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27 June 2009

THE ART OF SELECTION - PART 2

In the previous article of this series we had discussed the Price Earning Ratio and how to use it to filter stocks. I got a few very searching questions in the comments section. So I would request readers to go through those too. 

We now take the second step forward and one which could be a major stumbling stock for many an aspiring portfolio picks. If a stock fails this test, I would need towering logic to overrule it. 

All business is margin and it is the bottom line - the profit margin. The last word in the financial statement analysis and hence a major filter for us. Profit margins are of three types.

Gross Profit Margin
When a firm does business it gets paid for it(Revenue). For earning this revenue it spends some money which is called as Cost of Sales. Revenue - Cost of Sales is the Gross Profit. And Gross Profit divided by Revenue is Gross Profit Margin(GPM).

It is in percentage terms and hence normalised, permitting comparison across firms. A caveat - do not compare apples and oranges - try and compare two companies of the same kind. It may not be necessary that two firms in the same sector are compareable - e.g Infosys and TCS are compareable, Infosys, Helios & Matheson and Financial Technologies are not.

The comparison will reveal how effective is the company in keeping its costs in check. Are its executives playing around with shareholder value? (A sure shot indicator of this is - to what is executive compensation pegged to - Revenue or Profits). 

Operating Profit Margin
Mathematically it is Profit Before Interest and Taxes(PBIT or EBIT) divided by Sales.  Also termed as Return on Sales.

It is a very good indicator of the operating health of the company. It shows how well the firm is carrying out its core businesses. It disregards ( for the denominator) any revenue generated by non-core business activity like sale of asset or financial transaction gains. For the numerator, it omits expenses like taxation and interest which may skew the earnings due to say, a tax holiday given by the govt for a few years or a large debt on the books during initial years after setting up.

So I use it to evalute the following:-
  • New firms which are not yet profitable. eg. Cairn. 
  • A firm with an abnormally large debt.
  • A firm divesting part of its business or assets during the financial year.

Net Profit Margin (NPM)
Mathematically it equals the Net Proft(After taxation, interest etc) divided by the total revenue generated, multiplied by 100. 

This basically tells you how much money goes into the hands of the actual owners i.e, the shareholders after deducting all kinds of possible expenses per Rupee of revenue. It varies from industry to industry. A lower NPM does not necessarily mean a weak business - it could well be a conscious business strategy like for a discount retailer . A prime example in the indian context is Pantaloon Retail which operates on wafer thin margins. (For a detailed analysis of Pantaloon Retail read here)

A comparison between GPM and NPM can give you a good understanding of the cost structure of a company. However, all else being equal, the higher the NPM, better the firm.

In the next part of the series we shall delve into the Return on Equity - metric very close to the heart of many an equity investor.

Happy hunting !

26 June 2009

WATER, WATER.....

The heat is killing me and the electricity provider is not helping either, what with the power cuts and all that. To top that the Bhakra Nangal Board has said that it is going to either reduce or completely cut the water supply to Delhi, Harayana and Punjab as its reservoir is drying up for want of water. What do we have next? Water rationing? What impact does it have on our GDP and specific businesses?

We had initiated a discussion on this issue in Dec 08 in the post WATER, WATER EVERYWHERE BUT.....  with a view to explore the business opportunities available in the field. There are a few available today and many for a truly long term investor. This was followed by a detailed analysis of the situation in the post THE FROWN OF TETHYS AND OTHER STORIES, the premise being that a commodity which is essential for life itself and in such short supply shall exhibit tremendous business potential. That month being a december, not many throats were parched and probably hence a tepid reaction. Perhaps things would be different this time!

Now companies like Ion Exchange, L&T and Thermax come to mind easily. Worth a hard look.


19 June 2009

NIIT Tech Ltd : A Result Update Q4 Fy 08-09

I shudder to think about those days - the kind when no amount of logic could convince someone to buy a stock. And having bought one, you saw it go only one way - down. No fundamentals or technicals other than shorting worked. I am, of course, referrring to the period from Jan 08 to Mar 09.

In that period I started studying a stock called NIIT Tech Ltd. My first post on it in Jul 08 (A Gold Panner's Dream) showed it to be grossly undervalued. 

I still stand by it after the latest results of Q4 and my reasons are given below.

Positives
  • A 4 % increase in revenue despite the trying times.
  • A higher provision for taxation (Rs 22.4 Cr against Rs 13.8 Cr same qtr last year).
  • A high onsite-offshore mix of 60:40 implying higher billing rates.
  • An increase in revenue from the transportation and retail verticals (both potential high growth areas)
  • A reduced dependence on the top 5 clients.
  • Increased order flow of $170 Mn from US against $ 69 Mn last year. (Overall $312 Mn against $229 Mn last year). This is most heartening and an indicator of things to come - when the going gets tough, the tough get going!

Negatives
  • 1% fall in Operating margins from 19 to 18%
  • A 15% drop in Net Profit resulting in a fall in EPS to Rs 19.56 from Rs 23.05  same qtr last year attributeable to increase in operating expenses and depreciation ( a non-cash expense and hence a positive). 

Valuation
The trailing twelve months EPS is Rs 15.07 and it discounts the current market price of Rs 96 by 6.37 times. At a cost of equity of 15.7% and an expected growth rate of 12 %, the stock should be worth Rs 153, an upside of 60% from this level. 

12 June 2009

THE ART OF SELECTION - PART 1

Someone once asked me - "How do you select a stock from the complete universe?". For me its a long journey and my infrequent blog posts bear testimony to it!. However its a journey worth undertaking to achieve satisfaction both intellectual and material. Well let me share it with you here and in subsequent parts.

Well begun is half won. Thats the importance of the first step. In many ways it is like anything first - first bike, first love. It stays with you for good or worse. For me it is PE. Price to earning ratio. For the lay investor, it equals the current market price divided by the Earning Per Share (EPS) . It comes in various shapes and sizes - 

Historic PE. This uses the EPS as given in the latest annual report and hence historic .i.e reflecting the previous financial years efforts. Using this puts one on a firm footing as the figures are - well, firm. The figures read over the past few years accurately reflect any cyclicality in the business, unless the business is cyclical within the year (like cement) in which case you would need a quaterly breakup of the EPS. I use it only as a start point of the analysis.

Forward PE. Along with Historic PE it completes the yin-yang pair. It is anything but firm as it includes some prediction, lots of (guess?) estimates and dollops of hope (and prayers, if given out by a young intern/analyst). This is used fairly late in the analysis when one has developed a finer sense of the business and is able to make reasonable assumptions of the revenue growth, operating and net margins and the general business environment.

TTM PE.  Trailing Twelve Months PE uses the EPS totalled for the last four quarters, regardless of the financial year. It gives a more realistic, accurate and current picture of the business. A favourite of mine (we all have our albatrosses, dont we?!).

Relative PE
On a stand alone basis, PE is just a number. Its relevance emerges only with relativity. Is PE of 5 low and 30 high? What if I say that oil and gas sector traditionally figures in single digits but telecom trades at higher than 20? So 5 and 30 are just numbers and ONGC@ 5 and Reliance Com@ 20 are like chalk and cheese. How about Reliance Com (30.44) and Bharti(21). So compare it relative to :-
  • Peers in the industry.
  • Its own historic values.
  • The PE of the index it is part of.
Any major variation must not be inexplicable. So why must Rel Com trade at a 45% premium to Bharti? Thats food for thought for you and a thought for another post for me. 

And last but not the least - there are situations where PE cannot be used - try comparing Cairn and ONGC by this metric.

In the next part of the series we shall delve into the bottom (line) - I meant the profit margins!

Happy hunting till then.

08 June 2009

MY ASSOCIATION WITH MONEY VIDYA

You all must have noticed that I am an associate blogger of MoneyVidya.com as stated by the button on the right hand side of the blog posts.

I joined the site as a curious onlooker about 4 1/2 months ago but grew to like it so much that I visit it almost everyday. I have been posting my blogs there too before I was invited to join as an associate. I enjoy the very comfortable environment of sharing and mentoring. So I thought I must take this opportunity to tell you why I like it and what are my key takeaways from it.

First and foremost it is a place where I can get the pulse of the investor community. What's in what's out. What's the new favourite who's being dropped - a general feel of the market. 

Digging deeper I find a strong group of experienced and wise investors who share their knowledge without fear or favour and from whom one can learn and grow.

And at the core I came across a dedicated, committed and savvy team of bloggers /entrepreneurs who have given us a unique platform from where to take off from. A sort of aircraft carrier in the middle of the vast ocean of the investment world.

So happy blogging and investing.

06 June 2009

THE BEST OF BOTH WORLDS : TATA INVESTMENT CORP

Whenever I am in a quandry about my investments I go to my brother, philosopher and guide. Though I was in one today with this investment, I did not seek him out. Reason? I can clearly hear him say - "Its like putting money in a savings account, earning interest, being safe and seeing some capital appreciation". Thanks bro!!

The Business
Tata Investment Corporation(TICL) is a non banking finance company NBFC promoted by Tata Sons. 

It deals mainly with investment in shares, debentures, and other securities. It also undertakes capital and related customer services and financing of long-term investments in equity shares. In this it has a stated aim of increasing its investments in Tata Group companies.

Located in Mumbai, the company has investments in both, registered and unregistered entities. Among unregistered entities, it has investment in preference shares of Tata Auto Components (TACO) and Tata Sons. TACO is one of the leading auto-component providers in India, while Tata Sons has its fingers in all Tata pies including the cash cow, TCS where it is the majority stakeholder. TICL alongwith Tata Sons promotes Tata Mutual Fund and is also a chief stakeholder in Tata Securities, which distributes mutual funds and other investment related securities. 

The Financials
Tata Investment Corporation was rated by CRISIL, the highest rating of 'FAAA' since 1994 indicating maximum security in payment of interest and principal amounts. This rating has been affirmed every year since then and proves its credibility as a long term investment. That's Investment Rationale No 1 - 'being safe'.

TICL's revenue comes from dividend income and profit gained by selling investments. It has a portfolio with a book value of Rs. 1030 crore against a market cap of Rs 1418 Cr at the CMP of Rs 411. 

The company declared net profits after tax of Rs 186 Cr or Rs 54 per share in FY 2008-09. It is a debt free company with a dividend yield of 3.66 %. The table shown below highlights it. This is the Investment Rationale No 2 - 'akin to a saving bank account'.
The Valuations
An investment company like TICL is best valued using book value and an estimate of the current value of the investments. Something akin to an NAV on the basis of the market values of listed investments and the book values of unlisted investments. The managements' estimate as on 31 Mar 008 works out to Rs 805 per share, based on market values of the listed investments and the fair values of the unlisted investments after deducting tax, up from the previous year's Rs 588. At Rs 805 per share the company can be valued at Rs 2774 Cr against a market cap of Rs 1723 Cr (then) and Rs 1418 Cr (now) a discount of over 35%. That's Investment Rationale No 3 - likely capital appreciation.

The Caveat
Well besides the standard caveats for investments, this one calls for the heavy artillery. If you have a long term  horizon, lots of patience, not given to looking up the value of your investments too frequently and are looking at safety of investment prior to appreciation  but  do not want to put your money away in fixed income securities(and see IT and inflation erode your returns) then this is the stock you are looking for.

03 June 2009

SECTOR REVIEW : IT SERVICES POST FY 09

The Lehmann collapse and its aftermath seriously jolted the IT services majors. This is very evident in the analysis of the annual results of these companies.

The results reflect the debilitating business environment. Over dependence of the sector on the US and Europe, a sort of wage arbitrage, has skewed the earning profile. A very high and rising unemployment rate (8.9% in the US in April) threatens to remove this wage benefit accruing to these firms. A constant stream of dollar investments in India strengthens the Rupee while reducing the attractiveness of the Sector. This is why the expectation from this sector was lowered so sharply in the period Sep 08 to Mar 09. The graph below reflects the dampened sentiment.

In such a challenging business environment, the IT Services majors were not able to improve their revenue numbers. The Big Three in fact faced a decline in revenue, quarter-on-quarter, in their organic numbers. However for TCS and Wipro, their acquisitions helped grow the top line. This lack of growth is attributable to two factors - lesser business volume and lower pricing.

So in order to overcome the lack of growth in revenue, the companies focused on reducing cost, largely by controlling Selling, General and Administrative costs and doing lesser on site work. This strategy has its inherent limitations as it cannot be stretched beyond a point.

The Bottom Line
Well the business is not likely to grow significantly in the near future. Savings will come only from cutting costs and reducing headcount (the single largest expense) and in a business which is designed for systemic efficiency, one may not have much scope for the former. Not a very bright future, it seems. 

DISCLAIMER

This blog should not be construed as investment advice, either on behalf of particular stocks or in regard to overall investment strategies. It is a site aimed at understanding competitive advantages and valuing businesses. The information provided here comes from publicly accessible sources, but errors in these sources and in transcription may occur. Any investment decisions you make should be based solely on your evaluation of your financial circumstances, investment objectives, risk tolerance, and liquidity needs.