Monday 22 July 2013

Long Term Stock Selection


Stock selection is complicated business. Formulaic approches seldom work over a long term. Even super investors such as Walter Schloss had to return back money to investors saying he could no longer find stocks that fit his value framework. George Soros' too shut down his Quantum fund and returned money to investors saying he could not understand the markets.

How can ordinary investors then hope to allocate capital effectively ? I reiterate, there are no fixed answers but some tools provide a broad direction. Hard work is essential.

How do we identify good companies ?

I recently attended an investment workshop and had the privilege of interacting with India’s best investors. Unerringly every legend’s message boiled down to two essential ingredients 1) high return on capital and 2) business’ ability to deploy large amounts of capital without reducing return on capital. 

This seems like investors’ utopia but a large sample of companies have been able to demonstrate this ability for varying lengths of time. Needless to say, the most consistent of these enjoy very high valuation multiples. Essentially capital allocation decisions create most of the value
The company has three choices 1) invest in existing business 2) invest in a new business or 3) return money to share holders. Markets tend to reward companies opting for options 3 and 1 (in that order) but abhor option 2. Capital allocation decisions are subject to management influence. A business earning suboptimal returns and ploughing back cash in the same business will actually destroy value. By themselves indicators such as ROCE and capital allocation decisions do not provide a clear picture about investment attractiveness of the business.

One measure that I use is capex / unit compared to the margin / unit. This is just another form of estimating payback.  It allows me to rank businesses. Let me illustrate : 

A prominent two wheeler manufacturer in India has capital expenditure / motorcycle of about Rs 7700 and margin / motorcycle of about Rs 4800. That its balance sheet exhibits negative working capital, much larger than its capex requirement is very thick icing on the cake. Using the same yardstick for an oil refiner, we see capital expenditure could be approximately Rs 3600 per barrel per day while mid cycle margins could range between Rs 450 to Rs 550 per barrel at current exchange rates. A popular car manufacturer exhibits capex of Rs 122000 with margins per car of Rs 30000. 

Ranking these businesses for a long term investment horizon is very simple now. Additionally this framework can be applied for evaluating diversification decisions or change in business models.
It saves time and focuses my attention on the more important and difficult aspects of evaluating the business, namely, the competitive advantages, the moats and the longevity of cash flows from the current model. The last being the most difficult.

Consistent and conservative accounting policy is another time tested indicator of good companies. Generally speaking, conservative accounting policies lead to understatement of reported profits and therefore reduce incidence of taxation thereby becoming a cash preserving strategy. Consistently applied, this becomes a source of wealth creation for shareholders. 

Illustration: Let’s take 2 companies A and B with A depreciating assets over 10 years and charging R&D expense to its P&L. B on the other hand capitalises 50 % of its R&D expense and depreciates assets over their estimated useful working life of 20 years. For the next 10 years A’s reported profits will be substantially lower than B’s assuming identical size of assets, expenses and income. At similar tax rates, A’s tax bill will be much lower than B’s and cash flow will be much higher. This additional cash re invested in the business every year will create substantially more value for company A’s shareholders than B. For a long term investor, the virtues of conservative accounting policy cannot be overstated.
   
Size, brand name, parentage (MNC’s), even longevity are various factors used to describe good businesses / companies. However, we think good companies are not necessarily large, neither the most visible nor grouped in one or two sectors. In essence these are companies which continually evaluate themselves internally on stringent benchmarks similar to those used by external investors. 

Typically such conservative companies tend to minimise risk to their cash flows and thus have a higher chance of succeeding. Their focus on cash flow over reported profits is reflected in their valuations too.

Identifying good companies requires familiarity which comes from in depth knowledge which is a result of tracking these companies and their managers across cycles, interacting with their customers, competitors and creditors. In short bottom up research.

From time to time, some of these companies 1) fall out of favour and become cheap (FMCG sector from 2001 to 2006) 2) suffer business setbacks for eg: a failed product line (GSK Consumer’s ready to drink, bottled Horlicks milk for pregnant women) or 3) suffer valuation multiple contraction due to adverse publicity which has little impact on their core business. Investors have to be prepared to invest in these companies at such times.

Luck favours the prepared mind. The stock market requires preparedness in the following terms 1) tracking a sufficiently large universe to be able to spot opportunities in different market conditions 2) investing strategy should enable deploying significant amounts of capital in such opportunities and 3) maintaining investment discipline even under adverse conditions.

A look back in history suggests that investment opportunities are always present but it is the level of preparedness that is the key to returns.

Tuesday 2 July 2013

Banks



Dear All,

While I am veering around to the view that banking may shortly see its decadal peak and therefore presents only short term trading opportunities. Increased regulation has generally had a negative impact on businesses and stock prices.  Remember the impact of activist regulation on mutual funds and insurance industries or on cement in the past or currently in telecom. Banks were always highly regulated, but may see increased oversight especially with adoption of Basel III norms nearing.
Much of the regulatory oversight mentioned above is required from a consumers’ perspective and hence I am not arguing against the regulation but merely pointing out its impact.

Mandarins certainly would not have thought about banks when the Rupee was allowed to depreciate despite a history of corporate disasters due led by foreign borrowing. In this economic milieu there are winners too. Before I write more extensively on the sector allow me to point out a relative winner

City Union Bank

CUB is amongst the most profitable private sector banks in India, perhaps because it sticks to its knitting and provides basic banking services. The bank experienced some duress last year as a significant part of its exposure was to the textile sector which experienced volatility in cotton prices.
The Rupee will have a positive impact on textiles as imports will reduce and exports become more competitive thereby increasing total volumes for the sector. 

As a result textile merchants will experience and increased ability to service their debt and address any prior defaults. The bank will see an improvement in asset quality and therefore require lower provisioning. This should aid ROE and ROA (currently 1.6%)

Yesterday, RBI mandated banks to provide upto 0.8% on loans to corporate having unhedged foreign currency borrowings and provide 25% additional capital on their exposure. This fiat will increase cost of funds for banks who in turn will pass it to their clients. Larger banks will be the worst hit with such regulation as it increases capital requirements. A smaller bank like CUB may escape these measures with a minor impact as their primary clientele is small business.

As a result of these two events the disparity in CUB’s ROE and ROA compared to other banks will increase and could lead to an outperformace vis a vis the sector

Signing off
Sundeep