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Value Research
July 2017 Volume XI, Number 1
20 COVER STORY
EDITORIAL POLICY
The goal of Wealth Insight, as with all publications from Value Research, is not just limited to generating profitable ideas for its readers; but to also help them in generating a few of their own. We aim to bring independent, unbiased and meticulously- researched stories that will help you in taking better-informed investment decisions, encouraging you to indulge in a bit of research on your own as well. All our stories are backed by quantitative data. To this, we add rigorous qualitative research obtained by speaking to a wide variety of stakeholders. We firmly stick to our belief of fundamental research and value-oriented approach as the best way to earn wealth in the stock market. Equally important to us is our unwaveringly focus on long term planning. Simplicity is the hallmark of our style. Our writing style is simple and so is the presentation of ideas, but that should not be construed to mean that we over-simplify. Read, learn and earn – and let’s grow and evolve as we undertake this voyage together.
Editor Dhirendra Kumar Special Correspondent Mohammed Ekramul Haque Research & Editorial Mohit Khanna, Neil Borate, Prasobh, Vibhu Vats & Vikas Vardhan Singh
How to construct a winning portfolio 42 COVER STORY
52 COVER STORY
How to avoid wealthdestroying stocks What to do now? Your strategy in the current bull market
65 COVER STORY
73 COVER STORY
Design Mukul Ojha, Kiran Sindhwal Production Hira Lal Data source for stocks AceEquity
© 2017 Value Research India Pvt. Ltd. Wealth Insight is owned by Value Research India Pvt. Ltd., 5, Commercial Complex, Chitra Vihar, Delhi 110 092.
Value Guru stocks Investment strategies of value-investing greats
Editor: Dhirendra Kumar. Printed and published by Dhirendra Kumar on behalf of Value Research India Pvt. Ltd. Published at 5, Commercial Complex, Chitra Vihar, Delhi 110 092. Printed at Option Printofast, 46, Patparganj Industrial Area, Delhi-110092
Advertising Contact: Mumbai: 22838665 / 22838198 Delhi: 22457916 / 22457918 Venkat K Naidu +91-9664048666 Biswa Ranjan Palo +91-9664075875 Total pages 102, including covers
6 Wealth Insight July 2017
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Avoiding market noise
Columns
by
9
80
82
84
89
EDIT
GENERALLY SPEAKING
STRAIGHT TALK
MAIN STREET
THE CHARTIST
DHIRENDRA KUMAR
A new dawn India is well on its way to an economic revolution, and it’s one which few of us imagined
by
by
VIVEK KAUL
Why people will always love real estate Financial investments, like mutual funds and stocks, beat real estate hands down, but there is at least one aspect where they lag behind
by
ANAND TANDON
DEVANGSHU DATTA
Opening Pandora’s box?
Adjusting to GST
Keeping fingers crossed
A universal basic income can improve the efficiency of disbursals. But it can also let the genie out of the bottle.
The impending formalisation in the Indian economy will be expedited with the coming of goods-andservices tax
A combination of global and domestic factors will keep the Indian economy and markets on tenterhooks
48 FINANCE FOR ALL
92 EDITOR’S NOTE
A new way to invest in stocks
Economics of happiness Focusing on happiness, rather than abstruse concepts, can improve the efficacy of economics
10 Index watch 14 Big moves
by
SAURABH MUKHERJEA
91
At long last, Value Research Stock Advisor is ready to roll
EDITOR’S CHOICE
100
BEST OF WORDS WORTH NOW
Must-read books for investors
DISCLAIMER The contents of Wealth Insight published by Value Research India Private Limited (the ‘Magazine’) are not intended to serve as professional advice or guidance and the Magazine takes no responsibility or liability, express or implied, whatsoever for any investment decisions made or taken by the readers of this Magazine based on its contents thereof. You are strongly advised to verify the contents before taking any investment or other decision based on the contents of this Magazine. The Magazine is meant for general reading purposes only and is not meant to serve as a professional guide for investors. The readers of this Magazine should exercise due caution and/or seek independent professional advice before entering into any commercial or business relationship or making any investment decision or entering into any financial obligation based on any information, statement or opinion which is contained, provided or expressed in this Magazine. The Magazine contains information, statements, opinions, statistics and materials that have been obtained from sources believed to be reliable and the publishers of the Magazine have made best efforts to avoid any errors and omissions, however the publishers of this Magazine make no guarantees and warranties whatsoever, express or implied, regarding the timeliness, completeness, accuracy, adequacy, fullness, functionality and/or reliability of the information, statistics, statements, opinions and materials contained and/or expressed in this Magazine or of the results obtained, direct or consequential, from the use of such information, statistics, statements, opinions and materials. The publishers of this Magazine do not certify and/or endorse any opinions contained, provided, published or expressed in this Magazine.Reproduction of this publication in any form or by any means whatsoever without prior written permission of the publishers of this Magazine is strictly prohibited. All disputes shall be subject to the jurisdiction of Delhi courts only. ALL RIGHTS RESERVED
July 2017 Wealth Insight 7
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EDIT DHIRENDRA KUMAR
A new dawn India is well on its way to an economic revolution, and it’s one which few of us imagined Past performance is not indicative of future results. That’s something you see said about investment products, but I think it’s far truer of our country. In the case of investment products, this is generally said in a negative sense, but for India, it’s true in a positive sense: the future is much brighter than the past. After a long time, for the first time in my living memory, I get this feeling that the nation is on a path which leads out of the endless cycle of poverty and misery that an overwhelming number of our compatriots suffer from. Those of us who live in cities and read this magazine have seen an enormous improvement in our lives in the last three decades. However, I could never get rid of the feeling that in this journey of enabling India’s potential, only the easy parts will ever be done. As investors, we had learnt to live with the fact that when we talk about India as an economic entity, a market, at least half of our population doesn’t count. That’s not to say that we haven’t come a long way. It’s July again, and time for Wealth Insight’s anniversary. In the eleven years that have passed since the first issue of Wealth Insight came out, Indian equity investors have come a long way. At that time, in July 2006, the BSE Sensex was at 10,275 points. Now, it’s at 31,300 points, up more than three times in eleven years or 10.7 per cent a year. That’s not bad. So what does the future hold? I think there’s a massive economic revolution on its way, but it’s not the one that the economic elite was waiting for. Before Modi came to power, there used to be a lot of talk among the media and business chatterati about the economic reforms that the government would undertake. The general definition of reforms was always assumed to be the standard market-oriented
ideas that have come to be seen as reforms. However, this government’s ideas as well as execution turned out to be different. The obvious stuff like power, roads, railways, GST, etc., which appeared to be such insurmountable obstacles under the UPA are not only being done but at a breakneck pace that is unprecedented in India. However, there’s the massive and sharply defined focus on the the financial inclusion of the poor and on agriculture which were completely off the menu of conventional market-oriented reforms. Last month, the cover story of this magazine was on the investment impact of the rise in agricultural incomes, the context being the government’s project to double real rural incomes in five years. While this may sound like a pipe dream to the uninitiated ears, I pointed out last month that it was definitely possible. At this point of time, some 65 per cent of India’s population – the rural India – produces barely 30 per cent of GDP. Can you imagine what transformation this country will undergo if a wave of prosperity is unleashed? India would be well on its way to rising out of the ranks of underdeveloped nations. We would also be able to do what China has accomplished in the last three decades – lifting tens of crores of people out of poverty. The changes that we have seen in businesses and the investment markets in the past two decades will pale in comparison with what lies ahead. There will be entire industries that will be 10x or 20x of what we have today. This will be a hugely disruptive event, mostly in a positive way. For investors, it’s going to be an exciting as well as a dangerous time because all disruptions produce winners as well as losers. As I said, past performance is not indicative of future results. July 2017 Wealth Insight 9
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INDEX WATCH ONE-YEAR BEST PERFORMER
S&P BSE Oil & Gas 11.59
1.77
Price to earnings
Price to book
(` lakh crore)
Top gainers/losers
Price chart
Company name
16000
Market cap
Dividend yield (%)
Dynamics of the S&P BSE Oil & Gas S&P BSE Oil & Gas
11.74
3.09
S&P BSE Sensex
Price (`) 408
97.9
1,091
77.0
HPCL
529
70.6
Petronet LNG
443
56.1
1,418
43.6
BPCL
655
30.1
GAIL
368
28.5
ONGC
165
13.9
Castrol India
416
10.4
Oil India
287
7.7
IOC Indraprastha Gas
14000 12000
Reliance Industries
10000 8000 Jun’16
Sep’16
Dec’16
Mar’17
Jun’17
Price/earnings chart 26
1-year change (%)
22
Valuations
18
Price to earnings
Price to book
Dividend yield (%)
IOC
10.4
1.99
3.6
Indraprastha Gas
26.8
5.22
0.5
8.7
2.64
8.5
Petronet LNG
19.5
4.11
1.1
Reliance Industries
14.7
1.60
0.8
Company name
14 10 Jun’16
Sep’16
Dec’16
Mar’17
Jun’17
HPCL
Price/book value chart 3.2 2.7
BPCL
11.8
3.18
3.1
2.2
GAIL
17.8
1.91
3.0
ONGC
11.8
1.14
3.0
Castrol India
30.2
26.53
2.6
Oil India
14.9
0.79
5.0
1.7 1.2 Jun’16
Sep’16
Dec’16
Mar’17
Jun’17
Dividend-yield chart
Weightage (%)
4.2%
13.6
5.9
3.4
7.7
2.6
53.0
9.4
1.8
10.5
1.0 Jun’16 Sep’16 Data as on June 21, 2017
Dec’16
Mar’17
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Jun’17 Data as on June 21, 2017
Reliance Industries ONGC Indian Oil Corpn. BPCL HPCL Others
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INDEX WATCH ONE-YEAR WORST PERFORMER
S&P BSE IT 16.59
3.37
Price to earnings
Price to book
Market cap
Dividend yield (%)
Dynamics of the S&P BSE IT
(` lakh crore)
Top gainers/losers
Price chart S&P BSE IT
15000
10.84
2.27
S&P BSE Sensex
13500
Company name
Price (`)
HCL Technologies
844
9.8
Mphasis
594
9.5
3,656
5.7
Cyient
508
1.8
Persistent Systems
681
-2.3
Wipro
256
-8.6
2,406
-9.1
Oracle Fin. Services
12000 10500 9000 Jun’16
Sep’16
Dec’16
Mar’17
Jun’17
Price/earnings chart 26
TCS
1-year change (%)
Mindtree
519
-20.8
Infosys
944
-21.7
Tech Mahindra
391
-27.2
23
Valuations
20
Price to earnings
Price to book
Dividend yield (%)
HCL Technologies
17.5
4.68
2.84
Mphasis
20.0
2.66
2.86
Oracle Fin. Services
24.2
11.66
4.65
Cyient
24.1
3.04
2.07
Persistent Systems
18.5
3.03
1.32
Company name
17 14 Jun’16
Sep’16
Dec’16
Mar’17
Jun’17
Price/book value chart 4.5 4.0
Wipro
15.2
2.63
0.39
3.5
TCS
19.5
5.94
1.95
Mindtree
17.8
3.17
1.93
Infosys
15.7
3.19
2.73
Tech Mahindra
12.5
2.26
2.30
3.0 2.5 Jun’16
Sep’16
Dec’16
Mar’17
Jun’17
Dividend-yield chart 2.4%
Weightage (%) 5.1
11.9
2.1
6.8
1.8
39.4
10.1
1.5
26.8
1.2 Jun’16 Sep’16 Data as on June 21, 2017
Dec’16
Mar’17
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Jun’17 Data as on June 21, 2017
Infosys TCS HCL Technologies Wipro Tech Mahindra Others
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MARKET C MPASS
BIG MOVES: LARGE CAPS
Our large-cap universe has 100 large companies, making the top 70 per cent of the total market capitalisation. The list mentions the stocks that have fluctuated most wildly in the last one year.
Vakrangee Robust growth in revenues and net profit, coupled with rising FII interest, took the stock up.
Sun TV Network The company grew its profit by 12% YoY. It also expanded into new South Indian markets.
Rural Electrification The stock was available at dirt-cheap valuations. The government’s UDAY scheme also benefitted REC.
MRF Decline in rubber prices, expansion announcements and declining Chinese imports were positive for MRF.
Piramal Enterprises The company registered 58% growth in its net profit YoY. Its strategic investments should boost growth.
Bajaj Finserv The company’s profit grew from `2775 crore to `3450 crore over one year.
Indian Oil Corp. The company gained on the back of a cheap crude, which boosted its profit margins.
Vedanta A turnaround in commodities cycle benefitted the company, which returned to profit.
PNB Housing Finance* The company rode both the IPO boom and the rally in housing-finance companies.
Power Finance Corp. The stock was available at dirt-cheap valuations. The government’s UDAY scheme also benefitted PFC.
1Y returns (%)
Price to earnings 3Y avg RoE (%)
Net profit (` crore) 3Y earnings growth (%)
142.5
42.36 34.0
531 44.8
127.7
32.38 25.5
979 11.0
127.5
5.89 23.0
6,246 10.1
122.4
20.47 29.5
1,451 23.9
116.8
40.09 13.8
1,082 61.0
112.1
29.95 23.7
3,450 16.3
100.5
10.05 11.3
19,106 39.6
88.3
16.26 -0.5
9,411 -3.1
82.7
51.74 16.6
524 –
60.1
15.58 19.8
2,126 -26.8
1Y price (`) movement
425
175 846
372 188 83 71,734
32,250 2,908
1,342 4,257
2,007 411
205 241
128 1,627 891 132 82
*8-month returns. Data as on June 20, 2017
14 Wealth Insight July 2017
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MARKET C MPASS
BIG MOVES: MID CAPS
Our mid-cap universe has 243 mid-sized companies, making the next 20 per cent of the total market capitalisation. The list mentions the stocks that have fluctuated most wildly in the last one year.
Indiabulls Ventures The company’s entry into the high-growth consumerlending business is expected to propel growth.
Escorts FY17 profits grew 92% as tractor and constructionequipment sales increased.
Motilal Oswal Financial Net profit increased 123% YoY as net margin improved 500 bps to 20%. Revenues also increased 64%.
Adani Transmission Acquisition of Reliance Infra’s assets and new order inflows improved the company’s future outlook.
ITI The company is on the turnaround path and is forging new partnerships in the smart-cities space.
Avanti Feeds Net profit grew 43% YoY. Revenue growth was 35% YoY. Margins improved 100 basis points.
Future Lifestyle Fashion Revenue growth acclerated to 17.5% vs 5.2% last year. This is the fastest pace in three years.
India Tourism Devp. Corpn. Faster divestment of hotel properties to unlock shareholder value.
Future Retail* FY17 profits increased 2430% YoY. Revenues increased 134% YoY.
Indiabulls Real Estate A rally in real-estate stocks, along with a proposed business restructuring, resulted in stock gains.
1Y returns (%)
Price to earnings 3Y avg RoE (%)
Net profit (` crore) 3Y earnings growth (%)
716.1
76.49 42.4
102 0.2
295.5
67.66 7.6
191 2.1
275.2
49.11 9.0
365 105.1
242.3
31.28 6.0
416 –
237.9
37.19 0.0
140 34.0
180.4
27.9 49.1
227 48.1
174.3
132.2 2.2
46 25.1
148.3
476.22 6.4
13 14.1
144.6
50.34 0.7
368 –
115.3
25.03 3.8
354 15.4
1Y price (`) movement
178
22 725
183 1,222
326 118
35 93
28 1,317
470 318
116 569
229 393
161 209
97
*10-month returns. Data as on June 20, 2017.
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MARKET C MPASS
BIG MOVES: SMALL CAPS
Our small-cap universe (minimum market capitalisation `400 crore) has 710 smallcap companies, making the last 10 per cent of the total market capitalisation. The list mentions the stocks that have fluctuated most wildly in the last one year.
Millitoons Entertainment* This newly listed company grew its revenues 13 times and profit 29 times YoY.
Medicamen Biotech Net profit increased 975% YoY. The revenue increased 22% YoY.
Fiberweb India Thanks to the decline in crude prices, profits increased 100% in FY17 YoY.
Yuken India Profit increased 137% YoY during the January-March quarter of 2017.
Agarwal Industrial Corporation The revenue and net profit increased more than 100% YoY during the January-March quarter of 2017.
NR Agarwal Inds. The company posted solid growth in net profits in every quarter last fiscal.
Asian Oilfield Services The company won a big contract from Oil India.
Atlas Jewellery India The stock has gone up without any clear reason in sight. Investors should be cautious.
Indian Metals & Ferro Alloys The company posted net profit of Rs.370 cr in FY17 vs a loss of `85 crore last year.
Videocon Industries The company’s high debt roiled the stock. Its venture into the oil-exploration segment also backfired.
1Y returns (%)
Price to earnings 3Y avg RoE (%)
Net profit (` crore) 3Y earnings growth (%)
588.3
– 0.1
0.3 –
566.6
122.56 2.0
5 278.7
453.9
31.51 0.0
14 143.4
431.8
– 0.2
-5 -51.3
427.5
78 13.7
9 21.1
409.9
7.06 -4.8
70 437.2
361.6
– -67.2
-18 6.7
283.1
– 1.2
-9 -279.1
231.5
5.08 -0.6
250 85.5
-80.6
– -3.2
-1,726 -568.2
1Y price (`) movement
45 6.56 571
86 335
61 1,695 319 691
131 291
57 196
42 70 18
141 469 103
20
*11-month returns. Data as on June 20, 2017
18 Wealth Insight July 2017
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COVER STORY th ANNIVERSARY
How to construct
a winning portfolio Mohammed Ekramul Haque
M
any investors wander randomly while investing. They pick stocks that are market favourites, those that hit upper circuits. Or they just put their money where television-based market experts tell them to. One-by-one, a motley group of stocks is thus added to their portfolios – all without focus, direction or even reason. Such crudely put-together portfolios are doomed to give returns much below average returns. Well, none of our readers should invest like that. You shouldn’t have to wonder how to create a portfolio or depend on outsiders to do it for you. In this 11th anniversary issue of Wealth Insight, we bring to you a complete toolkit on how to create and
20 Wealth Insight July 2017
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maintain a portfolio that is focused on one thing: long term wealth creation. Constructing your portfolio involves working on two levels: the first level is about the individual stocks and the second is about portfolio construction and management. Therefore, the toolkit in the following pages is divided into two parts. The first part is about stock picking: how to pick stocks, when to pick them and what not to pick. The second part focuses on the portfolio: how to build a portfolio, how many stocks to add to it, how long you should hold a stock and when you should sell it. Keep the following tools at your disposal and you should be on the road to disciplined wealth creation – all on your own. Happy investing.
HOW TO PICK THE RIGHT STOCKS COVER STORY
What businesses to own?
We’ve really made the money out of high-quality businesses. In some cases, we bought the whole business. And in some cases, we just bought a big block of stock. But when you analyze what happened, the big money’s been made in the high-quality businesses. And most of the other people who’ve made a lot of money have done so in high-quality businesses. Charlie Munger
The first question any investor has to answer is what businesses he wants to own. Though this appears too elementary, many investments fail because the business the company was operating in was not adequately evaluated. One of the best types of companies to invest in is one that employs incremental capital at high rates of return. This high rate of return not only beats inflation but also generally the return earned by the rest of the industry. Castrol earns such high returns on its business that it doesn’t really know what to do with the excess cash. It therefore returns most of it to its shareholders. Look for
companies that have pricing power: those that can raise prices and still have customers buying its products. For instance, even if GSK Consumer Healthcare raised the prices of Horlicks, people would still continue to buy Horlicks and not a cheaper brand. Buy stocks of companies that sell essential goods and services. Hindustan Unilever sells detergents, soap, toothpaste, shampoos and hundreds of daily-use items. These are not glamourous products, no new-age world changer, yet the company did business of close to `33,000 crore last year and its profit before tax was about `6,400 crore. You can get all of the above qualities in a company that has a moat around itself. A moat gives companies ammunition to fight off new and disruptive entrants. It allows companies to raise prices and earn high rates of return – qualities you should look for in every investment you make and every stock you buy. Finally, when you get all the qualities you want in a stock, look at the price. A company with a moat can become a bad investment if you pay too much for it. Charlie Munger once famously commented, “The trick is to get more quality than you pay for in price. It’s just that simple.” July 2017 Wealth Insight 21
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COVER STORY
Pick businesses that you understand
Never invest in a business you cannot understand Warren Buffett
Many investors, especially those starting out, do not fully appreciate the value of understanding the business that a company is in. Many industries work in complex situations that not every investor easily understands. Take a look at some of the revenue streams of an industry leader: z Global Analytical Centre z Risk & Analytics z Coalition z Risk Solutions z Infrastructure Advisory The above revenue sources belong to the ratings giant CRISIL, apart from its ratings and research businesses. How many investors will understand how CRISIL’s revenue streams will perform in the years ahead? When picking a company, consider businesses that you can understand. Let’s take a look at GSK Consumer Healthcare, the manufacturer of market leader Horlicks. GSK owns 64.6 per cent volume market share in the health-food-drinks market in India, which is the world’s largest market. Malt-based food drink brings in over 90 per cent of GSK’s revenues. This is a relatively easier business to understand. How will Horlicks perform in the Indian market is the main determinant of GSK’s performance. Will more Indian children take to Horlicks? Who are its primary competitors? The table lists out businesses that 22 Wealth Insight July 2017
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Easy and complex Relatively simple Abrasives Air conditioners Automobiles: Two & three wheelers Batteries Cable Ceramics Cigarettes Domestic appliances Consumer food Courier services Cycles Diamond & jewellery Educational institutions Hospital & healthcare services Hotels, resorts & restaurants Paints Plastic products Printing & stationery Sugar Travel services Wood & wood products
Relatively complex Banks Chemicals Dyes & pigments Diesel engines Electric equipment Engineering Film production, distribution & entertainment Software Mining & minerals Oil exploration Pesticides & agrochemicals Petrochemicals Pharma Ratings Refineries Retailing Shipping Steel & iron products Telecom - service Transmission towers/ equipment TV broadcasting & software production
are relatively easier to understand and those that are relatively complex.
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COVER STORY HOW TO PICK THE RIGHT STOCKS
Buy companies with moats
We buy barriers. Building them is tough… Our great brands aren’t anything we’ve created. We’ve bought them. Charlie Munger
The word ‘moat’ was popularised by the legendary investor Warren Buffett. A moat is a channel of water around a castle. It is meant to keep enemies away from the castle. In terms of investments, a moat is a competitive advantage that cannot be easily imitated or some sort of barrier to entry. Let’s do a quick go-through of the types of moats. Brands: One of the most enduring sources of moats is brands that companies develop and nurture. Once fully developed, a new entrant cannot eat into a brand’s sales easily. Think Horlicks or Nestle’s Nan. Would you give your children a cheaper health food that is available on the market? Brands help companies develop customer loyalty that is often difficult to take away. Superior technology: This source of moat relies on the company’s technological superiority to drive revenues and fortunes. Well-known examples include Microsoft Windows. No other operating software has captured so large a market share in PCs worldwide as Microsoft. To keep revenue registers ringing, the company regularly offers fixes and upgrades that customers usually have no option but to buy.
Network effects: The more the number of
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people use a service the more the value of the system increases. Checking reviews on Tripadvisor.com is increasingly becoming common among internet-savvy travellers in India. The greater the rating and the reviews about a hotel, the greater the confidence potential guests have about the hotel. TripAdvisor has thus developed a service that has only limited competition. High switching costs: Sometimes a product becomes so mainstream that it’s very difficult to adapt to a new system, even at a lower price. Such products are said to have a high switching cost. Adobe’s Photoshop has created such a space in photo editing and designing that even free alternatives cannot take away Adobe’s users. Low costs: Companies that offer products and services at prices that competitors cannot match create a moat around them. A number of India’s pharma companies are amongst the lowest-cost producers of drugs in the world. High entry barriers: There is a set of companies that operate in industries with high entry barriers, in some cases enabled by government. Coal India is the largest coal miner in the country by virtue of regulation. ONGC is the country’s largest oil-exploration company, again by regulation. No other company in the coal or oil-exploration space can match the resources and strengths these two behemoths can bring to the table.
HOW TO PICK THE RIGHT STOCKS COVER STORY
Pick companies with consistent earnings
The point is I got rich looking for stock with strong earnings Warren Buffett
If there is one factor that drives a company’s stock price, it is earnings. Peter Lynch once famously commented that earnings are the only form of growth that counts. Consistent earnings drive shareholder wealth over the years. Among thousands of listed stocks, there are only a handful of companies that report
consistent growth in earnings. Take a look at the table below. It mentions companies with steady earnings growth over the last five years. Companies with consistent earnings growth have invariably resulted in higher share-price returns. The lesson to draw: pick companies with steady stream of earnings growth.
Steady earnings growth EPS 4 yrs ago
3 yrs ago
2 yrs ago
1 yr ago
Ajanta Pharma
8.80
12.77
26.61
35.23
45.61
57.30
80.47
BPCL
5.40
13.01
27.04
33.24
55.19
66.52
32.97
GHCL
4.45
7.14
10.85
18.19
25.64
38.21
45.07
58.17
81.76
94.47
126.07
155.59
248.67
45.88
1.98
3.36
5.78
6.52
9.63
11.07
57.26
Maruti Suzuki India Motherson Sumi Systems
Current
5-yr stock return (%)
5 yrs ago
July 2017 Wealth Insight 25
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COVER STORY HOW TO PICK THE RIGHT STOCKS
Invest in quality businesses
Leaving the question of price aside, the best business to own is one that, over an extended period, can employ large amounts of incremental capital at very high rates of return. The worst business to own is one that must, or will, do the opposite – that is, consistently employ ever-greater amounts of capital at very low rates of return. Unfortunately, the first type of business is very hard to find. Warren Buffett
Many investors skip enquiring into the quality of the business they want to put their money into. This is an expensive mistake that later comes to haunt them when stock prices follow the company’s fundamentals. Look at the table. It lists out companies that have eroded the quality of their businesses, as captured in their falling returns on the capital employed. Also, when companies do not earn a return high enough to
cover costs, they have to resort to external financing. In the table, take a look at the dismal stock returns. Some of the companies in the table, like Jaiprakash Associates, Punj Lloyd and Unitech, were the darlings of the stock market in the last bull run. Hence, whenever picking stocks, keep an eye out for the quality of the business if you want sustained long-term outperformance.
Quality going down ROCE (%) 5 yrs ago Latest
Amtek Auto Den Networks
7.43
-1.55
Debt/equity 5 yrs ago Latest
1.1
2.96
Price (Rs) 5 yrs ago Latest
102
34.3
5Y return CAGR (%)
-19.58
8.72
-4.05
0.2
0.61
92.55
82.7
-2.23
10.34
3.58
4.21
5.27
65.95
12.72
-28.05
Punj Lloyd
6.39
-15.24
1.53
-6.14
45.5
20.8
-14.49
Unitech
5.68
-3.9
0.52
0.45
22.05
5.2
-25.09
Jaiprakash Associates
Price as of June 2017
26 Wealth Insight July 2017
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COVER STORY HOW TO PICK THE RIGHT STOCKS
Ensure margin of safety
Grahamites… realized that some company that was selling at two or three times book value could still be a hell of a bargain because of momentum implicit in its position, sometimes combined with an unusual managerial skill plainly present in some individual or other, or some system or other. And once we’d gotten over the hurdle of recognizing that a thing could be a bargain based on quantitative measures that would have horrified Graham, we started thinking about better businesses. Charlie Munger Every stock you buy should carry a margin of safety. You can get a margin of safety if the company sells essential products that will not go out of fashion or by sticking with market leaders or by buying a stock that is worth more than its price.
ware will continue to be in demand well into the foreseeable future. The idea is to look for companies that sell products or services that are so essential that they will not become obsolete and are likely to see continued demand for a long time.
Margin of safety in essential products and services
Margin of safety in industry profit takers
When picking stocks, the more far out you can see the demand for a company’s products, the more margin of safety you get. Let’s start with the absolute essentials: personal-care products. Do you envisage a scenario where humans will not need soap, shampoos, detergents, toothpastes or sanitary pads? Do you see any of these products selling less or becoming obsolete 10 or even 20 years from now? What about transportation? Till the technology for teleportation is developed, and that seems far away today, we will continue using vehicles to go from one place to another. The requirement for housing means that you can safely say that cement, paints, wires, electrical components, pipes and sanitary28 Wealth Insight July 2017
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You can also find margin of safety in industry leaders. These companies are more likely to survive economic downturns and recover faster than other marginal players. Look at the top players in any industry. A more evolved method of looking at market leaders is to look at the profit takers in any industry. Stick with the top companies that corner all or a major portion of profits made in any industry and you’ll have names that will survive longer and remain more profitable than most others.
HOW TO PICK THE RIGHT STOCKS COVER STORY
Pay attention to the payback period
If we could see in looking at any business what its future cash flows would be for the next 100 years, and discount that back at an appropriate interest rate, that would give us a number for intrinsic value. It would be like looking at a bond that had a bunch of coupons on it that was due in a hundred years... Businesses have coupons, too. The only problem is that they’re not printed on the instrument and it’s up to the investor to try to estimate what those coupons are going to be over time. In high-tech businesses, or something like that, we don’t have the faintest idea what the coupons are going to be. In the businesses where we think we can understand them reasonably well, we are trying to print the coupons out. If you attempt to assess intrinsic value, it all relates to cash flow. The only reason to put cash into any kind of investment now is that you expect to take cash out – not by selling it to somebody else, that’s just a game of who beats who – but by the asset itself... If you’re an investor, you’re looking on what the asset is going to do. If you’re a speculator, you’re commonly focusing on what the price of the object is going to do, and that’s not our game. We feel that if we’re right about the business, we’re going to make a lot of money, and if we’re wrong about the business, we don’t have any hopes of making money. Warren Buffett Imagine you are looking at two business proposals to invest your money in and both demand an equal investment. It is generally a better option to opt for the one that has a lower payback period – the time required to recover your investment. The same is true for stocks. If there are two stocks with near-similar profiles and both are growing at near the same rates, it
is preferable to go with the one with a shorter payback period. Remember, the longer the payback period, the greater the uncertainty over any future developments that may further extend the payback period.
Payback period is not stock-price gain As Buffett mentions above, payback period has nothing to do with stock-price gains. July 2017 Wealth Insight 29
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COVER STORY HOW TO PICK THE RIGHT STOCKS
The stock you purchased could go up 30 per cent in one year, then fall 20 per cent in the next and then go up 5 per cent in the next, making it really difficult to measure accurately the payback you get. What should you take as the yardstick of payback period then? Try earnings per share, or EPS.
Measure payback with earnings per share Earnings are the most reliable way to look at your payback period. Compare the price you pay for a stock with the earnings that you get for it (this is called earnings yield). If you buy a stock for `500 and the earnings are `40 per share, your initial return comes to 8 per cent. If earnings grow consistently at 10 per cent, the payback period comes at the end of seven years. The accompanying table illustrates this example. Note that this exercise does not even look at stock-price returns but at the earnings that the company earns for you. The earnings are the only real gains that are guaranteed to you. The company can distribute its entire earnings of `40 to you as dividend or it can plough back the entire earnings into the business or it can give you a portion of your earnings and retain the remaining portion to invest in the business. The retained earnings, in turn, will increase the net worth of the business and the stock you own. The main point is that the `40 earnings is yours, as are all the future earnings till the time you remain invested in the company. The takeaway: ensure that your starting earnings yield is high.
Payback period Year
Adjusted EPS* (`)
Starting investment `500
Growth rate (%)
Return (%) on `500
Worth of investment (`)
540
1
40
10
8.0
2
44.0
10
8.8
588
3
48.4
10
9.7
644
4
53.2
10
10.6
713
5
58.6
10
11.7
797
6
64.4
10
12.9
899
7
70.9
10
14.2
1,027
How to reduce your payback period? What you want to do with every investment is to look at how fast a prospective investment can pay your invested capital back. 30 Wealth Insight July 2017
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This is inextricably linked to the price that you pay for the stock. ABB is a fine company, one of the best in its industry, yet its P/E ratio of 80x means the stock yields you a measly 1.25 per cent return on your investment. Think of the time it will take to recover your investment by way of the earnings the company will generate in the future. Let’s look at Rural Electrification Corp, which trades at 6x its earnings. This investment gives you a starting yield of 16 per cent. This will return your investment much faster than ABB will. A stock with a low P/E ratio is likely to result in a quicker payback period for your investment. The higher the P/E ratio, the longer the payback period becomes.
Earnings growth Over the long term, stock prices generally tend to move in sync with earnings growth. Lupin trades at 20x its earnings, which have grown at an annual rate of 21 per cent over the last five years. In the short term though, stock prices and valuations are affected on a daily basis by the market’s expectations of future earnings. The stocks of IT firms in the country have seen a de-rating in the last couple of months as the markets factored in the effect of Trump’s restrictive policies on their bottom lines.
How do you ensure a quick payback period? To find companies with quick payback periods, look for the following in any prospective stocks: z A low P/E ratio z High earnings growth z P/E below the earnings growth rate Whenever faced with two similar stocks with the same P/E ratio, go for one with higher earnings growth. Higher earnings will tend to reduce your payback period.
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COVER STORY HOW TO PICK THE RIGHT STOCKS
Use earnings yield to pick stocks
We just try to buy things that we’ll earn more from than a government bond. Warren Buffett
An effective way of looking what returns you will get when you buy a stock is to look at the stock yield. That is the earnings per share of the company divided by the share price. So a stock with an earnings per share of `20 and trading at `400 will give you a stock yield of 5 per cent. A stock with an earnings yield above the prevailing bond rate will give returns that will beat both inflation and the interest you would have earned on the bond coupon. Of course, you can also buy a stock with an earnings yield lower than the bond rate.
In such a situation, your bet is that the company’s earnings growth will, in a short time, push your yields above the bond rate. Stocks with a yield below the bond rate, therefore, can also be a good investment if the company has a good track record of consistent earnings growth and you can beat the bond returns in a short time. For a detailed analysis of picking stocks using earnings yield, see the May 2017 issue of Wealth Insight.
Earnings yield higher than the bond rate Company name
Earnings yield (%)
ROCE (%)
Debt/ equity (x)
1-yr
EPS growth 3-yr
5-yr
Hindustan Zinc
16.47
21.37
0.00
1.82
6.39
8.52
KPIT Technologies
15.27
22.11
0.18
-15.43
-1.89
9.18 23.73
Hindustan Media Ventures
13.90
26.68
0.19
6.04
19.45
NIIT Technologies
13.38
25.95
0.01
-10.91
2.38
4.27
MRF
12.85
48.41
0.36
-11.09
24.93
16.57
Coal India
11.90
56.98
0.04
-33.95
-14.55
-8.61
Balmer Lawrie & Co.
11.81
21.38
0.14
-4.92
2.99
2.81
Tech Mahindra
11.43
28.96
0.08
-0.03
-0.23
8.44
Bliss GVS Pharma
11.08
31.99
0.32
3.79
27.78
10.26
Apollo Tyres
11.06
24.24
0.24
0.52
2.68
21.56
10-year benchmark yield 6.532%. Data as on June 7, 2017
32 Wealth Insight July 2017
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HOW TO PICK THE RIGHT STOCKS COVER STORY
Don’t overpay
When you’re trying to determine intrinsic value and margin of safety, there’s no one easy method that can simply be mechanically applied by a computer that will make someone who pushes the buttons rich. You have to apply a lot of models. I don’t think you can become a great investor rapidly, no more than you can become a bone-tumor pathologist quickly. Charlie Munger On to one of the trickiest part of investing: how do you value a business? There’s no clear or easy way to do that. Two investors can come up with a completely different valuations for the same stock. Even Warren Buffett has never revealed his trade secret on how he values his investments, but true to his style, he has given us leads on how to go about it. One of the most straight-forward ways to value a business, according to Buffett, is to estimate what the future cash flows would be like and then discount them back at an appropriate interest rate. This will give you the intrinsic value. As easy as it sounds, the process involves a number of complexities. First, you have to estimate a company’s earnings going say over the next ten years – an extremely difficult job. You have to come up with a growth rate and then you have to fix an appropriate discount rate. Any misstep in either of the above will give you grossly wrong intrinsic values.
The easy way out Intrinsic value calculations are complex because of the assumptions that you need to build in them. They are not everybody’s cup of tea. There are, however, simpler ways to
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get to the fair value for a stock. With them, you can estimate whether a stock is undervalued, overvalued or fairly valued. Here are two methods to do so:
Peter Lynch’s method Famed investor Peter Lynch used what we today know as the PEG (price-to-earnings growth) ratio to estimate the fair value of a business. According to Lynch, if a company’s earnings grew by 15 per cent, you can buy the stock at a P/E ratio of 15 (PEG ratio of 1). A PEG ratio of less than one is attractive and that of more than one unattractive. A PEG ratio of half is very attractive and that more than 2 is very unattractive.
Using earnings yield As stated in the previous section, using earnings yield is a very good strategy on how to go about picking stocks. Buy stocks well over and above the current bond rate and you will have built in a margin of safety without getting into the complexities of discounting and estimating future cash flows.
COVER STORY HOW TO PICK THE RIGHT STOCKS
Assess the management
Passion is the number one thing that I look for in a manager. IQ is not really that important. They need to be able to work well with others and the ability to get people to do what you want them to do. I’d say intelligence, energy, integrity. If you don’t have the last one, the first two will kill you. Warren Buffett Management is one of the most under-rated elements when investors pick stocks. Many investors are just interested in the next hot stock. That is a colossal mistake. If the company you invest in does not have a capable management, your returns will suffer. Here are some signs of trouble relating to the management.
When there is internal power struggle: A number of once-successful companies have bitten the dust. Among other reasons, internal rift between promoters hastened their demise. Some examples include Modi Rubber and BPL.
When the management is accused of fraud:
once-successful companies have fallen because of management’s decisions to acquire expensive acquisitions that did not give the returns they had expected. Some examples include Suzlon and Opto Circuits.
If you look at Unitech’s numbers alone, it would appear that the stock is extremely undervalued. Yet with the promoters Sanjay and Ajay Chandra booked for duping home buyers, you should stay very far away from the company.
When the management takes on too much debt to go on an acquisition spree: Many
When the management actively works against minority shareholders: Many times
Buy a business any idiot can run
the management may want to clear resolutions that go against the interest of minority shareholders. For instance, dilution of equity is a bad sign.
Some of the most successful brands do not need a star manager to remain successful. Does it really matter much who is heading Nestle, Gillette, HUL or P&G? In the case of such brands, if the top management is just competent enough to continue to create value for the shareholders, the company will continue to do well.
When the management has pledged all of its shares: Managements who have pledged most or entire portion of their shares become vulnerable, both to the lenders and the external factors that affect the industry. When the CFO resigns: Dig deeper when the CFO of a company resigns. He is one of the most important personnel who knows the ins and outs of the company’s finances. 34 Wealth Insight July 2017
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COVER STORY HOW TO MANAGE YOUR PORTFOLIO
Build a dividend portfolio
The test on dividends is, ‘can you create more than one dollar of value with the one you retain?’ It would be a mistake for See’s to retain money because they have no ability to use the cash they make to generate a high return internally. Warren Buffett
Many investors like the certainty that dividends provide. In fluctuating markets, if there is one thing that remains certain, it is the regular stream of dividends. In this section, we look at how to build a portfolio for dividends.
What to watch out for in putting together a dividend portfolio? Here are a few things to look out for in a dividend portfolio: 1. Quality: As is a growth portfolio, you want your dividend portfolio to contain names that are of quality companies. Do not get enticed by unknown names that carry high yields. 2. Source of sustainability of dividends: For dividend stocks to continue giving you dividends in the future, the company should have cash resources and enough cash generation every year to sustain profits and pay dividends in the future. Stay away from companies that pay out most of their cash reserves as dividends in one single year with nothing left for the next. 3. Revenue and earnings growth: Revenue and earnings growth directly affect any company’s excess cash. Any weakness in them can disturb the payout that companies can give. 4. A cut in dividend: This is one of the early signs of impending stress that a company 36 Wealth Insight July 2017
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is likely to face. Be cautious of companies that announce a dividend cut due to ‘challenging times’. 5. Increasing leverage: Companies that take on more debt will find it increasingly difficult to service the same level of payout. For such companies, interest payments become the priority, not investor wealth. 6. Acquisitions: Companies that make bigbang acquisitions, especially those financed by debt, are more likely to come under stress, as many Indian firms have found out in recent times. 7. A too-good-to-be-true yield: If a stock quotes at a very alluring dividend yield, it may actually be too good to be true. Dig deeper. Why is the stock’s yield so high, especially in a high market? Is the business in decline? Markets generally do not let such opportunities pass without reason.
HOW TO MANAGE YOUR PORTFOLIO COVER STORY
How many stocks to hold?
If you have a harem of 40 women, you never really get to know any of them well. Warren Buffett One of the most important decisions to make once you’ve identified stocks that you want to buy is how many stocks to add to your portfolio. There are two schools of thought on this subject: the first says that you should diversify your portfolio by putting your eggs in a number of baskets. The rationale behind this is to mitigate risks from individual stock losses. A couple of most famous proponents of this strategy included Benjamin Graham and Walter Schloss, both of whom were comfortable holding between 30 and 100 stocks in their portfolios. The second group proposes a more concentrated approach. Their rationale is to load up on a couple of great investments when you find them. Their business should be such that you understand – What drives it, its economics and so on. We at Value Research subscribe to this philosophy. Here are the views of some of the most prominent economists, investors and writers on concentrated investing: According to Charlie Munger, “The Berkshire-style investors tend to be less diversified than
other people. The academics have done a terrible disservice to intelligent investors by glorifying the idea of diversification. Because I just think the whole concept is literally almost insane. It emphasizes feeling good about not having your investment results depart very much from average investment results. But why would you get on the bandwagon like that if somebody didn’t make you with a whip and a gun? Seth Klarman (investor and author, Margin of Safety): “The number of securities that should be owned to reduce portfolio risk is not great; as few as ten to fifteen holdings usually suffice.” Finally, here’s Buffett with the most extreme sort of concentration, “Charlie and I operated mostly with 5 positions. If I were running 50, 100, 200 million, I would have 80% in 5 positions, with 25% for the largest. In 1964 I found a position I was willing to go heavier into, up to 40%. I told investors they could pull their money out. None did. The position was American Express after the Salad Oil Scandal. In 1951 I put the bulk of my net worth into GEICO. Later in 1998, LTCM was in trouble. With the spread between the on-the-run versus off-the-run 30 year Treasury bonds, I would have been willing to put 75% of my portfolio into it. There were various times I would have gone up to 75%, even in the past few years. If it’s your game and you really know your business, you can load up.” July 2017 Wealth Insight 37
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COVER STORY HOW TO MANAGE YOUR PORTFOLIO
Diversify across industries
Our investment style has been given a name – focus investing – which implies 10 holdings, not 100 or 400. Charlie Munger When you are building your portfolio, it is prudent not to be fully exposed to a single industry in order to protect your portfolio from taking a hit it may not recover from.
Resilient industries No matter how the markets perform or where the economy goes, there are some industries that are more resilient. It would be a good idea to put your money in such industries first. Among these are: z FMCG, z Pharmaceuticals, z Oil and gas, and z Utilities. Do you see the common theme that runs across all of them? All of them belong to different but essential industries. Do you buy lesser food or medicines just because the economy’s going down? How about transport: do you travel less on days when the markets are down? Or use less electricity because the economic output contracted?
Buy hot industries that are out of favour A value investor always looks for more value in return for his money. You can get that when you look at hot sectors when they fall out of favour. Take technology for instance. Trump’s restrictive policies have de-rated a number of tech stocks to valuations not seen in a long time. Or buy agristocks when monsoons fail. Sentiments and valuations will both be down and you will 38 Wealth Insight July 2017
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get more bang for your buck. Look out for such industry-specific disturbances like the USFDA issue facing Indian pharma today, but remember that it can take a long time for things to turn around in any industry. Buy a good bargain and stay put.
Discover the bedrock of utilities Utilities are not considered attractive investments. They, however, provide stability to any portfolio. What you may not gain by share-price appreciation, you are more likely to gain by way of dividends. To be clear, when we talk of utilities here, we don’t mean loss-making public sector enterprises but those utilities that throw up so much cash that they don’t really know what to do with it and therefore send most of their earnings to the owners and you.
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COVER STORY HOW TO MANAGE YOUR PORTFOLIO
When to sell?
If you don’t feel comfortable owning something for 10 years, then don’t own it for 10 minutes. Warren Buffett When to sell a stock is one of the most difficult decisions you will have to make in stock investing. Here is some help.
Holding forever Buffett’s favourite holding period is forever. You ride the truly exceptional companies you own. You don’t sell them just because they’ve gone up or down or below your purchase price. That is how you create wealth.
Hitting the sell button There are situations when you would need to sell a part of your portfolio. Such situations can be divided into personal and stock-specific cases. A personal situation could be an emergency for instance. Here are some stock-specific reasons to sell: The story has changed: The management itself has changed or the company’s taking a new direction you don’t like. Revenue growth has taken a nosedive and profits and margins are spiralling down. The moat has deteriorated: The company has been unable to protect its moat, which has been encroached by competitors. A better opportunity: A new, more attractive opportunity is there. Your stock has done well: If your stock is the lone star of a market fancy and has run up to lifetime-high levels, ask why the stock could not go down? Too much debt: Rising debt is a bad sign.
40 Wealth Insight July 2017
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When not to sell Here are some situations when you shouldn’t click on the sell button: A bad quarter or two: All companies experience good and bad times.
The stock price has fallen below your purchase price: Find out why the stock has gone down. Is the reason temporary in nature, company-related or market-sentiment-linked? The stock’s just not going anywhere: If the company is healthy and is earning more every year, don’t sell just because the price is not going up. A roaring bull market: Don’t sell your stocks just to get on something else that is going up. Sell for just the heck of it: Some novice investors click on the sell button because ‘why not?’
Sell to buy the latest cell phone: Never ever sell
SELL
stocks to buy the latest cell phone or any other gadget you ‘must’ own. The lost gains will haunt you for a long, long time.
Annual exercise Once a year, take a look at the stocks in your portfolio and ask yourself if you would buy the same stocks today. If no, you need to reassess your investment.
HOW TO MANAGE YOUR PORTFOLIO COVER STORY
Track your portfolio Before computers invaded our lives, the only way to track your portfolio was to maintain a physical register where you would meticulously note down the details of your stock transactions. Today, you can use the Portfolio Manager on the Value Research website (https://www. valueresearchonline.com/port/) to track your portfolio. You can even import your transactions and directly upload them to it. It also automatically adjusts dividends, splits and bonuses. What’s more, you get many tools to analyse your portfolio. So why wait? Try it today. WI
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COVER STORY th ANNIVERSARY
What to do NOW Your strategy in the current bull market
Mohammed Ekramul Haque
A
s the Sensex scales new lifetime highs, this is a good time to refresh our minds about market cycles. Markets always move in cycles, from pessimism to euphoria and between scepticism and optimism. In this feature, we look at the market cycles that India has witnessed over the past two decades and where we stand now. We also look at what options you, as an investor, have when markets become overheated.
The four stages of a market cycle 1 PESSIMISM 2 SCEPTICISM 3 OPTIMISM 4 EUPHORIA
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COVER STORY Pessimism
Oh! There is nO hOpe
1
The stage of pessimism usually comes into play after a great bull run has ended and stock prices are in shambles. Headlines blare out stock-market losses and many stocks which were once market favourites now trade 80–90 per cent below their peak levels. This is a period when nobody wants to invest in the stock market. Everyone wants to sell and cut their losses. Short-term sure bets rather grudgingly become long-term investments. A rather interesting thing happens to market valuations, too. As the market falls, valuations become attractive. The same market that was once trading at lofty valuations and appeared attractive now trades at even half those
Fall from the peak: iT bull run 6500
valuations and is still shunned. Take a look at the two major market crashes in the last two decades. The first was brought upon by the end of the technology and communication boom that peaked in February 2000 and then went downhill from there. The second was the infrastructure and realty bull run that ended in January 2008. The fall that followed the crash of tech stocks saw the Sensex losing 56 per cent of its value. Valuations fell from a peak of 25.5 times trailing-12-month earnings to 13.5 times. The infrastructure and realty bull run that ended with the global financial meltdown of 2008 saw a loss of 61 per cent in the Sensex’s value. Valuations fell from a peak of 28.5x to 11.62x.
Fall from the peak: infra and realty bull run Sensex chart
5500
22000
Sensex chart
18500
-56%
4500
3500
-61%
15000
11500
2500
8000 Feb 11, 2000
Jan 8, 2008
Sep 21, 2001
Mar 9, 2009
scePTicism
Well, i am nOT sure
2
The period following a major market crash is then followed by scepticism. The market is not convinced that the the bottom has been reached. Investors are still away and the market stagnates. There is nothing that excites investors, not even low valuations. Even after the market crash of the IT bull run, the markets remained range-bound for most of 2001–2003, gaining 12 per cent by the end of this
period. Sensex valuations oscillated between 12–18 times in this period, averaging at 14 times. Similarly, after recovering from the shock of the financial meltdown, the markets again remained range bound for a period of a little over three years. This included the period of the ‘policy paralysis’ of the previous government. Sensex valuations moved between 16x and 24x.
July 2017 Wealth Insight 43
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Cover Story range-bound market after the iT crash
range-bound market after the financial crisis
4000
22200
Sensex chart
3600
20400
3200
18600 2924
2800 2600
2400
20356
Sensex chart
20947
16800 15000
Sep 21, 2001
Apr 25, 2003
Nov 1, 2010
Mar 3, 2014
oPTimism
lOOks inTeresTing
3
This stage is marked by hope that things will change for the better. The most recent example is the hope that the markets have placed on the change that PM Narendra Modi will bring to the country’s fortunes. Let’s look at how the market behaved from the time Modi was nominated as the next PM candidate to one year after election results. During this period of a little less than two years, the Sensex gained 38 per cent. Market valuations moved from 17x to 20x.
markets optimistic of modi-led change Sensex chart
30000 27000 24000
38.5%
21000 18000
Sep 13, 2013
May 15, 2015
euPhoria
Bring iT On
4
In the last three months of the IT bull run, the markets gained close to 40 per cent. The Sensex P/E ratio expanded from 18.5 to 25.5 in this short time. Let’s take a look at how the infrastructure and realty bull run ended. In the last one year of that rally, the Sensex gained close to 70 per cent. Valuations expanded from 19x to 28.5x.
Let’s tread into the euphoria territory. The markets by now have thrown all caution to the wind. The party, it appears, will go on forever and there will be a fundamental change in the world. This is the final stage of a bull run that has run its course.
euphoria at the end of the iT boom
euphoria at the end of the infra/realty bull run Sensex chart
6000 5500
19500
5000
17000
40%
4500 4000
Nov 1, 1999
Feb 11, 2000
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Sensex chart
22000
68%
14500 12000 Mar 5, 2007
Jan 8, 2008
COVER STORY
TIME TO BE CAUTIOUS TIME FOR ACTION
I
t’s easy to look back and see market peaks and bottoms. To understand where we currently stand is a rather different thing. This year, the Sensex is up 15 per cent. Valuations have moved up from 21x to 23x. If history can teach us anything, it is this: markets can remain expensive for a long time before going down and the fall, whenever it comes, takes everyone by surprise. For the prudent investor though, alarm bells should start ringing when continuous market peaks are not backed by fundamentals.
Where do we stand now? 30800 29600 28400
15%
27200 26000 Jan 2, 2017
May 17, 2017
In an overheated market, there are two strategies available for the prudent investor. SELL OR REDUCE YOUR PORTFOLIO: For the more conservative investors, this strategy involves selling or reducing their portfolios and sitting out of the market for some time. The markets will rise even after you sell or reduce your position and the wait for markets to fall could be a long one. Once the markets correct, you can start buying stocks again at lower valuations. SELL THE MOST EXPENSIVE STOCKS: The first strategy involves things like discipline, detachment, prudence and patience – qualities not all investors possess, not even the more experienced ones. For such people, the second strategy involves selling the most expensive stocks in their portfolios, stocks that now trade at valuations never seen before in the sector or the security. At the same time, you can keep on holding onto companies that will continue to make money for you even if the markets closed down. WI
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FINANCE FOR ALL
Economics of
Happiness Focusing on happiness, rather than abstruse concepts, can improve the efficacy of economics
F
or almost as long as I can remember, economics has been under fire both from within and outside. From within, as attempts were made by economists to record the peculiarities of human behaviour and document the various decision-making models that run in our heads, this subject eventual-
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ly came to be known as behavioural economics. From outside, the attacks came from the users of economic models. Like angry users of defective cars, they castigated the economics establishment for presenting the wrong service to meet a specific need or for meeting the wrong need with the service
FINANCE FOR ALL
that they have. So on the one hand, many economic models were flawed in their construction, and on the other hand, the economics objective of trying to ‘maximise utility’ had the wrong definition of utility. Utility started out as a measurable concept, an odd simplification of the concept of understanding and measuring human motivation. This was because of the rather odd obsession that economics had with being a ‘higher’ science. Hence, it was mathematical in its language. It looks comical today that anything that concerns itself with human behaviour would at all try to be mathematical, precise or even logical in construction, but the historical process of evolution takes us through strange pathways. One of the very interesting offshoots of this very interesting evolutionary pathway is the replacement of the concept of utility with a new definition of happiness. It is not mentioned much in the mainstream media because it is just an incipient trend, but if the objective changes, then the ramification of that will eventually be to change the entire body of underlying knowledge, transforming the entire body of economics. To start with, what is happiness? Only after you have defined it well will you be able to check how much of the current economic decisions and their modelling is actually even devoted to the pursuit of happiness. Just being provocative, but when is there going to be a parliamentary discussion on whether the Indian woman is getting her orgasms, as part of her marital (or sexual) rights? But I must explain myself, and to do that, I must first proceed to define the meaning of ‘happiness’, at least, as much as I have understood it myself. The basic dictionary definitions are many, and I will leave you to do the research yourself, but Wikipedia has a page on happiness economics, which says, “The economics of happiness or happiness economics is the quantitative and theoretical study of happiness, positive and negative affect, well-being, quality of life, life satisfaction and related concepts, typically combining economics with other fields such as psychology, health and sociology. It typically treats such happiness-related measures, rather than wealth, income or profit,
as something to be maximised. The field has grown substantially since the late 20th century, for example, by the development of methods, surveys and indices to measure happiness and related concepts. Its findings have been described as a challenge to the economics profession. Prof. Raj Rangnathan runs perhaps one of the most popular MOOCs (massive open online course) in the world on www.coursera.org, and he defines happiness as having seven elements. He conceptualises happiness as a dynamic concept, like a balloon that inflates when your behaviour pursues happiness and deflates when you choose other priorities. The surprising conclusion is that happiness is not always a priority. In fact, it is at the top of a pyramid that is made up of lower building blocks like survival, security and ego. And these lower-level needs always take precedence, not
Economics of happiness is a multi-disciplinary study that focuses on the enhancement of an individual’s quality of life and overall satisfaction necessarily in that order. For example, a large number of impulsive irrationalities are seen when the ego takes precedence over happiness. Consider the need to be right. There are two partners A and B. Partner A is fat and unhealthy. Partner B has been admonishing Partner A, cajoling him to take care of himself. Many years into this, Partner A meets a young, attractive girl who tells him to look good, and on her advice, this guy becomes a health faddist. Does Partner B just smile and let it pass? After all, Partner A has come to the right conclusion, even if it is due to someone else’s advice. No. The need to be right is paramount, so Partner B has to say, “I told you so.” When people were asked what Partner B should do, 86 per cent said that she should gloss it over, while 14 per cent said she should mention that she has been saying July 2017 Wealth Insight 49
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FINANCE FOR ALL this all along. But when people were asked what they themselves would do, the first number came down to 76 per cent. Twentyeight per cent people chose to be right rather than effective. This brings use to Prof. Rangnathan’s seven deadly sins of happiness. They are as follows: DEVALUING HAPPINESS: As mentioned above, the lower-level priorities of security and ego needs take priority in most of our micro behaviours. Happiness has to be understood, defined properly and then prioritised before it can be enjoyed. Half of all happiness is available to the person who makes conscious choices. CHASING SUPERIORITY: The need to be ‘superior’ creates a constant stress, which allows the ego to take over your personality. This ego state is a constant treadmill, which wears out your mind space, leaving no space for peace and tranquillity, without which happiness cannot take root. BEING NEEDY/AVOIDANT OR ASOCIAL: Extreme behaviour towards both needing social support and avoiding it creates the same tension/stress, leaving little space for happiness. The former is an ego state that needs constant reinforcement and validation, while the latter is an egotistical, judgemental state that looks down on people. Both are dysfunctional, the ideal middle being a state of detachment that allows your mind to be independent of social outcomes. BEING OVERLY CONTROLLING: Constantly worrying whether things are ‘in control’ is like the Gauls (of Asterix fame) constantly worrying that the sky is falling on their heads. ‘Control freaks’, as these people are called, get onto the treadmill of trying to control the uncontrollable. They turn to constant nagging, which affects their social relationships.
DISTRUSTING OTHERS: Trustworthiness is a public good, like civic consciousness or traffic safety. Learning to proactively trust works in two different ways: mistrust is insidious and pernicious and trust is really the bedrock of love, which is almost a necessary condition for happiness. DISTRUSTING LIFE: To live a life where you are detached from outcomes also empties out your mindspace of stress. Notice that vacating mindspace from the treadmill of ‘caring’ often frees up the mind for happiness. The obsession with the future gives way to an existence with the here and the now. For this, a particular skill has to be developed and that is called mindfulness. IGNORING THE SOURCE ‘WITHIN’: Mindfulness/ meditation is a big tool for stress relief, now made famous by yoga. Habit overcomes the sin, and exercise reinforces the habit – it’s like dieting. You have to control your intake of calories (eating) and increase your offtake (exercise). Similarly, good habits reinforce happiness, while bad habits reduce it. For example, you can be right or you can be happy. There is no correlation between academic and career success, and even less correlation between career success and life success. Economics is finding that many of its users are now defining success beyond money and tangible things. For the intangible, even spiritual objectives, you need flexible models that incorporate all the complexity that is embedded in human behaviour. The proverbial genie asked for three wishes and only 6 per cent of the people said they would ask him for happiness. Most ask for money, fame/success and relationships. As it embraces this complexity, economics will come down to be the most important of all professions, a life skill that you simply cannot do without. WI
Extreme behaviour towards both needing social support and avoiding it creates the same tension/ stress, leaving little space for happiness
SANJEEV PANDIYA
Part 1 of the series of articles on economics of happiness
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COVER STORY th ANNIVERSARY
How to avoid
wealth-destroying
stocks Vikas Vardhan Singh
When we invest in the stock market, we try to identify the best companies for wealth creation. Well, making a good investment does not only mean picking a good company but also avoiding bad ones – a penny saved is a penny earned. When you minimise the chances of picking a loser, you naturally increase the probability of picking a winner. This does not mean that we can create a foolproof stock portfolio, which doesn’t have a single loser. But we can still minimise the chances of picking a bad investment by closely studying what made companies to fail. In this story, we bring to you some iconic failures. Once rock stars of their times, these companies are now struggling for survival. There was a time when it was unimaginable that they could ever collapse in their lifetime. Yet they faltered. In the following pages, we try to decipher the causes of their failures and how to avoid such failures in An investor needs to do very few things future. right as long as he or she avoids big mistakes. Warren Buffett in the letter to shareholders in 1992
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COVER STORY
The Dinosaurs Big companies that are now obsolete
There was a time when dinosaurs ruled the planet. Not only were they the largest organisms of their times, they were also most widespread. Yet they
in this category were the first movers in their industries and had monopolistic positions thanks to the licence raj, but they were also arrogant enough to overlook the winds of change. They did not innovate; they did not improve their products; they did not understand the changing dynamics of their markets. They just sat down
are extinct today. No one could have overpowered them, yet they vanished. We use the term ‘Dinosaurs’ for companies which were once dominant in their areas but have now succumbed to changing times. Most of the companies
and watched their market share getting usurped by new, more innovative players. We assess six Dinosaurs to see what led to their collapse.
APTECH
HINDUSTAN MOTORS
Becoming inapt
Permanent brakes
Founded in 1986, Aptech is into computer education, which was a very specialised course at that time. But soon many colleges and schools started to offer computer education. Since people prefer a degree to a diploma, which Aptech offered, the company lost its appeal. Moreover, it lagged behind in terms of quality of curriculum. It missed the opportunity to become a niche player in computer education and became a generalist instead.
Hindustan Motors, a C K Birla group company, started its operation in 1958. Its landmark car was the Ambassador. The Ambassador thrived in India for over four decades and became a status symbol. Since the company was shielded from the entry of foreign carmakers, thanks to a closed Indian market, it garnered about 70 per cent market share. But once Maruti entered the market, HM started to feel the heat. It failed to keep the Ambassador brand alive. In 2014, when the manufacturing of the Ambassador finally stopped, it had sold only 2,200 units.
Price chart
Price Chart
`480
Aptech
360
S&P BSE Sensex Sensex rebased to stock price
Revenues (` cr)
163
240
FY1996
120
212
0 September 2002
June 2017
FY2017
`800
Hindustan Motors
600
S&P BSE Sensex Sensex rebased to stock price
Revenues (` cr)
1,253
400
FY1997
200
227
0 January 1991
June 2017
FY2014
July 2017 Wealth Insight 53
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COVER STORY HMT
KINETIC MOTOR COMPANY
Time stops for no one
Losing motion
Hindustan Machine Tools (HMT) was set up in the 1970s in collaboration with Citizen, a Japanese watch maker. HMT developed a very good technical base and produced good-quality products. Before the 1990s, it had a massive 90 per cent market share. But what it lacked was the style and variety in its products. Then came Titan from the Tata’s stable. It took the market by storm. It offered what HMT was lacking, viz., variety of designs. HMT did not realise that watches were no more meant for just time keeping but had become an ornament.
Kinetic Motors was a joint venture between Kinetic Engineering and Honda Motor Company of Japan. In 1988, Honda exited the joint venture. After Honda’s exit, things started getting worse. The company lost its appeal and failed to innovate. Once known for the Luna, it sold off its plants to Mahindra and got merged with the parent Kinetic Engineering. A few years later, the company ceased to exist. It had a market market cap of just `20 crore when it last traded.
Price Chart
Price Chart HMT
`160
S&P BSE Sensex Sensex rebased to stock price
120 80
Revenues (` cr)
789 FY1996
40
288
0 April 1996
June 2017
FY2016
`1600
Revenues (` cr)
Kinetic Motor Co. S&P BSE Sensex Sensex rebased to stock price
1200
270
800
FY1997
400
141
0 January 1991
June 2017
FY2008
MTNL
PREMIER
Dropping the call
Un-premiumed
MTNL, a public-sector enterprise, failed to change itself with time. It failed to adequately invest in its infrastructure to enhance its coverage and service quality, despite having a huge cash pile of around `4,892 crore in 2009 and being debt-free. MTNL, which now has negative net worth, until 2010 used to generate huge free cash flows. Operating in only two major metro cities, MTNL had 28,877 employees as on December 31, 2016, while Airtel, which has a pan-India presence, operates with 22,815 employees.
Premier made the old iconic car Fiat 1100D or the Premier Padmini. This model was first launched in 1973 and remained the same till 1998, without many changes. Before Maruti 800, it was the favourite car of the upper middle class. After its demise, the company now manufactures a lesser known car RiO, which has failed to take off. The company also manufactures CNC (computer numerical control) machines but this division has frequently faced quality issues and customer complaints.
Price Chart
Price Chart MTNL
`2000
S&P BSE Sensex
Revenues (` cr)
Sensex rebased to stock price
1500
3,448
1000
FY1996
500
2,969
0 May 1995
June 2017
FY2017
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`1200
Premier
S&P BSE Sensex
Revenues (` cr)
Sensex rebased to stock price
900
97
600
FY1998
300
100
0 January 1991
June 2017
FY2016
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COVER STORY
How to avoid a Dinosaur? It is easy to look at the past and point at the companies that failed. When it comes to the present, it is difficult to figure out what company is on the road to extinction. One way you can spot future failures is by finding companies which are not changing with time. Most of the examples discussed above did not introduce a new product or make improvements to their existing product line for decades. Their volume sales declined consistently but they did not put in effort to build up new capabilities. The balance sheet is a good indicator of future failures. Despite having resources, if a company doesn’t incur capital expenditure for long periods, that could be a sign of trouble. Another cue is a lack of passion in the management. How do you spot a management that is passionate and has hunger for growth? Consider Bajaj Auto and Eicher Motors, the manufacturer of the
Royal Enfield. Royal Enfield has kept its brand lively by introducing new variants and new features. It has held onto its niche of high-power bikes and originality of concept. Similarly, Bajaj has focused on constant changes to its bestselling model Pulsar. It kept innovating it, even though it was already doing well, and never grew complacent. Also look for businesses that are coming up with innovative ideas and those that have remained relevant over time. Titan is one such example. It started with manufacturing watches in 1980s and took away the market share of HMT. It also sensed that the watch segment will have limited growth by the 1990s and, therefore, it ventured into the jewellery market through its Tanishq brand. It did not stop there. It captured the youth market by introducing its new brand Fastrack in the 2000s. Guess what, it is now testing a new market: that of sarees.
The Atlases
Companies saddled with high debt In Greek mythology, Atlas was a Titan who held the sky. In modern times, perhaps his counterparts are companies which are heavily leveraged. Leveraging means borrowing money to improve profitability by investing it, often in some big-ticket avenues. But leverage is also a double-edged sword. If it fails to produce profits, it can even lead to big losses on account of payment of interest and principal. Adverse market conditions and a reversal in the market cycle can further lead to spiralling problems for over-leveraged companies. Since borrowers have a superior claim on a company’s profitability and assets, high leverage can create a deficit for equity owners. How can you find over-leveraged companies? A simple measure of the level of debt is the debt-to-equity ratio. In this section, we present to you some companies that have a 56 Wealth Insight July 2017
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high debt-to-equity ratio, coupled with a low return on capital employed (ROCE). This means that not only are these companies heavily in debt, they aren’t making much on their invested capital. Great companies thrive on the soundness of their business, not leverage. Consider the Sensex. Its constituents, barring three, have never had a debt-to-equity ratio of more than two.
COVER STORY ABAN OFFSHORE
HCC
Troubled waters
Sea of problems
Aban Offshore is an offshore drilling-services provider. The company had taken loans of `13,000 crore against a net worth of just `506 crore at the market peak of 2008. A debt-to-equity ratio of more than 16 times made it too fragile a company. It had a dismal return on capital of less than 7 per cent. This was a result of a big expansion plan. The company did generate profits, but they remained stagnant. High interest costs left little for the equity holders.
Hindustan Construction Company operates in the engineering and construction space. Bullish on the future, the company raised huge debt for its projects. But business cyclicality and delays in its landmark project Lavasa hit its revenues and thus profitability. It has been a loss-making company for a long time. Even before the 2008 crisis, when business sentiment was quite bullish, the company had a poor return on its investment, of less than 10 per cent.
Debt-equity and ROCE
Debt-equity and ROCE
24 Debt to equity
RoCE (%) 12
18
9
12
6
6
3
0
0
Latest data (FY2016)
6.19
30 Debt to equity
RoCE (%) 12
15
9
0
6
-15
3
-30
0
Debt-equity
FY07
FY10
FY13
FY16
2.41%
Latest data (FY2017)
9.39 Debt-equity
FY08
ROCE
FY11
FY14
FY17
-24.7% ROCE
JAIPRAKASH ASSOCIATES
KINGFISHER AIRLINES
Dark times
Wings clipped
Jaiprakash Associates is into cement, construction, power, real estate, fertilisers and many more businesses. In the last financial year, the company had around `70,000 crore debt against net worth of `12,891 crore and a market cap of just `3,617 crore. It has remained highly indebted for a very long time. Even when it was witnessing good times till 2008, it had a debt-to-equity ratio of more than three. Its ROCE was 13 per cent, which is not safe for a cyclical business.
Kingfisher had been a loss-making entity since the day it started trading on the stock market, in 2006. Yet the company took on more debt, taking its debt-to-equity ratio to over two. As losses mounted, debt kept on accumulating. The business couldn’t be revived and instead of changing the business strategy, the promoters kept waiting for good times, which, in their case, never came.
Debt-equity and ROCE
Debt-equity and ROCE
8 Debt to equity
RoCE (%) 20
6
15
4
10
Latest data (FY2016)
3.58
7 Debt to equity
RoCE (%) 1800
0
0
-7
-1800
-14
-3600
Debt-equity 2
5
0
0 FY07
FY10
FY13
FY16
5.27% ROCE
Latest data (FY2013)
00.0 Debt-equity
-21
-5400 FY04
FY07
FY10
FY13
-0.73% ROCE
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COVER STORY RELIANCE COMMUNICATIONS
SUZLON ENERGY
Reliability crisis
Losing energy
Reliance Communication, an Anil Dhirubhai Ambani group company, is the latest entrant to the loan defaulters’ club. The company has sought time till December 2017 to repay its debt. Its debt-to-equity ratio, which is below 1.5, doesn’t look too bad. But its ROCE, which averaged 4 per cent in the past five years, is too low to service debt for a long time. Total consolidated debt stands at `45,000 crore as per the latest filings. The business has taken a hit due to the fierce competition in the telecom sector and due to the coming of Reliance Jio.
Suzlon Energy is in the business of wind-power generation and it also manufactures and installs equipment for that. Suzlon was ahead of its time. Looking at the bright future for renewable energy, the company aggressively acquired many companies overseas. It raised debt in the process. But the acquisitions did not work. Suzlon’s debt has soared year on year, except for the last year. Its return on capital has largely remained negative or insufficient to cover debt repayments.
Debt-equity and ROCE
Debt-equity and ROCE
1.6 Debt to equity
RoCE (%) 20
1.2
15
0.8
10
0.4
5
0
0
Latest data (FY2016)
4.18
50 Debt to equity
RoCE (%) 30
25
0
0
-30
-25
-60
-50
-90
Debt-equity
FY07
FY10
FY13
FY16
1.29% ROCE
VIDEOCON INDUSTRIES
Conning shareholders Videocon was mainly into consumer electronics and then it diversified into highly unrelated businesses like power and oil exploration. The management says it wants to be an oil and energy company in the coming times. To fulfil this ambition, the company has also raised huge debt, which currently stands around `50,000 crore. But then the company defaulted on its loan due to a slump in the oil sector. Banks are increasingly classifying Videocon’s debt as non-performing.
Debt-equity and ROCE 10.0 Debt to equity
RoCE (%) 30
7.5
20
5.0
10
2.5
0
Latest data (FY2015)
1.78 Debt-equity
0
-10 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY13 FY14 FY15
5.87% ROCE
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Latest data (FY2016)
8.50 Debt-equity
FY07
FY10
FY13
FY16
-1.61% ROCE
Avoiding Atlases In general, avoid companies which are highly leveraged and at the same time are not able to earn more than what they have to spend on their borrowings. To be precise, stay away from companies with debt to equity of more than two. Even if it is lesser, make sure the company earns a high ROCE so that it can service the debt on time. If the ROCE is low, then the company will have to take on more debt to service its past loans. Another measure to assess the degree of leverage is the interest-coverage ratio. It is calculated by dividing the profit before interest and taxes by interest expenses. The higher the interest-coverage ratio the better it is. Go for companies with ratios of more than two times. One more effective tool is the Altman Z-Score. A score of less than three indicates likelihood of default and should call for a thorough investigation. To know more about the Altman Z-Score and check the score on any stock, log on to www.valueresearchonline.com and search for that company. See the Essential Checks section on the right side.
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COVER STORY
The Rogues
Companies with shady managements In developed countries, while most businesses are run by professionals, in India, most listed businesses are managed by promoters themselves. At times, there are situations where the business is doing well and the products are good but the promoters’ greed proves to be the Achilles’ heel. The promoter may try to extract as much as possible from the company by hook or by crook. On the brighter side, the interest of the business is aligned with the interest of promoters when the promoters are at helm.
A management with poor skills or mala fide intentions can bring the complete business down to zero in a matter of days whatever the prospects of the industry. On the contrary, a good management can build a strong business, even in adverse times. For example, in the airlines industry, while Kingfisher completely vanished due to an incompetent management, Indigo prospered. Following are some companies which destroyed shareholder wealth due to promoters’ and managements’ incompetence and greed.
BILCARE
BIRLA POWER SOLUTION
Being careless
Failing in style
Bilcare is one of the largest blister-packaging companies in India. Its problems started when it acquired the plastic-film unit of the Swissbased Ineos for `607 crore in 2010, which was a much bigger firm than itself at that time. The acquisition turned sour and took the consolidated margins down. In FY13 and FY14, the management was quizzed for dubious accounting practices as well. Its working capital requirement kept growing swiftly. In FY14, the company was declared a wilful defaulter.
A part of Yashovardhan Birla group, Birla Power manufactured generators. The company defaulted on the its debt. It also had significant financial transactions with group companies despite having unrelated businesses. The debt taken for a power project was used to provide money to the group companies for different reasons. Apart from this, huge investments were made in foreign assets with little operations. The promoter of the company, Yash Birla, is famous for his flamboyant lifestyle and partying.
Rising cash conversion cycle (days)
High related-party transactions
150
Latest data (Mar 2017)
120
750 Related-party transactions (` cr) Total revenues (` cr) 600
Latest data (Mar 2017)
90
45.6%
450
33.0%
60
Promoters’ stake
300
Promoters’ stake
30
00.0%
150
0 FY02
FY04
FY06
FY08
FY10
FY12
FY14
FY16
Pledged stake
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1.4%
0 FY09
FY10
FY11
FY12
FY13
Pledged stake
COVER STORY EDUCOMP
FINANCIAL TECHNOLOGIES
Mass exodus
Ponzi tricks
Educomp markets equipment for educational training. In its greed for high growth, the company changed its business model from an asset-light one to a leveraged one. In this attempt the company took huge loans and started struggling. The management and promoter were questioned for corporate governance when the CFO’s resignation was followed by the company secretary’s and compliance officer’s resignations in 2012. The very same year, a related company Edusmart witnessed four consecutive resignations.
Financial Technologies, now called 63 Moons Technologies, was embroiled in a `5,600 crore scandal. Its subsidiary, National Spot Exchange, a commodity exchange, was involved in a Ponzi scheme, along with its founder Jignesh Shah. The company offered paired contracts which were floated without the permission from the commodities regulator. The company also issued fake warehouse receipts to show the underlying commodities. The company also didn’t publish its consolidated results on a quarterly basis.
High debtors in relation to sales
Large difference
2500
Gross sales (` cr) Debtors (` cr)
2000
Latest data (Mar 2013)
1000
Conso. net profit (` cr)
Standalone net profit (` cr)
750
Latest data (Mar 2017)
1500
1.1%
500
44.8%
1000
Promoters’ stake
250
Promoters’ stake
500
85.6%
0
0 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15 FY16
Pledged stake
100%
-250 FY04
FY06
FY08
FY10
FY12
FY14
FY16
Pledged stake
SATYAM
UNITECH
Truth prevails
The great fall
Satyam’s promoter and CEO, B Ramalinga Raju, was convicted for an accounting fraud. Under him, the company inflated its revenues and profits through fake invoices. It also faked its cash reserves by inflating them by around `5,000 crore. The news of the scam broke in January 2009. One forewarning was that Raju had been constantly selling his stake in the company. He held 22 per cent stake in Satyam in 2002. He brought this down to just 2 per cent in December 2008.
Unitech, a realty company, struggled due to its overambitious plans during the real-estate boom of 2008. It delayed the delivery of its projects for several years and used home buyers’ funds to buy more land elsewhere. Sanjay Chandra, the then MD of the company, was also jailed for his involvement in the 2G scam. The company’s work in progress (projects under construction) grew to the tune of `15,739 crore in FY09. The promoters had also pledged 77 per cent of their holding in the company in 2009.
Promoter’s holdings
High inventories
30% 24
Latest data (Dec 2008)
18
2.2%
12 6 0 2001 2002 2003 2004 2005 2006 2007 2008
20000 Net worth (` cr) Net revenues (` cr) Inventories (` cr) 16000
Latest data (Mar 2017)
12000
20.6%
Promoters’ stake
8000
Promoters’ stake
00.0%
4000
Pledged stake
76.2%
0 FY02 FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10
Pledged stake
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COVER STORY
How to escape the Rogues While it’s difficult to find accounting irregularities due to unscrupulous promoter behaviour at an early stage, there are a few factors which send signals that something wrong is going on in the company. Related-party transactions: For a promoter, extracting money from a listed company is not easy. Hence, promoters often create multiple companies with their stakes in them. These related parties transact with the main company to take out the money in the form of supplier payments, donations, loans and investments. To avoid such a situation, do go through the annual report and the mandatory reporting on related-party transactions. Check the nature of transactions and relationship with the promoters or the management. Lack of consolidated numbers: Another situation which calls for doubt is when the company does not report consolidated financials despite having meaningful subsidiaries, or delays publishing its results quite often. Sometimes companies also create a special purpose vehicle but drops its details while filing their financial reports.
Accounting policies: Check if the management is changing accounting policies too often, such as depreciation method, inventory-valuation method, etc., to fit its cause. Loans to service existing debt: Taking loans for a strategic expansion is okay but a loan taken to service an existing debt raises suspicion. One should stay away from such companies. Share pledging: A very high level of share pledging also warrants a deeper look. Pledging means promoter borrowing money against shares as collateral. Defaults on such loans can lead to a vicious circle, where the stock price tumbles because the lender sells pledged shares to recover its dues. Qualitative aspects: Along with numbers, one should also look at the qualitative aspects of a company. For example, serial resignation by several key personnel in a short span signals trouble brewing up. Promoter’s lifestyle: Another very important aspect is the lifestyle of the promoter. In order to maintain his lavish lifestyle, the promoter may take decisions which are not in the interest of the business.
Our own failures
Our stock recommendations that failed miserably Henry Ford, the founder of the Ford Motor Company very aptly said, “The only real mistake is the one from which we learn nothing.” Over the years, we have recommended several stocks in our Stock Analyst’s Choice section. On an aggregate basis, they have given good returns and beaten
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the Nifty 50 Index by a wide margin. However, there have been a couple of failures also. We do admit that those recommendations were mistakes. But every cloud has a silver lining. Those mistakes have become great stepping stones for us to further enhance the quality of our recommendations. In the last section of this story, we present to you three companies that we recommended but which failed badly. We also analyse why this happened.
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COVER STORY INNOVENTIVE INDUSTRIES
OPTO CIRCUITS
In dust
Short circuit
Innoventive Industries, which dealt in tubes, sheets and auto products, took a hit because of the slowdown in the auto and power sectors. The company raised `219.6 crore through its IPO in 2011 and planned to use the funds for expansion and repayment of loans. However, the funds were not used to repay loans. Instead the company took even more loans. Warning signs were rising working-capital requirement due to high credit sales. The company took short-term debt of `700 crore in FY13, which was more than its net worth.
Opto Circuits is a manufacturer of medical equipment and devices. It acquired many companies serially and took debt for acquisitions. A series of acquisitions by a company right when it is doing well can be a method to extract money out of the company by a greedy promoter, especially when those acquisitions have little explanation without a strategy. Opto Circuits took huge working-capital loans, which accounted for almost 50 per cent of the net worth in FY11. This was a big red flag.
Revenues and debtors
Revenues and debtors
1000
Revenues (` cr)
Debtors (` cr)
800
Latest data (FY 2016)
2500
Revenues (` cr)
Debtors (` cr)
2000
Latest data (FY 2016)
600
18%
1500
531%
400
Debtors to sales
1000
Debtors to sales
200
-77%
0 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15 FY16
Short-term debt-equity
ZYLOG SYSTEMS
Zylog’s management was accused of several frauds. The promoters had pledged more than 40 per cent of their stake in the company. They were also accused of manipulating the share price by trading in the open market with company’s funds. What went unnoticed was a high debtors-to-sales ratio, which means the company was recognising more sales without receiving the payments. Secondly, it took huge short-term loans. Since it is an IT company, this looked suspicious. Zylog also delayed the payment of dividend.
Revenues and debtors Revenues (` cr)
Debtors (` cr)
2000
Latest data (FY 2016)
29%
1500 1000
Debtors to sales
500
-103%
0 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15 FY16
0 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15 FY16
Short-term debt-equity
Lessons for us
Systemic failure
2500
61%
500
Short-term debt-equity
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A very important observation in all the examples was rising short-term loans, meant mainly for working capital. Working capital is the money required for day-to-day operations of a company. When a company borrows to operate on a day-today basis, that triggers a big problem for it. Therefore, avoid companies which have short-term loans of 40 per cent or more of their net worth. Check the quality of a company’s revenues. Highquality revenues mean that the company’s sales are backed by actual cash flows. A company can inflate its sales by selling on credit.The debtors-to-sales ratio is a good indicator to check this. Avoid companies with rising debtors or those which have debtors more than one-third of their sales, unless it is a businesses that takes long-term contracts. Last but not the least, monitor the holdings and pledged shares of the promoters in the company. A sustained reduction in promoters’ holding may mean that promoter wants to cash out his stake. Similarly, high pledging by the promoter is prone to defaults and thus may trigger huge sell-offs. WI
COVER STORY th ANNIVERSARY
Value Guru stocks Vikas Vardhan Singh & Mohammed Ekramul Haque Five years ago, when the Sensex was at 17,000 levels, we had come up with a feature on how to invest like the value-investing greats – Benjamin Graham, Walter Schloss, Peter Lynch, Joel Greenblatt and John Neff. Five years are more like eternity for many Indian investors. Most of them rarely hold onto their investments that long. Yet sticking to such robust investing principles holds one in good stead – in up markets and down. Many sceptical investors, even some fund managers, sneer whenever the talk of value investing comes up. “We are in a long-term bull market; value doesn’t work in India,” many of them often quip.
However, if you had invested in the Value Guru stocks mentioned five years ago, your annualised returns would look like as shown in the graphic. As you can see, all of the portfolios handsomely beat the benchmark index. In the following pages, we again take you through the strategies of Value Gurus. We then adapt them as per the Indian context and tell you the stocks that fulfil the criteria. With the Value Research Stock Advisor subscription, you get exclusive access to the Value Guru screens, where we create portfolios that match those of the gurus mentioned above in real time, whenever you want.
40.2%
25.4%
23.3%
22.8%
21.5%
John Neff
Walter Schloss
Peter Lynch
Ben Graham
Joel Greenblatt
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13.8%
Reliance ETF Nifty BeES (Benchmark)
COVER STORY BENJAMIN GRAHAM
The father of value investing Benjamin Graham, whom Warren Buffett considered his guru, focused on earnings yield and avoided high P/E stocks
Ben Graham is considered to be the father of value investing and Warren Buffet’s guru. His focus was on value stocks – companies that were trading far below the value of their assets. Graham said investors should analyse a company’s financials and come up with intrinsic value and buy the company only when it’s trading below the intrinsic value. The best stocks of this nature are those that trade at least one-third below their net current asset value (current assets minus liabilities). GRAHAM’S FILTERS 1. In his analysis, Graham used earnings yield (which is the inverse of the P/E ratio) and the ratio of stockholders’ equity to total assets. 2. Earnings yield, the first criterion, had to be at least twice that of what AAA-rated corporate bonds yielded. For an investor to venture into stocks, that should be the minimum rate of return.
3. The other criterion was based on the assumption that a company should own at least twice of what it owes. In other words, the ratio of shareholder equity to total assets should be a minimum of 50 per cent. 4. This mechanical stock selection called for holding a portfolio of 30 such stocks for a period of three years or till a 50 per cent gain is achieved, whichever occurred first.
5. How much could an investor applying this technique expect to gain? On the basis of extensive back-testing, dating back 50 years, Graham suggested that an investor following this strategy could have netted twice as much as the Dow Jones Industrial Average. 6. Additionally, all stocks had to have a maximum P/E of 10. Graham was against buying stocks above that premium.
Modified Graham filters for Indian markets 1. Earnings yield more than 1.5 times that of AAA corporate bond yield (7.25%) 2. Total debt less than half of book value (debt to equity less than 0.50)
3. Current ratio greater than 2 4. Total debt less than 2 times net current asset value (NCAV)
5. 5-year earnings growth rate of at least 10% CAGR 6. Current and average 5-year ROE of more than 12%
Indian context: The Graham stocks Earnings yield (%)
5Y avg RoE (%)
668
24.3
14.2
2.94
14
164
15.3
480
20.6
26.5
2.35
2
118
20.2
13,341
15.8
14.1
3.01
2,686
1,375
7.6
105,084
14.9
21.2
2.44
0
19,231
8.5
2,432
13.7
21.4
2.15
252
525
9.2
FMCG
516
12.9
28.7
2.94
24
87
38.0
Sasken Technologies
IT
785
12.6
21.2
2.93
0
177
11.8
Goodyear India
Automobile & Ancillaries
2,020
11.8
21.7
2.10
0
16
15.6
Wipro
IT
123,999
11.1
24.1
2.15
12,522
24,059
8.9
Infosys
IT
216,820
10.8
25.0
3.83
0
39,872
11.5
Company name
Sector
Sandesh
Media & Entertainment
R Systems International
IT
SJVN
Power
Hindustan Zinc
Non - Ferrous Metals
KPIT Technologies
IT
Chaman Lal Setia Exports
Market cap (` cr)
Data as on June 21,2017
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Current ratio Total debt (` cr)
NCAV (` cr)
5Y EPS growth (%)
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COVER STORY PETER LYNCH
Beating the Street
Having multiplied his funds 28 times in 13 years, Peter Lynch is widely acclaimed as an investor who made investing doable for the comman man Peter Lynch was the legendary portfolio manager of the Fidelity Magellan Fund from 1977 to 1990 and multiplied his corpus 28 times in 13 years. He wrote the highly popular ‘One Up on Wall Street’ and ‘Beating the Street’. The essence of Lynch’s method is ‘invest in what you know’. His technique asserts that an individual investor can beat a fund manager at investing because he is able to spot investments in his day-to-day life before Wall Street can. He used measures of growth and valuation and preferred companies with low institutional holdings and little analyst coverage. MODIFIED LYNCH FILTERS In his bestselling book, One Up on Wall Street, Lynch mentioned how he categorises companies. Following are his criteria: Slow growers: These are large and mature companies not expected to grow faster than the economy but at the same time are regular dividend payers. In India, basic industries roughly trail the GDP growth rate. These are not the type of stocks that Lynch liked. Stalwarts: These are large companies that are still compounding
their earnings by at least 12-13 per cent. These firms provide downward protection in bad markets. Fast growers: These are smaller, more aggressive companies with annual earnings growth of 20 to 25 per cent a year. Lynch preferred these companies to be in sectors that are not fast changing. This category was his favourite and he bet the biggest gains could be made in these types of stocks but they also carry considerable risk. Cyclicals: Cyclicals are companies that manufacture products whose
demand varies from time to time, for instance, steel, cement, aluminium, etc. In the Indian context, the fortunes of companies like Tata Steel, Hindalco, SAIL, etc., depend on how global commodity prices fluctuate. Normally, it is difficult to tell when the cycle will turn. But if you can catch it, you can make money. Asset opportunities: These are companies the value of whose assets outweighs their own market capitalisation. (See Walter Schloss’ screen for more such companies.)
Modified Lynch filters for Indian markets 1. 5-year earnings growth of more than 15% but less than 30% 2. Debt to equity of less than 1
3. ROE of more than 15% 4. P/E less than 15
5. Inventory change less than less than 1.2 times the sales growth 6. Institutional holding less than 30%
Indian context: The Lynch stocks P/E
ROE (%)
Debt/ equity(x)
5Y EPS growth (%)
Institutional holding (%)
820
9.2
23.00
0.93
23.03
3.89
1,080
13.1
22.68
0.62
18.24
4.22
Media & Entertainment
667
9.2
22.17
0.03
15.33
0.02
GM Breweries
Alcohol
636
14.5
21.92
0.00
25.99
1.39
Hindustan Media Ventures
Media & Entertainment
1,994
10.3
21.92
0.19
24.26
17.41
Talwalkars Better Value Fitness
Miscellaneous
896
13.7
15.73
0.85
19.29
20.38
Ambika Cotton Mills
Textile
759
13.6
13.97
0.06
19.05
4.43
Company name
Sector
Cosmo Films
Plastic Products
Balaji Amines
Chemicals
Sandesh
Market cap (` cr)
Data as on June 22, 2017
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WALTER SCHLOSS COVER STORY
The manufacturing man
Walter Schloss didn’t like services companies and focused on manufacturing enterprises. He preferred stocks available below book. Walter J. Schloss was a disciple of the Benjamin Graham. Schloss asserted that the lows of the stock price over the last couple of years give us a good idea of where the stock can land in case of a weakness, and the highs of the past can indicate the level of fall the stock has seen. It is also better if the management owns a lot of the company, though the management’s reputation can be a deal breaker. Depressed stocks need about four-five years to turn around. His screener looked for long-standing but undervalued companies with high promoter holdings. SCHLOSS’ FILTER
Buying assets at a discount is a better deal than buying future earnings, which may or may not turn out as expected: that was Schloss’s motto. While earnings could change rapidly, asset values change more slowly. This focus on assets led him to buy stocks at or below their book values. New listings would never excite Schloss; he considered companies with a track record of 20 or even 30 years. That kind of being around would give him a better picture,
For Walter Schloss, a company with little debt and trading below its book value were just starting points. Schloss would be interested only in companies that engaged in manufacturing of some sort. He was not comfortable with service industries and would even ignore successful franchises such as McDonald’s. He was interested in companies in basic industries such as power, chemical and metals.
more visibility, more understanding and more comfort. Schloss believed that the lesser the debt, the more the margin of safety. Whether it was the effect of the Great Depression which he lived through or prudent investing philosophy, Walter avoided companies with debt like a plague. For his analysis, he looked at the balance sheet and the income statement but he never met companies’ managements.
Modified Schloss filters for Indian markets 1. Exclude service companies
3. Price to book value less than 1
2. Debt to equity less than 0.50
4. Promoter’s holding at least 25%
5. Companies with operations of at least 10 years 6. Average 3-year ROCE more than 12%
Indian context: The Schloss stocks Price to book
Dividend yield (%)
3Y avg ROCE (%)
Debt/ equity(x)
Promoter’s holding (%)
469
0.57
2.79
12.16
0.12
63.0
585
0.63
1.53
14.48
0.42
75.0
Chemicals
4,883
0.74
1.80
12.05
0.27
37.8
Gujarat Industries Power
Power
1,680
0.75
2.43
13.34
0.24
58.2
Oil India
Crude Oil
22,651
0.77
4.25
13.63
0.45
66.6
Balasore Alloys
Ferro Manganese
456
0.85
1.17
14.31
0.31
61.4
ONGC
Crude Oil
205,973
0.93
3.02
14.73
0.30
68.1
Sunflag Iron & Steel
Iron & Steel
682
0.96
0.00
12.28
0.41
49.1
NALCO
Non - Ferrous Metals
12,158
0.97
3.18
12.27
0.00
74.6
Company name
Sector
Manaksia
Trading
Kothari Products
Trading
GSFC
Market cap (` cr)
Data as on June 22, 2017
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COVER STORY JOEL GREENBLATT
The market magician
Joel Greenblatt developed the Magic Formula, which combined earnings yield and ROCE to pick 30 best stocks Joel Greenblatt is a professor at the Columbia University and the founder of Gotham capital, a hedge fund which returned an incredible 40 per cent to investors every year for 20 years. Greenblatt is known for two books, ‘You Can Be a Stock Market Genius: Uncover the Secret Hiding Places of Stock Market Profits’ and ‘The Little Book that Beats the Market’. Greenblatt is quite open about how he searches for value. He also teaches his techniques. Greenblatt’s research on value investing techniques is his most famous claim to fame. His Magic Formula investing technique is his most acclaimed achievement. Magic Formula Investing is a modification of Graham’s method to select bargain stocks. In his Magic Formula, Greenblatt combines companies’ earnings yield with return on capital to come up with a list of high-quality companies available cheap.
Indian context: The Greenblatt stocks ROCE (%)
Earnings yield (%)
Combined rank
Coal India
56.98
12.73
1
eClerx Services
52.92
9.35
2
Larsen & Toubro Infotech
53.83
8.92
3
112.58
7.39
4
TVS Srichakra
55.30
7.23
5
SQS India BFSI
51.22
7.80
6
Harita Seating Systems
41.69
9.64
7
MRF
48.41
7.65
8
Goodyear India
35.84
11.80
9
Ultramarine & Pigments
36.82
9.80
10
Tata Consultancy Services
43.94
8.32
11
Stovec Industries
46.90
7.26
12
Kewal Kiran Clothing
60.82
6.04
13
Oracle Fin. Services Soft.
52.30
6.40
14
Castrol India
178.80
5.33
15
Avanti Feeds
67.42
5.77
16
Atul Auto
52.46
6.38
17
Hero MotoCorp
46.79
6.49
18
GM Breweries
33.72
11.22
19
Bajaj Corp
55.84
5.69
20
MPS
32.72
11.77
21
Orient Refractories
44.59
6.53
22
Bajaj Auto
43.38
6.69
23
Bliss GVS Pharma
31.99
11.83
24
Torrent Pharmaceuticals
46.42
6.10
25
Modified Greenblatt filters for Indian markets
VST Industries
63.66
4.99
26
Divis Laboratories
35.18
8.59
27
1. ROCE consistently more than 20% over the past 5 years
Hawkins Cookers
74.56
4.70
28
2. Rank the companies on the basis of earnings yield and then on the basis of the latest ROCE.
Hexaware Technologies
35.58
8.26
29
Infosys
30.57
10.85
30
GREENBLATT’S MAGIC FORMULA In the Magic Formula, first, earnings yields of the companies under consideration are calculated by dividing EBIT (earnings before interest and taxes, also called operating profit) by enterprise value. They are then ranked; the higher the yield the lower the rank. Next, returns on capital employed (ROCE) for the companies are calculated. ROCE is derived by dividing EBIT by the capital employed. Again the companies are ranked. The higher the ROCE, the lower the rank number. Finally, the two ranks are combined. The list is then sorted in the increasing order of the rank number and the top 30 stocks are selected.
3. Take 30 stocks based on the combined rank.
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Company name
Accelya Kale Solutions
Data as on June 21, 2017
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COVER STORY JOHN NEFF
Mr Contrarian
John Neff looked for out-of-favour stocks that were cheap in relation to their earnings growth and dividend yield John Neff headed Vanguard’s Windsor Fund, one of the best-performing mutual funds in his time. A contrarian investor to the core, Neff’s technique focuses on out-of-favour quality companies. He calls himself a ‘low price-earnings investor’. He looks for stocks that are cheap in relation to their total return (earnings growth plus dividend yield divided by the P/E ratio). This technique often captures future returns better than skittish growth stocks. Neff’s portfolios were a diversified set. His typical allocation was 1 per cent to each stock, though in some cases he would go as high as 5 per cent. NEFF FILTERS
Sales growth: Sales growth deter-
Low P/E stocks: According to Neff,
mines whether the cash register would keep on ringing for an extended period of time. Sales growth rate is also taken between 7 and 25 per cent. Free cash flow: Companies should have enough cash available at their disposal to buy back stock or pay dividends or invest profitably where the management sees fit.
stocks with single-digit P/Es always existed because “the market’s boundless capacity for poor judgment ensures a steady supply of out-of-favour candidates.” Earnings growth: Companies with good earnings growth but not too excessive. EPS growth rate is thus taken between 7 and 25 per cent.
Consequently, companies with positive free cash flow in the preceding two years are considered. High margins: Companies with high margins, like operating margins better than their respective industry medians or high return on equity than the industry, are considered. Total return ratio: Only stocks with total return ratio twice the market’s return ratio are considered. WI
Modified Neff filters for Indian markets 1. P/E less than 15 2. Positive free cash flow in the last three years
3. Sales and earnings growth in the last five years between 7% and 50%
5. ROE more than the 15%
4. Total return ratio – 5Y EPS growth plus dividend yield divided by current P/E – of more than 1
Indian context: The Neff stocks Market cap (` cr)
P/E
5Y revenue growth (%)
5Y EPS growth (%)
Tea & Coffee
6,304
7.3
10.1
30.1
45.2
730
4.12
Sutlej Textiles & Industries
Textile
1,505
9.5
7.9
37.9
23.2
41
4.12
KPIT Technologies
IT
2,399
10.1
17.2
9.2
21.1
195
1.09
Hindustan Media Ventures
Media & Entertainment
1,994
10.3
9.4
24.3
21.9
122
2.40
Hindustan Zinc
Non - Ferrous Metals
106,710
12.8
10.5
8.5
20.2
7,447
1.57
Balaji Amines
Chemicals
1,080
13.1
10.2
18.2
22.7
18
1.44
HCL Technologies
IT
121,108
14.1
19.6
30.8
22.5
5,053
2.32
Larsen & Toubro Infotech
IT
13,955
14.4
15.4
16.9
46.0
696
1.47
GM Breweries
Alcohol
636
14.5
11.6
26.0
21.9
48
1.84
eClerx Services
IT
5,208
14.7
23.0
16.7
40.4
256
1.14
Company name
Sector
Bombay Burmah Trading
Data as on June 22, 2017
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3Y avg free Total return RoE (%) cash flow (` cr) ratio
COVER STORY
AVOIDING
MARKET NOISE I
Mohit Khanna
f you thought that paying attention to what is going on in the stock market on a day-to-day basis is what you need to do to succeed in it, don’t be surprised if we tell you that it’s just the opposite; not paying attention to the daily events of the stock market is what is actually needed. Why? Because much of what happens in the market is not relevant to the investor. Paying attention to market noise is a sure way to lose track and get confused. Here we present to you the bakwaas that happens in the market and which business channels broadcast all day long. Not just business reporters but even company managements also indulge in this nonsense, which makes little difference to the long-term investor. By recognising market noise, you will be forearmed to ignore it.
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COVER STORY
I am a bottom-up stock picker. Here are my multibagger ideas for the day.
8.45 am 9.15 am
STOCK
T-20
THE DAILY MATCH Some shows on business channels portray stock investing as some form of sport. Don’t pay attention to such drama. Investment in stocks should be for the long term and that too after thoroughly studying business fundamentals.
The action starts now!
THE DAILY MULTI-BAGGERS Business TV shows come up with multi-bagger stock ideas ‘daily’. It is as if the market were full of such multi-baggers. In reality, only some companies build wealth for their investors over the long term and it requires rigorous research to identify them.
XYZ Ltd can give you 20% returns in one month.
9.45 am
SHORT-TERM PERSPECTIVE Investing in the stock market without a long-term outlook is plain speculation. It can very well result in the loss of capital.
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COVER STORY
Markets are down because of profit booking.
Investors are leaving the market 11:30 am
10.45 am
ABC Ltd’s biggest drop in one month
There are more sellers than buyers. There’s a 10% probability of the markets declining.
But it is still a buy-on-dips market.
PET STATEMENTS These are some pet statements of businessnews channels. They are of limited use to the long-term investor.
CATCHING THE ATTENTION Financial reporting, like ordinary reporting, is meant to shock and awe. Don’t pay attention to it.
Technically, cement and infra indices are at support levels today. Indian markets will outperform if FII flows remain stable, RBI cuts rates and monsoon is normal. 12:00 pm
I am bullish on infra, cement & telecom.
I am bearish on cement, telecom & infra. Statistically, one of our experts is always right. 12:45 pm
MACRO VIEW There is always something happening in the world and the economy. If you pay attention to that, you will only be more confused. Ignore the macro noise and stay invested in quality companies through all phases of the market. 76 Wealth Insight July 2017
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EXPERT VIEW There are too many experts in the market, and they can hold exactly the opposite views. This can gravely confuse the viewer.
COVER STORY
Almost 84 percent of your promoter shareholding consists of pledged shares and of late, the market is very concerned about companies where 70-80 percent of the shareholding is pledged. Is this one of your priority concerns?
The pledged shares are not related to the market price. They are held by the banks and other term-lenders. It is related to the main borrowings of the company secured by company’s assets with the promoter’s shareholding as collateral. This has no bearing on the rise or fall of the company’s share-price. The percentage of pledge should not be a worry from that perspective at all. 1.15 pm
But diversification can be done in two ways. You make `100 crore from a client; you grow the pie to `200 crore, you diversify it. But if `100 crore becomes `50 crore, right, that is revenues going down. It is diversification but a forced diversification?
Look at the other way round, if you are now empowered to be able to go to other clients as a part of the deal where your major revenue is coming from, so how do you grow simultaneously whilst staying there. So from our perspective we are on an identified path of our growth strategy. We have added 15 clients during this fiscal already.
SHIRKING RESPONSIBILITY This is what Arun Kumar Jagatramka, the MD of Gujarat NRE Coke, said in an interview. The MD is clearly downplaying the seriousness of the pledging matter.
Business lunch!
1.45 pm
CONUNDRUM OF WORDS This is what Raj Jain, the MD of a small software firm RS Software, said in an interview. Not only is the interviewer’s question vague, the MD’s reply is even more curious. July 2017 Wealth Insight 77
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COVER STORY
Can you give us an update of your business? What kind of sales is Hindustan Motors doing month after month and is there any recovery that you are seeing currently? The auto industry, as on date, is going through turmoil. Nobody expected such type of fall in the growth rate... People are there to buy the vehicles but the decision making is a big question today. As far as Hindustan Motors is concerned, it is seeing growth in last two months. In the last quarter, we improved upon our performances. Quarter four, we are still improving. We are maintaining the trend. We are leveraging on the strength on the brand loyalty and the operational excellence. These two are the real factors where we are able to push up ourselves.
The company declared 1000% dividend last year. 2:30 pm
INCOMPLETE PICTURE Dividend per cent is expressed in terms of face value of a share, which is very small. Hence, a big dividend per cent is actually a small sum. In general, don’t get carried away by financial reporting. Dig deeper to know the full picture.
3:00 pm
HOW TO BEAT THE ODDS
NOT TOO BAD This is what Uttam Bose, MD of Hindustan Motors, said in 2013. Most managements don’t like to paint a negative picture. They often sound upbeat.
3:15 pm
Relax and watch...
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For the last few days, there is fresh buying in the market after 3.00 pm.
FOOLISH TRENDS Reporters try to act smart by spotting trends that matter little. Trying to play trends can backfire. Curiously, they fail you the moment you begin to trust them.
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GENERALLY SPEAKING
VIVEK KAUL
REAL ESTATE
Why people will always love real estate Financial investments, like mutual funds and stocks, beat real estate hands down, but there is at least one aspect where they lag behind
O
No one bothers to account for the cost of maintaining real estate over the years. No one talks about property tax that needs to be paid over the years.
n a recent flight, I got talking to the person sitting next to me. I soon figured out that he was from Delhi and he figured out that I write on finance and economics to make a living. Given this, we started talking about that one favourite topic of Delhi wallahs – real estate. To my surprise, he was still gungho about real estate. “But prices have not gone anywhere in the last five six years. In fact, in large parts of the National Capital Region, they have fallen,” I protested, hoping to build in some sense into him. “While there have been next to no capital gains if you had owned real estate as an investment over the last few years, you would have had to continue to pay expenses like property tax as well as the society-maintenance charges over and above the EMI if you had brought the home on a loan,” I continued, hoping that the individual would listen to what I had to say. “Oh, I have heard all that before,” he replied very confidently. “But when I buy real estate, I am buying something tangible. I can see it. I can touch it. I can feel it. It’s my money before my eyes.” “So?” I asked, briefly wondering why would anyone want to see, touch and feel an investment, instead of trying to figure out whether it was making money or not. “So, I can leave behind a home for my
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sons and not just some pieces of paper, which is exactly what I would do if I were to invest in mutual funds. Or I would leave behind some digital entries if I were to invest in stocks,” he explained. I found this philosophical explanation rather weak, but I decided to tackle it in my own way. “That is interesting,” I said. “But why do you exactly want to leave behind real estate for your progeny?” “Oh. So that they have a home in these expensive times.” “Interesting. What makes you think that if you invest in stocks or mutual funds, your sons won’t have a home to live in?” “How will they have a home to live in if I buy stocks and mutual funds and not a home?” he asked rather perplexed. “Well, by simply selling those investments and buying a home at an appropriate point of time, as and when they need it,” I replied. “Also, they will have a choice to buy a home that they want to live in, rather than maintain and live in a home that you bequeathed to them.” “But what if they sell the investments and waste the money instead of buying a home,” he said. “Do you think they would do that? Have they shown tendencies like that?” “To be honest, right now they are in
their late teens and haven’t shown any such tendencies,” he replied. “But who knows how they will eventually turn out to be.” “So, you mean that right now you trust them, but you don’t know how they will turn out to be in the future, and so you can’t trust them.” “Yes.” “And if you leave behind a home to live in, they are unlikely to create any mess.” “Yes,” he said with the smile of an allknowing person, who had everything figured out. “But even if you leave behind a home, they can sell the home and waste that money away,” I tried to explain. “If you are not around, what will stop your sons from doing that?” Now that was a point that the gentleman hadn’t really thought about. And all he could say was, “Oh!” The silence lasted a few seconds and the gentlemen retorted again, “So, what if they sell out, the maximum amount of money is always made in real estate.” “Oh, that is really not true. Typically, what happens in the case of real estate is that people only talk about the price it was bought for and the price it was sold for. And what we get as the difference is a very large number, and people automatically assume that a lot of money has been made. All of us have heard at least one such story. And the power of these stories is immense. No one goes about doing a detailed calculation. For example, no one bothers to account for the cost of maintaining the real estate over the years. No one talks about property tax that needs to be paid over the years.” “Hmmm.” “And most importantly, no one bothers to take into account the time value of money. If all that is done, the internal rate of return earned on real estate over the long term is pretty mediocre. It’s just that most people do not know about the concept of the internal rate of return, which is the right way of calculating returns on any investment. Over and above that, there is never really enough data available to calculate the right
return on investment in the case of real estate. All this basically leads people to assume that any investment in real estate generates a lot of money.” “But what about the population? You know as the population goes up, more people need housing and given that realestate prices will always keep going up,” he said with the confidence of a man who was back in the boxing ring. “Well. Look at Delhi and how it has expanded in all directions. So, where exactly is the shortage of land? While, this logic might work for a city like Mumbai, it doesn’t hold for other cities, where there is enough land going around and given this, cities are expanding in all directions. Also, the other point is about population growth. India has now reached a stage wherein in a few years, the new babies born will just about replace the people dying. Hence, the rate of increase in population will keep falling. These two things essentially make sure that the over the long term, the population argument will not hold.” This seemed to convince my co-passenger and he started to nod his head approvingly. Once he was done nodding, he smiled and asked, “But what about black money?” Now, I did not have any answer for that question. I smiled and then looked out of the window into an ocean of darkness. WI
Most people do not know about the concept of the internal rate of return, which is the right way of calculating returns on any investment
Vivek Kaul is the author of the Easy Money trilogy. He can be reached at
[email protected].
July 2017 Wealth Insight 81
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STRAIGHT TALK
ANAND TANDON
UNIVERSAL BASIC INCOME
Opening Pandora’s box? A universal basic income can improve the efficiency of disbursals. But it can also let the genie out of the bottle.
I
United Nations Development Programme reports that India added only 140 million jobs between 1991 and 2013 against an increase in the working-age population of 300 million
f you had the opportunity to redesign our world, what is the most important thing you would change? Freakonomics.com, a website devoted to examining socio-economic issues that are off the standard beat, asked this question to a few economists. A suggestion that attracted considerable debate was that of universal basic income (UBI). At its core is the idea that if everyone had enough to survive without having to work for it, would it lead people to have more meaningful lives? The Economic Survey of 2017 examined such an idea for India. India’s working-age population increases at the rate of a million a month, but there are not enough jobs. United Nations Development Programme reports that India added only 140 million jobs between 1991 and 2013 against an increase in the working-age population of 300 million. This clearly leads to social issues, one of which is high pressure on land, farming being the default option for many of the unemployed. One of the many ways this manifests is in the form of farmer unrest.
What UBI means for India With a population of about 1.3 billion and about 40 per cent below the age of 18, we need to provide income to about 82 Wealth Insight July 2017
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800 million adults. For a moment, let’s take `50,000 per adult per year as the payment that we target. I consider `50,000 as a meaningful number that would allow an adult to sustain a reasonable standard of living. This translates into `40 trillion per year. The total government expenditure of the central government is about `21 trillion, about half the amount required. Putting together state-government expenditure will barely bridge half the remaining gap. Overall, we cannot afford a ‘high’ basic income to all adults. The Economic Survey used poverty line as the basic income desired. The survey estimates the poverty line at `7,620 per year per head for year 2017. At that level or marginally higher, the estimated expense would be roughly 5 per cent of GDP. The Survey also points out that centrally sponsored schemes actually make up more than 5 per cent of GDP. We could, in theory, replace many of the schemes of the government and simply pass on the benefits to citizens as a direct-income credit. This has a major benefit of increasing payout reaching the end beneficiary. Importantly, poverty line is defined on the basis of money required to pay for nutrition and does not include other living expenses, medical and education
Table 1: Counting farmers AGRICULTURAL WORKERS
Year
Total population
1951 361.10 1971 548.20 1991 846.40 2011 1210.80 2015* 1256.00
Rural population
298.60 439.00 630.60 833.70 864.82
% of total population Cultivators
82.69 80.08 74.50 68.86 68.86
69.90 78.20 110.70 118.70 123.13
% of total rural Agricultural population labourers
23.41 17.81 17.55 14.24 14.24
among them. Consequently, removal of the Public Distribution System will increase food costs, MGNREGA removal will reduce wages and taking away the mid-day meal will have deleterious impact on education outcome and health. Without significant restructuring of government expenditure, adding UBI will be an unbearable burden on the country, one that can prove unsustainable. But can we take a more restrictive spread? What about offering basic income to farmers only? Could basic-income guarantee to farmers ensure that the cycle of indebtedness and farm waivers that the country deals with would go away?
How many ‘farmers’? Estimating the number of farmers in India is no easy task. Farmers include farm owners as well as those who work on farms of other people. Some data reflect those working in related fields like fisheries, etc. However, if we use the classification of the Registrar General of India and the census figures, we realise that while the percentage of population engaged in agriculture is reducing, the absolute numbers are going up (see Table 1). This is perhaps also a reflection of a lack of alternate opportunities. Assume that everyone engaged in agriculture is to be supported. With 270 million individuals, payout at `7,620 amounts to approximately `2 trillion. MGNREGA expenditure in FY17 totalled 0.58 trillion – about 30 per cent of estimated payout. Some rejig of other expenses (for example, increased taxes on petro products when input prices have fallen
% of total rural population
9.14 10.82 11.83 17.31 17.31
27.30 47.50 74.60 144.30 149.69
Total
% of total rural population
% of total population
97.20 125.70 185.30 263.00 272.82
32.55 28.63 29.38 31.55 31.55
29.92 22.93 21.89 21.72 21.72
have increased revenues by an estimated `0.5 trillion) and reduction in administrative costs consequent to direct transfer to user accounts can bring this figure within reach.
Politics of economics The Economic Survey points out that UBI needs to increase with time to compensate for inflation. It suggests a linkage as a percentage of GDP. This means a steady increase in expenditure. Once introduced, UBI cannot be removed; no political party would have the political capital to take it away. Consequently, to ensure that a profligate government does not stretch government finances beyond the breaking point would need legislative or constitutional safeguards. Already the left parties demand that no existing support be cut while introducing UBI, clearly leaving unanswered the question of where the money is going to come from. A clear threat to agri-targeted UBI would be the urban poor, who are likely to demand similar benefits. Farm stress and demand for loan waivers are gathering pace. Job creation remains weak in other sectors. Putting more pressure on land to increase productivity is not a sensible choice – it increases input costs while reducing output prices – further increasing distress. In fact, focus should be on frugal use of inputs so that whatever output is produced is at a lower break-even price. Farm incomes can be supplemented by UBI, helping people to explore the possibility of moving away from farming to other activities. Despite many moral and social issues, it’s time for India to examine this option in detail. WI
Once introduced, UBI cannot be removed; no political party would have the political capital to take it away
Anand Tandon is an independent analyst.
July 2017 Wealth Insight 83
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MAIN STREET
SAURABH MUKHERJEA
HISTORY OF FORMALISATION
Adjusting to GST The impending formalisation in the Indian economy will be expedited with the coming of goods-and-services tax
“O
By 1870, the American rail network was already fairly extensive and this created a booming trade in fresh produce. Between 1880 to 1929, America’s per capita annual consumption of fruit rose from 80 pounds to 194 pounds.
ver the next few years, the West will slowly turn back on immigration, outsourcing and economic integration. This will have major consequences for everybody in the world. India will have to focus on its own domestic market and not on exports. Automation and Chinese overcapacity will hit manufacturing, and growth will come in services. Employment and entrepreneurship will happen through platforms that aggregate farmers, retailers, truckers and vendors. This will result in the formalisation of the economy in a big way as finally the benefit of being in the system, thanks to affordable and reliable credit, will be higher than staying out.” – Nandan Nilekani, ‘An Alternate View of the Future’ (June 2016) “Networking inherently implies equality. Everyone, rich and poor, is plugged into the same electric, water, sewer, gas and telephone network. The poor may only be able to hook up years after the rich, but eventually they receive the same access.” – Robert J Gordon, ‘The Rise and Fall of American Growth’ (2016) Small/informal businesses flourish in an underdeveloped economy, where, due to the lack of availability of electricity, good roads, reliable communication
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networks and affordable credit, businesses can operate only a small scale and that too within the confines of their immediate locality. However, as the quote shown above from Robert Gordon suggests, the installation of ‘networks’ – rail, electric, water, gas and telephone – in America between 1840 and 1920 rapidly formalised that economy. Before the arrival of networks, Americans used to eat whatever they could procure locally. This meant that during winter months, when fruit and vegetables were hard to get due to the ground being frozen, Americans would largely subsist on meat and eggs. By 1870, the American rail network was already fairly extensive and this created a booming trade in fresh produce. Between 1880 to 1929, America’s per capita annual consumption of fruit rose from 80 pounds to 194 pounds. As refrigerated freight cars made a variety of processed foods affordable for Americans, the America of the 1870s and the 1880s saw the rise of its first large FMCG companies – General Mills and Pillsbury for flour, HJ Heinz for canned vegetable and condiments, and Coca Cola (created in 1886), Campbell’s Soups and Quaker Oats are some of the more famous names in an era when FMCG became big in America (even before the arrival of the motor car).
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With the rise of these FMCG companies, the local grocer – who had hitherto been the monopoly supplier of foodstuffs in his neighbourhood – found himself under threat. Customers now expected pre-set prices (rather than having to haggle) and that too for a wide range of products (from brooms to baskets to food and wine from all parts of the country). Furthermore, as early as the 1880s, customers expected the products to be attractively displayed under one roof. Thus began the rise of the American department store. A&P was founded in 1859; the Great Atlantic and Pacific Tea Company, in 1869; Grand Union, in 1872; and Kroger, in 1882. By 1930, the leading national chain stores had 30,000 outlets (half of which were A&P) and the local grocer was history. As Robert Gordon explains in his epic book The Rise and Fall of American Growth , an even more dramatic ‘formalisation’ took place in the clothes sector. Until 1870, except for upper-class women who could afford to hire a dressmaker or buy designer clothes, most women made their own clothes and most of their husbands’ and children’s clothes. Obviously, this was
extremely time consuming and thus per-capita spend on clothing was only $11 in 1869 (around 10 per cent of a customer’s total annual spend). Then with the rise of the rail network came the mail-order catalogues – Montgomery Ward started in 1872 and Richard Sears and Alvah Roebuck started their catalogues in 1894. With ‘your money back with no questions asked’ promise, mail-order catalogues transformed shopping, especially for rural women. The catalogues offered low prices and (even by today’s standards) huge variety – the 1902 Sears catalogue contained 1,162 pages (from hats, wigs, coats, corsets, cycles, guns, nails, hammers and even central heating furnaces). By then Sears was fulfilling 1,00,000 orders a day. (Interestingly, at present, the entire e-commerce industry in India fulfils around 8,50,000 orders per day.) The success of the catalogues owed a lot to another network – the US Post Office’s Rural Free Delivery scheme, which began in the 1890s. Sears’ success with catalogues led it to become a retailer in 1925 and modern retail was well and truly entrenched by the time the Great Depression arrived in 1929. The per-
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capita spending on clothing grew from $11 in 1869 to $30.50 in 1929.
Formalisation is inevitable in India (regardless of the impact of GST)
As the PM goes after benami property and as the real-estate regulator cracks down on the sector, there is a high chance that SME owners will find that their property is no longer theirs
As with America after the Civil War, India has over the past decade seen the rapid installation of networks, especially with regards to roads, communication networks and availability of credit. Regardless of the impact of GST, these three forces are already triggering the formalisation of the Indian economy. The parallels between the mail-order catalogues in America and Amazon and Flipkart in contemporary India are obvious (with 4G playing the role of ‘Rural Free Delivery’). The advent of e-commerce in India from CY10 has meant that the improvement in access to end-markets for SMEs in India has improved inorganically. GST will work in sync with the formalisation drivers given above. For example, as companies gradually build up their GST files (in the process of paying GST for every single transaction), lenders will start demanding that prospective borrowers show them their GST file so that lending decisions can be taken on the basis of borrowers’ revenues and costs (as per the GST file). As a result, companies which cannot furnish such a file (because their transactions are in black) will face a much higher cost of borrowing. Furthermore, such companies will find it harder to operate across multiple states. Their competitors – which are operating in the formal economy – will be able to take advantage of low-cost capital, the online economy, modern transport networks and highly automated plants to spread their wings across the Indian economy. This process would have happened without GST and the allied crackdown on black money. However, it seems certain that GST and the black-money squeeze will hasten the process of formalisation and drive consolidation in the Indian economy. This will give market-leading players cause for celebration, even as millions of small companies in the informal sector are driven out of business.
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Investment implications GST and the other networks highlighted above are transforming India beyond recognition (just as happened in America in the half a century leading up to the Great Depression and in Japan over 1920–70). However, the losers in this ‘revolution’ will far outnumber the winners. Eighty-eight per cent of Indian factories have less than 100 workers. Some of these SMEs will become suppliers or sub-contractors to larger organised companies (who will be the big winners from formalisation) but most of these SMEs will die like the local grocer who disappeared in America. Not just the poor in India but also many SME owners have hazy property rights because they have bought property/land using black money (and therefore purchased the property in somebody else’s name). As the PM goes after benami property and as the realestate regulator cracks down on the sector, there is a high chance that SME owners will find that their property is no longer theirs. Bulls who believe that the ‘jugaad’ of the Indian entrepreneur will bail him out have to contend with the persistence of red tape which continues to suffocate the SME owner. For example, in Bangladesh, the monthly minimum wage is around `5,000 (with no perks). In contrast, in Maharashtra, the monthly minimum wage is `10,000 (with another 40 per cent being added for social security, insurance, etc). As a result, the Indian SME in capital-light, labourintensive sectors, like textiles, sports goods and leather products, face an uphill battle to be competitive, especially once they are forced to pay GST. Therefore, I reckon caution is warranted at this time of flux in the Indian economy. A few companies will win big whilst millions of SMEs and their workers will be casualties of the changes sweeping through the Indian economy. WI Saurabh Mukherjea is CEO - Institutional Equities at Ambit Capital and the author of The Unusual Billionaires and Gurus of Chaos..
THE CHARTIST
DEVANGSHU DATTA
INDIAN ECONOMY
Keeping fingers crossed A combination of global and domestic factors will keep the Indian economy and markets on tenterhooks
T
Valuations are high but not quite in the red zone according to most institutions. But if EPS growth does not meet projections, valuations could climb to dangerous levels.
he stock market bottomed out on the budget day of 2016, when the Nifty 50 hit 6,800. In the next 15 months, equity has soared. The Nifty has returned 21 per cent since February 2016 and mid caps have returned even more. Can we expect this rally to continue? The first and the most essential element for the bull run has been liquidity. Foreign portfolio investors have bought equity worth over `70,000 crore since January 2016, while domestic institutions have bought close to `50,000 crore. Retail participation has also been very positive. That works out to about `7,000 crore/ month of net institutional buying on average or a little over $1 billion/month. Second, institutions will pay attention to profit growth. Institutions expect earnings growth to accelerate to around the mid-teens for the major indices, seeing growth at somewhere between 14–18 per cent for the next year or two. If we look at the forward P/E estimates, the implied growth rates are similar or higher. If growth disappoints, there could be an institutional pull-back. Valuations are high but not quite in the red zone according to most institutions. But if EPS growth does not meet projections, valuations could climb to dangerous levels. Apart from fundamental equations of
valuations and earnings, there could be pull-backs across India, along with other global equity markets. This may happen for multiple reasons which might not have much to do with India. One danger is geopolitics. Tensions between Qatar and other Arab nations could lead to a spike in oil prices, for example. Then there’s Brexit, which will impact economic growth. There are increased tensions between the US administration and the European Union, which could have negative consequences. US protectionism could also lead to a knock-down on growth, hitting Indian IT and pharma sectors in particular. And, of course, there could be an escalation of tensions, already serious, between India and Pakistan or North Korea–South Korea, China–Japan, Iran–US, Russia– Ukraine, Israel– Syria, etc. Apart from geopolitics, ‘geoeconomics’ could be a negative factor. The US Federal Reserve could continue to hike US dollar policy rates. The European Central bank also looks set to tighten its monetary policy. Both situations could have adverse impacts on FPI liquidity. On the home front, there are several worries. As of now, Indian banks have stressed loans outstanding to the equivalent of 9.5 per cent to 10 per cent of July 2017 Wealth Insight 89
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Fig 1: YoY changes in Sensex EPS 90 EPS growth is volatile but often exceeds 15%
YoY changes (%)
60 30 0 -30 -60 99 19
8 0 1 2 3 4 5 6 7 8 9 0 1 2 3 4 5 6 7 -0 200 200 200 200 200 200 200 200 200 201 201 201 201 201 201 201 201 7-1 7) 1 y -1 0 2 a (M
Fig 2: Nifty 50 rolling one-year returns 120
1-year returns (%)
80 40 0 Returns trend to be negative for buys above P/E 22
-40 -80 10
15
Once GST does settle down, it should be an improvement on the current system. But GST took quite a while – two fiscals or so – to settle down across the EU
20
25
30
GDP. That may affect credit growth badly in future. Everybody will be watching how the Indian system deals with that problem. Nothing has worked so far. The second bother is that the adverse effects of demonetisation are still showing up. Farmers couldn’t get reasonable prices for their produce and massive farm-loan waivers have now become politically necessary. More such loan waivers could follow. That will hit bank balance sheets; it will increase fiscal deficit; it may also affect rural household consumption patterns. GST is another big question mark in the short run. It’s complicated; it’s disruptive; it offers ample scope for lowlevel corruption. Once it does settle down, it should be an improvement on the current system. But GST took quite a while – two fiscals or so – to settle down across the European Union. Most
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European countries have between two and four GST rates and no absurd ‘antiprofiteering’ clauses. India has around 11 rates if you take the cesses into account. GST might cause lots of confusion in the short run. Quite apart from what it could do to corporate results and consumption patterns, it will lead to massive changes in revenue collections and fiscal deficit. Let’s take a look at historic valuations and EPS growth rates. The historic record suggests that growth at 14–18 per cent EPS may be possible, though it does not happen too often. The Sensex has sustained EPS growth rates of 25 per cent at least four times in the last 16 years. However, the overall EPS CAGR is only about 10 per cent since 2000. So it’s not a common occurrence (see Figure 1). The last time very high growth happened was 2009–10, when the index EPS jumped 40 per cent as there was a global rebound from the subprime financial crisis. There is a global economic revival at the moment since the US, EU, and China are all registering good numbers. Q4 results do show that the return on equity is rising for Indian corporates, and the Nifty’s Q4 results indicate that the aggregated EPS rose by 11 per cent for the top 50 companies. (The weighted EPS will be different.) This may reinforce the general air of optimism. The Nifty 50 is currently trading at a P/E over 24. There are multiple statistical studies that show that the one-year return tends to be negative for investments made at a P/E of 22 or above (see Figure 2). This gives us some sort of roadmap for the coming year. There are multiple disruptive possibilities ranging from domestic (bank crisis, GST, assembly elections) to international (Brexit, international tensions) which could affect the market. Some of these (GST, solutions to bank crisis) may be positive. Keep watching for changes in these variables. Be prepared to wait out a long period unless there is an extraordinary jump in the EPS. WI The writer is an independent financial analyst.
EDITOR’S CHOICE
Must-read books for investors Here is a list of non-finance books picked from the library of Charlie Munger and Morgan Housel that will add to your financial wisdom and world view The Financial Expert
The Big Change
– RK Narayan
America Transforms Itself, 1900-50 – Frederick Lewis Allen
The story of a man who sat under a banyan tree and dispensed financial advice, which made him rich
Influence The Psychology of Persuasion – Robert B. Cialdini An interesting psychological account of what causes people to act in the way you want them to
The Science of Fear How the Culture of Fear Manipulates Your Brain – Daniel Gardner How to rise above your everyday fears and be the person you want to be – a psychological account
Charting America’s growth trajectory, which made it the most powerful country in the world
The Wealth and Poverty of Nations Why Some Are So Rich and Some So Poor – David S. Landes Understanding what results in success/failure at the macro level
How the Scots Invented the Modern World The True Story of How Western Europe’s Poorest Nation Created Our World & Everything in It – Arthur Herman Scotland’s contributions to human development
Guns, Germs, and Steel
The Wright Brothers
The Fates of Human Societies – Jared M. Diamond
The Dramatic Story-Behindthe-Story – David McCullough
An interesting description of the progress of human civilisation
A story of innovation and what propels individuals to think out of the box
The Great Depression
The Birth of Plenty
A Diary – Benjamin Roth and James Ledbetter
How the Prosperity of the Modern World was Created – William J. Bernstein
Exploring the Great Depression of 1929, what caused it and how it affected people
Understanding how we prospered over time – a useful perspective for investors
July 2017 Wealth Insight 91
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EDITOR’S NOTE th ANNIVERSARY
A new way
to invest in stocks
At long last, Value Research Stock Advisor is ready to roll
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EDITOR’S NOTE
What is Value Research Stock Advisor?
O
ur long-time readers often ask us why we stopped recommending stocks in this magazine. In every issue, they read our recommendations track record (see page 96) that we still publish. That track record is absolutely superb (25 per cent CAGR), even though we’re still carrying the losers. Naturally, everyone wants more of that and want us to restart recommending stock investments. Well, here they are, but in a shape and form that they’ll work even better than they did in the printed magazine. Value Research is on the verge of launching a new service, one which we believe will revolutionise equity investing for those who will use it. In a few weeks from now, you will be able to start using Value Research Stock Advisor, an online equity-investment advisory service. This service will be the logical next step in a journey that began in mid-2006, when we launched our first equity analysis product, which was this magazine.
Exactly what the name says. It advises you on what stocks to buy. Our research team maintains a list of stocks that you should invest in. You invest in them and make money. When any of the stocks is no longer investment worthy, we tell you to sell them. What could be simpler? I’m not being facetious. There are obviously some more features to the Value Research Stock Advisor but it’s entirely possible to use it in the ultra simple fashion that I have described above. In fact, the basic concept of the service is exactly that – a transparent, fundamentally-driven, source of ready-to-use research on what stocks to invest in. The recommended set of stocks is divided into two classes: ALL-WEATHER STOCKS: These are companies that we believe should be good for many years, perhaps forever. They are worthy of investment regardless of the state of the markets or that of the economy or global economic conditions or the political dispensation. TIMELY STOCKS: These are stocks that are worthy of investment currently but do not share the deep, long-lasting strength of the all-weather selection. These are more likely to be somewhat opportunistic. For example, there could be a business cycle which we know won’t last forever but which makes some stocks particularly compelling buys at a certain price level.
There’s more – a lot more For those of you – and I hope that will mean all of you – who would like to go beyond just following our prescriptions, Value Research Stock Advisor will help you discover and hone your own talent for stock research. Each of the recommendations we make is published explaining the logic of choosing it with complete transparency. Just reading through each one will be highly educational for anyone who has set out to be a fundamentally-driven, long-term equity investor. The crowning glory of the Value Research Stock Advisor is the Stock Screener feature that we have implemented. This is a unique tool and nothing like it July 2017 Wealth Insight 93
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EDITOR’S NOTE has been available for the Indian equity investor till now. It enables you to screen stocks based on any kind of a financial criteria that can be applied to a company’s financial and market data. Readers of Wealth Insight will recognise this as an interactive, customisable version of the screens that we have been publishing for many years now. But that’s not all. We have also implemented a set of predefined screens that are based on different types of criteria. There are the familiar financial screens like ‘Attractive blue chips’, ‘Discount to book value’, ‘Growth at reasonable price’, etc. However, we also have what we call the ‘Value Guru’ screens.
The Stock Screener feature of Stock Advisor will enable you to screen stocks based on any kind of a financial criteria These are stocks that are automatically filtered and screened according to the investment methodology followed by the five gurus we have chosen, namely, Benjamin Graham, Joel Greenblatt, John Neff, Peter Lynch and Walter Schloss.
Periodic guidance While the great gurus have established time-tested principles that guide our selection, investors also need inputs when the equity markets are in any kind of unusual situation, whether positive or negative. At such times, I plan to create special reports with specific guidance on how to manage your investments, and more importantly, your approach to investing in such phases.
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Rigorous process Of course, there’s nothing in the world of investments that can do without monitoring and that’s true of all the stocks that we recommend in both our categories. Obviously, the rigour that we apply to monitoring the recommended stocks comes later; first comes the process by which we select stocks. Value Research may have launched Wealth Insight only eleven years ago, but equity research and evaluation of companies and stocks has been an inherent part of our research capability from the beginning. Evaluating the investment portfolios of equity mutual funds for decades has meant that we actually have a more thorough understanding of equity investing as well as a much deeper appreciation of what works and what doesn’t work in equity investing on a sustained basis. Through this experience, we have evolved our own framework for evaluating and selecting good stocks. It begins with the entire universe of listed companies and applies a series of conditions, filters and checks. Interestingly, because of the perspective we have, we understand that a framework for selecting good stocks is as much a framework for rejecting bad stocks. We have developed a set of conditions that are absolute no-go for stocks. No matter how good a stock looks otherwise, if it qualifies on one of these negative factors, then we absolutely will not consider it. After that we have a set of qualitative and quantitative factors that we apply to further narrow this down to a list of investible companies.
Funds or stocks? When they hear about our new product, one of first questions that some of our old followers ask is whether we are implicitly saying that mutual fund investors should drift towards investing directly in stocks. This is far from the truth. We firmly believe that both types of investing have their places. Mutual funds are the best way to start investing
EDITOR’S NOTE
For those who would like to go beyond just following our prescriptions, Stock Advisor will help them discover and hone their own talent for stock research in equity. Of the people who get used to equity investing, a certain number will have the time, inclination and talent to do their own research and invest in equities directly. Value Research’s equity products Wealth Insight and now Stock Advisor are meant for these people. Both are designed to be advisories as well as learning tools. Of course, because it’s an online and interactive tool, Stock Advisor can go far beyond Wealth Insight for those who are so inclined. A service like Stock Advisor is actually half-way between a mutual fund and doing equity investing entirely by yourself. When you invest in an equity mutual fund, you are accepting the investment decisions of the fund manager in toto. When you invest by using Stock Advisor, you are being given recommendations by us, but you are free to either follow them 100 per cent, or understand them and then modify them if you have the skill.
Simplicity There are a number of services that are similar to Stock Advisor. I’m not talking of the short-term punting and trading advice that brokers and such hand out. However, even the ones who profess to research and recommend fundamentally-driven recommendations have some basic problems that Stock Advisors does not have. For one, they separate types of recommendation lists (always charged separately) which have different types of labels like large
caps, small caps, growth stocks, value stocks, etc. We believe that this approach loads the complexity of equity investing back on the investor. Our service is simple; it has just one unit and the job of selecting which stock of which type is entirely ours.
Ready to go Wealth Insight readers will recall that one year ago, in our tenth anniversary issue, I had first mentioned Value Research Stock Advisor. At that time, I had said that the service would be launched soon. However, one full year has gone by and you must be wondering what happened. The truth is that we have worked much harder at making our selection process more rigorous than I had thought we would. The legal process also took its time. However, now we are ready with the service and will present it to you shortly. WI
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STOCK ANALYST’S CHOICE
Our scorecard
O
ver the years, we have analysed and recommended several stocks. The table below shows our performance since July 2011. Yes, we have a few failures, but we also have many successful picks. A portfolio comprising the stocks below has delivered an IRR of 25.26 per cent, including dividends, assuming one had invested `10,000 in each of the stocks at the time of the recommendation. In all one would have invested `10,10,000. The current value comes to `28,78,440 (including dividends) on June 21, 2017, whereas investing the same amount in the Nifty would have generated `17,88,015 (including dividends), yielding 13.03 per cent, as per the total returns index. WI Recommended price (`)
Recommendation date
Jul-11
Aug-11 Sep-11
Oct-11
Nov-11
Asian Paints Bosch Castrol India Colgate-Palmolive CRISIL Cummins India Exide Industries ITC Larsen & Toubro Nestle India NMDC Pidilite Industries Titan Company Lupin Opto Circuits Bank of Baroda Castrol India Power Grid Corporation Rural Electrification Tata Coffee Torrent Power Zee Entertainment Ent. CMC* Graphite India Zylog Systems Godrej Consumer Products
295 6,917 244 458 693 481 149 123 1,095 3,888 258 159 229 461 213 152 254 103 87 70 211 123 858 78 197 397
Performance Total returns* since July 2011
25.3% 13.0%
Stock Analyst’s Choice
Nifty 50 Index
*As on June 21, 2017 Current price (`)
1,155 24,226 415 1,102 1,920 913 225 309 1,754 6,759 111 818 523 1,095 9 167 415 206 185 131 183 505 2,032 148 4 1,954
Value of `10K invested (`)
39,145 35,024 16,993 24,060 38,401 18,984 15,072 25,070 16,019 17,385 4,345 51,339 22,849 23,776 425 11,014 16,329 20,039 21,380 18,569 8,670 40,875 23,674 19,135 196 49,284
Total return (% per annum)
26.7 24.1 11.3 17.6 20.4 13.7 8.2 18.8 9.2 10.9 -8.9 32.4 15.0 16.5 -40.9 2.3 10.8 14.6 19.3 11.7 -0.9 28.1 25.7 14.8 -48.3 33.4
Returns for less than one year are absolute. Total returns include dividend income. Returns as on Jun 21, 2017. Transactional fees not taken into account. * CMC merged with TCS with effect from September 29, 2015. Its current price is the last traded price.
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STOCK ANALYST’S CHOICE Recommended price (`)
Recommendation date
Dec-11
Jan-12
Mar-12
Apr-12 May-12
Jun-12
Aug-12
Sep-12 Oct-12
Nov-12
Dec-12
Feb-13
Mar-13
Tata Consultancy Services Transformers & Rectifiers Gujarat State Petronet Noida Toll Bridge Tata Motors GAIL Mahindra Lifespace MRF Bajaj Finance Gabriel India Opto Circuits Shriram Transport Finance TTK Prestige Bata India GSK Consumer Healthcare Swaraj Engines Ajanta Pharma Elecon Engineering Kirloskar Pneumatic Hero Motocorp Supreme Industries VST Industries Amara Raja Batteries Redington India Lupin MindTree Solar Industries Grindwell Norton KPIT Technologies Mcleod Russel City Union Bank Petronet LNG Wockhardt Balkrishna Industries KEC International Torrent Pharmaceuticals Emami Gruh Finance
1,087 197 92 23 180 291 245 6,859 83 23 221 581 2,647 423 2,770 395 75 53 470 2,082 237 1,695 195 71 567 172 197 130 120 306 53 158 1,647 290 64 365 410 108
Current price (`)
2,406 361 165 10 457 368 441 71,709 1,417 161 9 1,000 6,644 528 5,376 2,347 1,534 60 1,185 3,769 1,219 3,331 842 131 1,095 520 821 401 124 181 181 443 579 1,665 246 1,199 1,135 447
Value of `10K invested (`)
22,145 18,306 17,922 4,227 27,767 12,645 17,988 104,480 189,874 70,593 410 17,189 25,100 12,481 19,406 59,438 203,456 11,324 25,206 18,104 51,521 19,655 43,153 18,293 19,300 30,224 41,722 30,874 10,287 5,913 36,809 28,156 3,516 57,370 38,533 32,809 27,656 41,414
Total return (% per annum)
18.3 11.4 11.9 -3.5 19.8 6.5 13.6 53.5 72.5 45.7 -44.8 12.2 19.8 5.1 14.8 45.9 82.4 4.7 21.7 15.8 42.3 17.4 36.3 14.9 15.6 29.1 36.0 29.1 1.6 -9.2 32.0 26.3 -19.6 49.2 36.5 34.5 27.6 40.2
Returns for less than one year are absolute. Total returns include dividend income. Returns as on Jun 21, 2017. Transactional fees not taken into account.
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STOCK ANALYST’S CHOICE Recommended price (`)
Recommendation date
Apr-13 May-13
Aug-13
Nov-13 Dec-13 Feb-14 Mar-14 Apr-14 May-14 Jun-14 Aug-14
Sep-14 Oct-14 Nov-14 Jan-15 Mar-15 Apr-15 May-15
Berger Paints India Innoventive Industries# Kaveri Seed Company Navneet Education V-Guard Industries Cairn India## Indraprastha Gas Nesco Bajaj Corp HCL Technologies Voltas J&K Bank Tata Consultancy Services Cummins India Swaraj Engines AIA Engineering Godrej Consumer Products Rallis India Titan Company Finolex Cables NBCC Gateway Distriparks GMDC V-Guard Industries Finolex Industries Hindustan Media Ventures Mahindra Holidays & Resorts Tata Coffee Infosys Tata Motors Apollo Tyres Ipca Laboratories Voltas Astral Poly Technik VST Tillers Tractors Just Dial Shriram Transport Finance
69 103 252 57 35 296 309 730 237 581 89 135 2,213 433 622 560 764 167 256 164 40 232 154 47 297 155 299 93 966 482 208 681 256 449 1,380 1,253 1,099
PORTFOLIO TOTAL #
Current price (`)
251 4 636 185 184 285 1,094 2,480 376 843 468 95 2,406 913 2,347 1,395 1,954 244 523 489 210 257 147 184 608 274 599 131 943 457 260 470 468 686 2,326 409 1,000
Value of `10K invested (`)
Total return (% per annum)
36,591 407 25,249 32,321 53,064 9,650 35,412 33,978 15,835 14,528 52,412 7,026 10,872 21,062 37,762 24,916 25,583 14,605 20,461 29,817 52,980 11,119 9,519 39,182 20,504 17,694 20,058 14,025 9,762 9,909 12,520 6,905 18,275 15,271 16,853 3,261 9,092
36.4 -62.8 25.6 35.5 50.0 2.9 39.7 37.2 17.6 13.7 59.9 -8.8 5.0 28.2 53.4 33.8 34.3 14.4 26.0 43.5 73.0 6.7 0.4 60.1 31.0 23.1 30.0 14.0 1.6 -2.0 10.1 -14.5 30.0 20.7 27.0 -40.1 -3.2
27,81,796
25.3
Stopped trading since Jun ‘16. Stopped trading since Apr ‘17. Returns for less than one year are absolute. Total returns include dividend income. Returns as on June 21, 2017. Transactional fees not taken into account. ##
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BEST OF
WORDS WORTH NOW
My [demonetisation] decision is kadak like my chai. The kadak tea suits the poor but warps the expression of the rich. Narendra Modi Prime Minister, Business Standard, November 15, 2016
The UP election has made a mockery of the criticism that the demonetisation got. If a lot of people had not supported the demonetisation programme, such an election outcome would not have been possible... Doing demonetisation at such a short period and ahead of the country’s most important state election is a highly risky strategy, which not many politicians across the globe would have done...
Digital is the only way to get rid of corruption and unaccounted cash. Otherwise, in another two years, people will again start accumulating cash... Those who claim that they need cash because they are unable to pay labourers are those who are not paying minimum wages. I am making an open offer – anyone who wants their employee’s account to be opened, we will have a camp to get their bank account open.
Christopher Wood, MD, CLSA, Business
Arundhati Bhattacharya Chairwoman, SBI,
Standard, March 15, 2017
The Economic Times, November 16, 2016
We are all judged by our actions. In Kannada there is a saying: if you sit under a toddy tree and drink milk, people will think you are drinking toddy. So, it is very important for us not only to do the right thing, but also to be seen doing the right thing... [On market speculation that Infosys paid a huge severance pay to its CFO because he had some damaging stuff about the company]
Jio is not a punt, it is a wellthought-out, engineered ecosystem. Mukesh Ambani, MD, Reliance Industries, economictimes. indiatimes.com, October 18, 2016
N R Narayana Murthy, Co-founder, Infosys, Mint, February 13, 2017
Let’s not rubbish the IT services industry. We should celebrate it. If you link it to labour arbitrage, you’d be doing great injustice and you’d be talking the 1980s, not 2017. Instead of asking us why we didn’t build another Windows, you should ask Microsoft why they didn’t build another TCS. N Chandrasekaran, Chairman, Tata Sons, Business Standard, February 16, 2017
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