2,130 b, investors will be able to get an annual return of 30.80%, 43.90%, and 55% when it is priced at a PE of 15, 20, and 25 respectively in 2020. Those are returns for 3 years. If we move to a 5-year target, keeping the same pricing multiples, the expected returns will be 17.50%, 24.40%, and 30.10%. We are again back to what is plausible, probable, and possible. 

What if Infosys achieves its targets in 7 years? Then the returns would be 12.20%, 16.90%, and 20.70%. Note that these returns are not that bad. And topping these you have those juicy dividends targeted at 70% of free cash flows; they will be in excess of Rs.50 b each year. 

Even when these targets are achieved in 10 years, the expected returns based on those PE pricing will be 8.40%, 11.50%, and 14.10%. If an investor gets that 8.40% return at the lower multiple and receives a dividend yield of 2.50-3%, the aggregate returns will not look too bad. I have not included exchange rate changes in this model; investors can choose to incorporate that if they are able to. 

There is also the possibility of Infosys being priced at an earnings multiple of 10; who can rule that out? Finally, we have to ask whether this $10 b and 30% targets are achievable at all. Now, that's a question, which I will not be able to answer. 

of bulls, bears, and expected return: s&p-500

From 1982 to 2000, the US markets witnessed the greatest bull market period. Prior to that there have been at least 3 secular bear markets: From 1910 to 1924, from 1929 to 1944, and then from 1965 to 1982, the stock markets were under immense pressure. After the 2008 crash the markets were lying low; but then, the bulls began thrusting from 2013, and we are now staring at an obvious conundrum: is this a secular bull, or just cyclical, where we will see it wag between bull and bear side?

The markets are usually priced, and the most common pricing tool is the PE multiple. While the PE is not the only one to be looked at, fundamentally, it also depends upon cash flows, growth, and risk in cash flows of the business. The higher the cash flows and growth, and the lower the risk, the higher the PE multiple accorded to the business.  

From 1910 to 1924, the S&P-500 (at 10) went nowhere despite running around and increasing earnings by 1.47% annually. Perhaps, it didn't even meet the expectations of Lewis Carroll's The Cheshire Cat, where when you even walk long enough, you are sure to get somewhere. In September 1929, it stood at 31.30, helped by the mood of the market at the time representing 20 times earnings. By March 1933, the index was reduced to 6.23. It did start moving up from 1935, but then by 1942, it was again in a slippery zone, at 7.84 in April. It started getting better from 1943 onwards. Yet, it was able to match the previous high only in September 1954, albeit with a much lower multiple of 12. In January 1965, the index was at 86.12 with the multiple marching higher close to 19. Then came December 1968 and January 1973, leading the index to 106.50 and 118.40 respectively, but maintaining the multiple. By January 1980, the undertone was so low that the market thought it was apt to accord the index a value (110.90) equivalent of 7 times earnings. Even in January 1985, the index value of 171.60 represented only 10 times earnings. One had to wait until August 1987 to see the S&P-500, 21 times earnings, at 329.40. In October and November of 1987, the index was lower by massive 12% each month. If there was a marching bull, its horns weren't that clearly visible at the time. January 1997 (766.22) was not too high at close to 20 times earnings. Nevertheless, January 1998 saw the index valued at 24 times, and January 1999 (1248.77) at 33 times. The index was at 1485.46 in August 2000. The dotcom bubble started fizzling out after March 2000, affecting Nasdaq more than S&P-500. The irony was that it was valued at 46 times earnings in January 2002 at 1140.21. Only by January 2007 (1424.16), the multiple of 17 appeared more reasonable. Then again, it had to witness one of the largest falls in history, dropping from 1216.95 in September 2008 to 968.80 in October 2008; a 20% slip. Earnings fell significantly in 2009 when the index value of 865.58 in January appeared too expensive at 71 times. It did seem like an aberration only in hindsight, because by January 2011, earnings picked up rather significantly, and the index was 1282.62 at only 16 times earnings. Such lower pricing continued until 2013. It took more than 12 years for the index to get back to its August 2000 value when it touched 1480.40 in January 2013. Since then, the bulls have held horns thrusting up into the air effectively. As of now, the S&P-500 is trading at 2357.49, priced at almost 25 times earnings. 

Of course, you can play with the PE multiple the way you want to. However, the key is to be internally consistent when dealing with it. If we use forward earnings, the multiple gets lower. But then again, we can also use 5-year forward earnings and bring the multiple much lower. What analysts don't get is that they are revising the denominator without checking on the numerator. You can also use an average (say, past 3-year) earnings. There are far too many options.

Are you the buyer at these levels? An important data is the trend for the long term inflation and interest rates. That will decide the opportunity costs available to the investors. If the 10-year treasury is yielding 2.34%, anything higher than that should be fine given the expectation that treasury rates don't change significantly over long term. This is something we cannot predict though. Therefore, it will be more sensible if we expect a reasonable premium on the treasury rates. We need it just for the additional risk borne; and we also need it so that we are able to increase our long term purchasing power.

The American companies have been distributing cash, in the form of both dividends and buybacks, larger than earnings. Effectively, this has had no room for retained earnings, the gap for reinvestment being filled by debt. Obviously, this cannot continue forever.

Instead of valuing the index, if we attempt to price it, we need the near-term growth rate for the earnings of $95.25. Let's project it to be 5%; we can even be brave enough to project this rate for the next 10 years. Then we need an exit multiple for the index. We can choose 10, 15, 20, or 25 depending upon the level of our optimism. Based on the current index value of 2357.49, the expected return would be as follows:

At an exit multiple of 20, the expected annual return would be 0.62% and 2.79% over 5-year and 10-year period respectively. We, obviously, do not want that. The return would be just over 5% for both periods at 25 times. At a more aggressive multiple of 30, we have 9% and 7% returns. At 35 times, it would be 12% and close to 9%. Over 5-year period, a multiple lower than 19, and over 10-year period, lower than 15 would yield a zero percent return. Remember the bears that we saw in the stock market history? It doesn't take long for the bears to appear. Who can rule out lower multiples? Yeah, including dividends and buybacks, may be one can have returns of 2-3%.

I am not sure whether I will be the buyer at this levels. Heck, where else can I invest, and how much? All-treasuries?  

tesla, auto, energy, and what else

Toyota sells more than 10 m vehicles annually, and has a market capitalization of $177 b. So do Volkswagen and General Motors, which have a market-cap of $74 b and $51 b respectively. Renault-Nissan together sell close to 10 m vehicles; Renault's equity is worth $25 b, and Nissan's $40 b. Hyundai sells more than 7 m vehicles, and is worth $37 b. Ford sells more than 6 m vehicles, and market considers it worth $46 b. Fiat-Chrysler is worth $21 b, and sells more than 5 m vehicles. Then there are Honda, more than 4 m vehicles and $54 b, Peugeot-Citron, more than 3 m vehicles and $15 b, and Suzuki, more than 3 m vehicles and $20b. 

And we have Tesla, which sold 50,700 vehicles in 2016, and its equity is worth $48 b. Isn't this amazing?

Tesla was worth $4 b in April 2012.

During the period, Tesla has overtaken its competitors on the stock markets with enough pizzazz. This story has it, and I picked those pictures.

And recently it went past Nissan.

The story is has warning for the other automakers.

But then Tesla is not about only auto, is it? And boy, did it embarrass Ford.

If it is no longer an auto manufacturer, what is it? It is a vertically integrated energy company as per its latest annual report.

Tesla sells Model S sedan and Model X SUV electric cars, which are meant for high-end consumers. It has plans to manufacture and sell mass market Model 3 electric cars in 2017. It also sells energy storage products. Post acquisition of SolarCity, it sells renewable energy.

So there it is; Tesla is not only an auto manufacturer. As such, it is not fair to compare its market-cap with other auto companies. But then, it is fair to compare its business with its market value.

Tesla incurred a loss of $675 m on revenues of $7 b in 2016, and so far, auto revenues form a significant part.

As of December 2016, Tesla had $3.5 b cash, and debt of $7 b. It had negative operating cash flows of $124k, and $1.4 b of capital spending. Currently, it has been funding the gap through issue of new equity and raising debt. It also has a much higher order booking for vehicles, more than 400,000 apparently.

In November 2016, Tesla acquired SolarCity for $2.1 b through issue of Tesla shares priced at $185.04 per share. As of now, each Tesla share is trading at $298.52. It is not clear what was the actual acquisition price especially when CEO of Tesla was also the Chairman of the board of SolarCity, having a 22% ownership in SolarCity. Not surprisingly, the CEO of Tesla got 22% of new shares issued by Tesla; not a bad deal. How about the minority shareholders of Tesla?

Elon Musk has a different take:

Where does Tesla go from here?

amazon $600 b; bezos $100 b

Jeff Bezos is set to become the first person to be worth $100 b as Amazon sets to become a $600 b firm. Unless, of course, Bill Gates goes past sooner. 

I simply cannot fathom the mystery behind Amazon's run up on the stock markets; it's crazy. 

At $427 b, Bezos is worth $72 b, and an increase of just, yeah in Amazon's and market's terms, it's just, 38% will take Amazon near $600 b and Bezos to $100 b. As such a target price of $1,210 for the stock does not seem far-fetched. 

There you go. But then the stock has a business behind it. Is the business really worth that much? 

Finally, Amazon has turned profits.

Amazon Web Services is growing faster than Amazon retail (media and merchandise), although, it is still 9% of total revenues.

Nevertheless, AWS contributes over 74% of Amazon's operating profits, and has operating margins of 25%. Whereas, even North American segment, which is profit-making, has operating margins of less than 3%. Excluding AWS, Amazon has far lower operating margins since International segment is not yet profitable.

It is yet to make money on its shipping activities.

Sure, there is a remarkable improvement in generating free cash flows.

Amazon needs to know that acquisitions are a part of reinvestment.

I would also not exclude stock based compensation of $2.975 b from cash flows just because Amazon omitted one part of the process. If it had issued new shares and sold in the market, and then paid out cash to its employees, the activity would be part of cash flows. Why is it any different now? The revised free cash flows to firm then would be $6.615 b.

As of December 2016, Amazon had cash of $26 b, and debt of $20 b excluding its operating lease obligations.

The entire story of Amazon is based on long term and high growth. It earned $4.90 per share in 2016; and is trading at 178.84 times earnings. Almost all of it is attributed to the future; that is the price of growth. 

Strictly on the basis of growth and price, I would not be surprised if the stock is priced at $1,200 right away as it implies an earnings multiple of 247 instead of 178. Is that a big deal? 

There you go, the market has the potential to make Bezos $100 b and the richest man on earth. I never underestimate market's psyche, like I don't underestimate anyone who overestimates oneself.

d-mart and markets

Radhakishan Damani, the promoter of D-Mart supermarkets, lived up to his reputation and market expectations as his company, Avenue Supermarts Limited listed on the stock exchanges at unprecedented premium valuations.

The bid opened on 8 March, and closed on 10 March; the stock got listed, and started trading on the exchanges on 21 March 2017. 

Avenue Supermarts in engaged in the business of organized retail, and operates supermarkets under the brand D-Mart. Prior to the public issue, the company had 561.542 m shares outstanding, of which over 90% was held by the promoters.

The company issued 62.541 m new shares at a price of Rs.299 per share based on which the promoters valued the entire equity in the company at Rs.186 b.

The promoters know the business better than others is a fair assumption. Consequently, they must have assessed the business fundamentals, industry, and macro structures before arriving at the issue price. The company earned Rs.3,187 m for the previous year, and Rs.3,874 m for the nine months ended December 2016. When we extrapolate, the net earnings for 2017 would be Rs.5,165 m. Therefore, the issue price is 58 times current earnings and 36 times expected earnings; not quite modest.

The stock closed at Rs.641.60 on 21 March 2017 valuing its total equity at Rs.400 b. The return expectations don't change unless there are changes on intrinsic basis: cash flows, growth, and risk. Yet, the value of the company's equity increased by Rs.213 b in a day. 

Of course, it made the promoters, who are already rich, richer. Besides that it showed us a glimpse into the market psyche. 

Avenue Supermarts is one of the most profitable retail chains in India. It is organized into 3 divisions: Foods (50%), Non-foods FMCG (20%), and General Merchandise and Apparels (30%); most of its revenues comes from Maharashtra.

It has three wholly owned subsidiaries, and one associate.

Currently, it operates from 117 stores across the West and South.

Based on its track record and growth plans, the company will require cash to fund its future expansions.

Avenue Supermarts had revenues of Rs.87 b for the nine months (December 2016) and Rs.85 b for 2016; net earnings were Rs.3.87 b and Rs.3.18 b respectively. Net margin increased to 4.47% in 2017 compared to 3.71% (2016).

The annual growth during the past four years was 40% (revenues) and 51% (earnings). 

The book value of equity capital in December 2016 was Rs.19.054 b, which will increase to Rs.37.754 b post public issue. Consequently, the return on equity of 21% (2016) will fall down to 14% (projected for 2017). The company cannot double its profits overnight by doubling capital. Also, much of the proceeds is being used to pay down debt; only Rs.7.5 b is being used in operations; while equity capital has doubled, cash used in operations has not. 

In order to achieve past growth rate of 40%, the company will have to reinvest 160-250% of its earnings considering its return on equity. It has already been reinvesting in excess of its earnings in the past.

There aren't any free cash flows at the moment; and I don't see any dividends soon either, if the company wants to maintain its growth momentum.

As of December 2016, Avenue Supermarts had cash of Rs.661 m, and debt of Rs.14 b.

Proceeds from the issue will be used for repaying a significant part of debt.

The company had financial expenses of Rs.907 m for the nine months (December 2016), which might seem likely to decrease in the coming years. However, as we noted, the company needs reinvestment far in excess of profits in order to sustain its growth rate. Where would it come from? I see two options: reduce growth rate expectations, or borrow again. By retiring its high cost old debt, the company may have plans to borrow again at current lower rates. Anyway, I would not count on significant increase in profits due to reduction in interest costs. In fact, its free cash flows might remain negative for much long and much worse compared to the past due to higher reinvestment.

The company might earn Rs.5.16 b (extrapolated) for equity in 2017. At its closing value on 21 March of Rs.400 b, the markets are pricing Avenue Supermarts at 77 times its projected earnings. I will keep the intrinsic valuation for another day. The question now is: is the market correct in its pricing mechanism? Where does Avenue Supermarts stand in the expectations game?

So what has happened post public issue? First what has not happened: Avenue Supermarts' revenues and profits have not increased; its cash flows, growth, and risk parameters have not changed significantly. There could be some changes in costs due to accessibility of public markets and in expectations due to public market investors. The company's corporate governance will be monitored more closely.

Avenue Supermarts is now worth top 6 retailers together. The next best in terms of market-cap are Pantaloons at Rs.117 b and Future Retail at Rs.116 b.

Some individuals and entities have gotten richer. The lead managers got richer by Rs.94 m. Certain management personnel are collectively worth Rs.1 b now.

The promoters, owning 82% of equity, are worth Rs.329 b now.

Since their cost of acquisition was negligible, the return on investment is exceptional.

Do they deserve this? Of course, they do. This is how free markets reward capitalists.