Archive for category Interesting Reads
I had researched on Sabero Organics about a month back but was too lazy to update on the blog. Thought would rectify it in the new year 🙂
I have not yet invested in the stock. Still reading and researching. Right now, the opportunity costs of investing are pretty high.
Sabero Organics – manufactures agro-chemicals – fungicides, herbicides and insecticides. Sabero is a leading manufacturer of generic products in the agro-chemical space.
Investing theme is broadly – i) patents of major patented agro-chemical products will expire in 2014 ii) Due to increasing environmental concerns and consolidation in China (along with appreciation of yuan), there is a significant possibility of lower production from the Chinese along with better price from India iii) Significant operating leverage and synergies that can be achieved by the Coromandel group.
Their major products in each of the segments are:
1) Herbicide – Glyphosate
2) Fungicide – Mancozeb (registered in the first country in Europe (France) recently); potential of Mancozeb worldwide is $500M; current share is 10-11%; aspiration to take to 20%; it contributes 35-40% of Sabero’s sales (while other core products such as Acephate, Monocrotophos, Glyphosate each contribute 15 per cent to the total sales respectively with the balance 15 per cent coming from Chloropyriphos and others intermediates.)
3) Insecticides – Monochrotophos (main competitor: United Phosphorous)
Share of revenue of Fungicide:Insecticide:Herbicide is 40:40:20
They have subsidiaries in Australia, Europe, Brazil and Argentina.
2009 – 10 AR
Customers of Sabero Organics:
a) 30% of business from MNCs
b) 40% of business from domestic and international B2B
c) 30% of business from dealer distribution network
Sabero is setting up a plant in Dahej SEZ at a cost of Rs. 55 cr. Potential sales of 2-3 times investment. Funded from $9M in ECB debt and rest from internal accruals.
Increased capacity of Chloropyriphos by 50% by Sep 2010.
2010 – 11 AR
2 plants shutdown primarily due to project executions and EMS (environmental) objections
Started supplying to Brazil. Got technical registration for Mancozeb (Brazil is the 2nd largest customer after US in agro-chemicals)
Dahej plant will manufacture synthetic pyrethroids, which have a potential market size of $600M-$700M
Main RMs of Sabero – Ethylenediamine (suppliers are Akzo Nobel, Huntsman and BASF) and Phosphorous, Acetic Anhydride (main supplier Celanese)
Mancozeb plant working at 60% capacity
Supply to Europe has not begun as data protection gets over in June 2011 (Update: In 2013 AR, they do indicate they have registered in France)
40% marketshare in Monochrotophos, rest 60% with United Phosphorous (Cheminova exited the business, leading to a duopoly here)
The joint venture to co-venture partner Markan is under arbitration (Update: In 2012 AR, they have resolved it, taking a hit of approx. 2cr)
2011 – 12 AR
Coromandel (and its subsidiary Parry Chemicals) take 74.57% ownership; Sabero will contribute only 5% of Coromandel’s revenue.
There was a PIL (public interest litigation) filed against the company. Considerable investments were done in environmental management systesm and processes. April 2011 – they were manufacturing 0%; Dec 2011 – their capacity was ramped up to 75%
Manufacture of formulations has begun in Dahej in March 2012
Case with Brazilian company settled
Propineb, with a market potential of $150M – commercialization will begin next year
There has been a sharp fall in the number of Glyphosate herbicide manufacturers, and there can be a 30% reduction in capacity due to consolidation in China in the next 3-5 yrs
Power, fuel and utilities costs shot up to 13.6% vs 7% last year
RM costs also rose sharply
Domestic scale up didn’t happen properly because of availability of products (due to constrained capacity) and erratic monsoons
2012 – 13 AR
Many agro-chemicals going off-patent and due to GM seeds, there has been diversion of R&D funds from agrochemicals to GM seeds
Propineb has been launched (worldwide market of $110M)
Current status of registrations: 296 registrations on 16 products in over 54 countries (183 unique proudcts/country combo)
There has been a 40% increase in trade payables and 100% increase in trade receivables, while sales have grown by only 44%. The massive increase in trade receivables vis-à-vis sales is shown up as negative operating cashflow (-19cr) for the first time. (Are they pushing products on lenient terms then?)
There is absolutely no mention of the status of the Dahej plant.
There are planning to do some capital investment in utilities (drawing board stage), and are targeting EBITDA margins from current 10% to 15%. They can potentially do a 1000 cr turnover in FY15.
Net Fixed Assets
Fixed Asset Turnover
H1 FY14 PAT is 26 cr. Given H1 and H2 are similar for Sabero, FY14 PAT would be 52 cr. (There would be no tax impact this year because 61 cr is carried forward from FY12. 7.7 cr has been set off. This 52 cr can also be set off against 61 cr). Tax impact would be 30% from FY15 (unless we know further status of Dahej in which case, it may be a bit lower).
PAT 52 cr. Mkt cap – 492 cr. P/E of 9.5 (Even EV/EBIT (since Sabero has debt) is about 9.5). What would be a fair valuation for such a company?
For FY15, assume best case scenario:
1000 cr turnover, 15% EBITDA margins would imply 150 cr EBITDA. 30 cr interest deduction. 120 cr EBT. 30% tax – PAT would be 84 cr. On a similar 10x multiple, we are looking at 70% upsides from here.
On a realistic basis, 1000 cr turnover, 10% EBITDA, would lead to 50-55 cr of PAT. There is no growth between FY14 and FY15 in PAT (due to full taxation in 2015). Beyond that, there are too many variables.
Of course, increased demand for Mancozeb from Europe (if France is done, other countries can’t be far behind) may further provide tailwinds.
The major risk I see here is any PIL would lead to further pullbacks as production might be stopped. Also, GPCB has given time till mid-Feb to clear out some backlogs on environmental concerns. I think getting a clearance would be paramount (although, given Coromandel’s pedigree, don’t see much of a risk here).
Another major risk is obviously steep increase in RM prices. This is a risk on balance – as production of end product from other countries is dwindling, and as is the manufacture of phosphorous from China. We may get into a higher pricing scenario, but so would our RM cost increase. Net-net, I don’t see an asymmetric benefit of China rampdown.
Another risk is inter-party related transactions – say, if the Dahej plant production is being restructured to be a backward integrated supplier for Coromandel-Liberty merger, then the upside is going to be very limited. We need to be careful of the pricing structure here. Of course, delisting is another risk (will lead to re-investment risk)
Disclosure: I have not invested as of yet. This is not a buy/sell recommendation. This post is only for learning and posterity. Please do your own due diligence before investing
There have been a few interesting corporate actions over the past 2 months. I will elaborate a couple of them here.
a) PVR Ltd – The first one is from PVR Ltd. (of PVR Cinemas fame). I observed this strange set of events way back in August and yesterday’s Devesh’s tweet on the event was the final push required to write this blogpost.
In summary, PVR Ltd. did a buyback in 2011 (in the May-Oct timeframe) and now sold shares (in the Aug-Oct timeframe). You’d wonder if PVR was in the entertainment business or financial engineering business. On the whole, it seems to be value-accretive to PVR, but this buy-sell stuff in the space of 1 year is a little unsettling.
PVR in June 2011 announced a buyback of shares not exceeding Rs. 26.21 cr representing 9.99% of the company (as an aside, a buyback greater than 10% requires a EGM and hence most companies don’t do it), with the max. share price of Rs. 140/-. 10% of 27,149,372 shares (total equity) represented 2,714,937 as per audited Balance Sheet at March 31, 2011. The Company proposed to buy-back a minimum of 562,000 Equity Shares.
Anyway, cut to the chase, as per this September 2011 notice, PVR had bought back 1,388,328 shares utilizing Rs. 15.82 cr (excluding brokerage and taxes) and that was the end of the buyback (that is approx. 5.1% equity was bought back at an average price of Rs.114/-). As an aside, the book value (net of debt) of PVR Ltd. as of March 2011 was Rs.126.12 cr. That is, 12.55% of book was used to buy approx 5% of equity back – not a great buyback by any standard, but not extremely poor either.
Anyhow, that was history. Cut back to the present. Aug 2012. This news item indicates that a private equity player called L Capital wanted to buy 10% of PVR’s equity at a price of Rs. 200/- (a 7.5% premium on the then market price Rs.186/-). This translated to 28.85 lakh shares (well, there were just 2.595 cr shares after the buyback and then PVR issued a some fresh shares (0.3 cr shares) to L Eco (at Rs.200/-) leading to equity dilution and hence now the equity is actually 2.85 cr shares). With this sale, PVR gets Rs. 57.7 cr for further expansion. (There is a small bit on further Rs.50 cr investment from L Capital into PVR Leisure, a PVR subsidiary (and PVR will eventually have only a 35-40% stake in this business), but that is not pertinent to this discussion).
PVR bought back 13.88 lakh shares for Rs. 15.82 cr in Sep 2011.
PVR sold 28.85 lakh shares for Rs. 57.7 cr in Sep 2012.
Is it value-accretive to PVR? Certainly. Even if you consider that the 13.88 lakh shares which were bought back were sold, the firm netted a gain of 75% within one year without considering the extra benefits of the network of a private equity player, the extra investment into the PVR subsidiary etc. Also, the debt has not increased due to the equity sale, so hurrah!
But should PVR indulge in this buying and selling of equity frequently? The jury is still out on that one.
b) TV18 – This Network18 group has always fascinated me. Not like a Page Industries fascinating, but fascinating with their ingenious financial engineering capability.
This time, the Network18 media group decided on the rights issue part of engineering. Of course, all and sundry do know about the Reliance-Raghav Bahl-ETV-Network18-TV18 story and complications, so I will not get into it (please to google, if you are not aware of it – the twists and turns will put the movie ‘Race’ to shame).
I will analyze this TV18 rights issue as an ‘expert’. That is, I will try to exactly explain why the stock moved from the lows of 20 to the highs of 30 today. (Actually, to be fair to ‘experts’, I am cheating. I had done this analysis much before and only blogging about it today). I have had no positions nor will I ever have positions with the Network18 media group. Their skill in shortchanging minority shareholders is unparalleled and since I have a day job, I can’t monitor their schemes daily.
Anyway, here’s the analysis I had done once the rights issue was declared –
The rights issue size of TV18 is Rs. 2700 cr. For every 11 shares held, 41 shares will be issued on a rights basis, each share costing Rs. 20/-. CMP of TV18 Rs. 22/-. If I had 100 shares today (as total equity), post-rights issue, I will have 500 shares for the company. But since the equity is coming through at close to market price, major correction may not happen. In fact, there might be upsides (unless of course, the management dreams up something else). The management of Network18 stock will garner money through its own rights issue and invest in TV18 rights issue. Therefore, the chances of higher allotment are very low (and since the rights price is very close to market price, why would I want to go for a higher allotment?)
The stated intention of the management is that total debt of TV18 would be re-paid and remaining amount would be used to fund the acquisition of ETV channels. The possible increase in revenue due to acquisition of ETV channels aside, this debt repayment has very interesting ramifications on the EPS of TV18.
Consider the P&L statement for the year ending March 31, 2012 (I am looking at standalone results. The consolidated results are much worse, and they are losing money at an operating level). The EBITDA of the company is Rs. 97.42 cr. The interest payment is Rs. 93.48 cr. That is, 96% of the money generated is funding the interest costs. What would happen if the interest costs vanished, since the debt would be extinguished? Let’s do a small financial exercise –
Assume revenue doesn’t increase (which is a pessimistic assumption, since ETV channels are going to earn some revenue). So, EBITDA, say will be around Rs. 97 cr. Now, there are no interest costs to service since the debt has been extinguished, utilizing the funds from the rights issue. Depreciation of Rs. 25 cr. Therefore, PBT is Rs. 72 cr. Due to accumulated losses over the past 6 years (yeah, they have been losing money in all six except the year ending 2012), taxes would be zero. Profit would be Rs. 72 cr.
Now, the equity base currently is 34 cr shares. March 2012 profit is Rs. 9 cr. That is Rs. 0.26 per share. The equity base will increase by 135 cr shares, taking the total equity base to 169 cr shares.
Therefore, technically (forget the interest of June 2012 quarter for a moment), the EPS would be Rs. 72 cr/169 cr = Rs. 0.42 per share, an increase of 63% in EPS, without any increase in revenue. Of course, now we consider June 2012 interest and Sep 2012 interest (sum approx to Rs. 58 cr). That would bring down the EPS to Rs. 0.09/-, but that’s only in the short term.
If the tailwind of digitization works (Safir Anand’s pet topic) and ETV revenues flow through, at the very least, TV18 is going to earn a decent profit, maybe equivalent to March 2012 profit, but with zero debt. A stronger balance sheet ideally should propel this stock to greater heights. Even considering consolidated results, if the management pays off the entire debt as claimed, I think TV18 will generate a decent profit at the end of FY13. However, I am not buying. Too many ifs and buts.
P.S: If you are on twitter and not following Devesh (@_devesh_) and Safir (@safiranand), you are missing on interesting conversations. Go, follow!
Disclosure: I have no positions in PVR and TV18 (or Network18). This is not investing advice. This post is only for analysis purposes and not a buy/sell recommendation.
Special Situation: Open Offer Analysis – Tata Steel’s Open Offer for Tinplate Company of India and Tata Sponge Iron
Last Friday (15th June, 2012), there was a corporate announcement by Tata Steel. It had announced an Open Offer for two of its group companies – Tinplate Company of India and Tata Sponge Iron.
Seemingly, there was some insider information trading already (hello, Rajat Gupta speaking!) going by the increase in stock prices of both stocks as seen below (courtesy: Moneycontrol)
Tinplate Company of India
Tata Sponge Iron
Of course, nothing can be proved in India and hence we can all rest easy and get back to Insider trading (kidding!).
Anyhow, I was all excited about this Open Offer since the closing price was Rs. 45/- for Tinplate Company of India and Rs. 306/- for Tata Sponge Iron. In my excitement, I wrote up an investment note about this Open Offer. I however didn’t realize that the announcement had come about after market hours and I didn’t consider the impact costs.
Please download the investment note (clicking on the link will automatically start a word document download) Open Offer_Tata Steel_Evaluation that I wrote up for the Open Offer. Even if using this document doesn’t generate any returns currently, it atleast has the framework to work on future open offers.
Looking forward to your comments/insights/learnings from past open offers.
P.S: I had shared this investment note with a few senior investors on Saturday. Thanks to Neeraj and Ankur, I realised that I have to include the following points in that analysis:
a) Consider impact costs. Ankur was a little gentle, saying that I didn’t consider impact costs in the calculations while Neeraj was a little more blunt saying ‘this is theoretically perfect, but practically, the market will not give you a chance since you didn’t consider impact costs’ 🙂 .
b) Tax implications: If and when you tender in an Open Offer, since you don’t pay STT, the gains are subject to taxes (long term and short term). The market will usually raise it up to a level where there is no arbitrage due to the tax angle. This is another angle that I need to add to my Open Offer framework note.
I had written about Economics of IPL on my other blog some time ago.
Yesterday, one of my acquaintances reached out to me and informed that he was working on a case study for valuation of IPL teams. He had read my IPL economics post and enquired if I could help him with the right valuation technique for IPL teams and thereby make an investment decision (investment time frame 3-5 years). Here was my response (feel free to add any other inputs on this). Presumably, he has all the revenue and cost structures of all IPL teams and since he didn’t share that with me, what follows is more ‘gyaan’ than actual numbers. Let me know your thoughts.
Interesting exercise on valuing IPL teams.
Discussing Economics of IPL is pretty straightforward. Valuation though is a different beast because, a) there is the element of ‘price you pay’ and b) every assumption/step can be challenged since there is no ‘correct’ common way.
Anyway, here are my brief thoughts on the exercise –
a) Using DCF/Free cash flow yield methods is essentially GIGO in this case. In my view, to use any of the two methods, you need atleast 10 yrs of data (and I am assuming 10 yrs covers an entire business cycle of bull/bear and see how your market works). Else, the result is complete bullshit (irrespective of using the concept of ‘margin of safety’). You can do a ton of weird stuff with excel (with CAPM, Royalty rates, Projected sales etc., but as they say, just because we can be excel gods, doesn’t mean we can become good investors).
b) Using ‘comparable sales’ is a good option. As long as you have the sales data and cost structure, profitability is easy. But comparing across teams might be difficult. Sales for a CSK might be higher, but the cost structure of CSK is also significantly different. But this is a good starting point.
c) Price multiples would seemingly make it quite easy (along with the sales data). But the deal is how do you get to the price vs value equation? (or EV for that matter, where price is critically important). Let me flip this equation by comparing it with a listed security on the Indian markets. Let’s say CSK = HDFC Bank on the bourses. We know HDFC Bank is expensive at current valuations (on almost every parameter), but people stick to HDFC Bank and it deserves the current multiple because of the sales, risk mgmt, profitability, management strength etc. (and hence comparable to CSK in terms of winnings, sponsorships, star players etc.). So, the issue we might have to deal with here is ‘if I pay a higher price, will I get a correspondingly higher value’?
d) And I would say if you are using a multiple, rather than P/S, EV/Sales would be a better option just because these folks might just have a ton of debt on their B/S.
e) Financial stmt analysis is absolutely important (esp. some bit of forensic analysis) since multiple things can go wrong here. Working cap mgmt (of when you pay money to BCCI, when you get money from sponsorships etc.), Earnings vs Cash flow (am I just booking sales, or is there some cash to show for it etc) needs to be checked. I mean, that’s like a given (if you have access to those figures that is).
f) One other parameter that we need to consider in this valuation is something to do with a asset (player) sale/transfer. How likely is one team to trade a player for another, or just sell a player for money? This has had some wonderful windfall profits for a few teams, so this is not just ‘extraordinary income’. Over a period of 5 years, I see atleast 3 yrs of this ‘extraordinary income’ coming into play.
g) You can assign ‘brand/royalty’ value using any of the goodwill calculation methods. But really, beyond CSK/MI/RCB, I wouldn’t assign any royalty value for any other teams in the competition.
h) Also be aware of changing cost structures every 2-3 years because of the auctioning and re-auctioning.
Hope that helped in some tangential fashion. Let me know how your analysis comes out and if you can share it with me once you are done with it.
Every Tom, Dick and Harry seems to be posting about Berkshire’s Annual Letter 2011. Most of the blogposts I’ve read seem to be interpreting what Buffett said. However, my endeavor in this blogpost is to cull out the bits that I liked (and thought were important) in the Annual Letter and present them here. No interpretations, no extension of logic etc. Just pure excerpts from the annual letter found here. I am sure each one of us on different points on the investing learning curve will interpret his statements differently and there is no one single interpretation that would do justice.
On Berkshire’s intrinsic value,
Our share of their earnings, however, are far from fully reflected in our earnings; only the dividends we receive from these businesses show up in our financial reports. Over time, though, the undistributed earnings of these companies that are attributable to our ownership are of huge importance to us. That’s because they will be used in a variety of ways to increase future earnings and dividends of the investee. They may also be devoted to stock repurchases, which will increase our share of the company’s future earnings.
On Buffett’s Natural Gas bet,
A few years back, I spent about $2 billion buying several bond issues of Energy Future Holdings, an electric utility operation serving portions of Texas. That was a mistake – a big mistake. In large measure, the company’s prospects were tied to the price of natural gas, which tanked shortly after our purchase and remains depressed. Though we have annually received interest payments of about $102 million since our purchase, the company’s ability to pay will soon be exhausted unless gas prices rise substantially. We wrote down our investment by $1 billion in 2010 and by an additional $390 million last year.
On Berkshire’s performance in bull and bear markets,
We’ve regularly emphasized that our book-value performance is almost certain to outpace the S&P 500 in a bad year for the stock market and just as certainly will fall short in a strong up-year. The test is how we do over time. Last year’s annual report included a table laying out results for the 42 five-year periods since we took over at Berkshire in 1965 (i.e., 1965-69, 1966-70, etc.). All showed our book value beating the S&P, and our string held for 2007-11. It will almost certainly snap, though, if the S&P 500 should put together a five-year winning streak (which it may well be on its way to doing as I write this)
On Stock buyback/repurchases,
Charlie and I favor repurchases when two conditions are met: first, a company has ample funds to take care of the operational and liquidity needs of its business; second, its stock is selling at a material discount to the company’s intrinsic business value, conservatively calculated.
The first law of capital allocation – whether the money is slated for acquisitions or share repurchases – is that what is smart at one price is dumb at another. (One CEO who always stresses the price/value factor in repurchase decisions is Jamie Dimon at J.P. Morgan; I recommend that you read his annual letter.)
When Berkshire buys stock in a company that is repurchasing shares, we hope for two events: First, we have the normal hope that earnings of the business will increase at a good clip for a long time to come; and second, we also hope that the stock underperforms in the market for a long time as well.
Let’s do the math. If IBM’s stock price averages, say, $200 during the period, the company will acquire 250 million shares for its $50 billion. There would consequently be 910 million shares outstanding, and we would own about 7% of the company. If the stock conversely sells for an average of $300 during the five-year period, IBM will acquire only 167 million shares. That would leave about 990 million shares outstanding after five years, of which we would own 6.5%.
The logic is simple: If you are going to be a net buyer of stocks in the future, either directly with your own money or indirectly (through your ownership of a company that is repurchasing shares), you are hurt when stocks rise. You benefit when stocks swoon. Emotions, however, too often complicate the matter: Most people, including those who will be net buyers in the future, take comfort in seeing stock prices advance. These shareholders resemble a commuter who rejoices after the price of gas increases, simply because his tank contains a day’s supply.
On Insurance businesses,
At bottom, a sound insurance operation needs to adhere to four disciplines. It must (1) understand all exposures that might cause a policy to incur losses; (2) conservatively evaluate the likelihood of any exposure actually causing a loss and the probable cost if it does; (3) set a premium that will deliver a profit, on average, after both prospective loss costs and operating expenses are covered; and (4) be willing to walk away if the appropriate premium can’t be obtained. Many insurers pass the first three tests and flunk the fourth.
On his two new personnel,
Todd Combs built a $1.75 billion portfolio (at cost) last year, and Ted Weschler will soon create one of similar size. Each of them receives 80% of his performance compensation from his own results and 20% from his partner’s. When our quarterly filings report relatively small holdings, these are not likely to be buys I made (though the media often overlook that point) but rather holdings denoting purchases by Todd or Ted.
On Berkshire’s derivative positions,
Though our existing contracts have very minor collateral requirements, the rules have changed for new positions. Consequently, we will not be initiating any major derivatives positions. We shun contracts of any type that could require the instant posting of collateral. The possibility of some sudden and huge posting requirement – arising from an out-of-the-blue event such as a worldwide financial panic or massive terrorist attack – is inconsistent with our primary objectives of redundant liquidity and unquestioned financial strength.
On basic choices for investors (which I highly recommend to be read in full rather than this brief summary),
Investing is often described as the process of laying out money now in the expectation of receiving more money in the future. At Berkshire we take a more demanding approach, defining investing as the transfer to others of purchasing power now with the reasoned expectation of receiving more purchasing power – after taxes have been paid on nominal gains – in the future. More succinctly, investing is forgoing consumption now in order to have the ability to consume more at a later date.
From our definition there flows an important corollary: The riskiness of an investment is not measured by beta (a Wall Street term encompassing volatility and often used in measuring risk) but rather by the probability – the reasoned probability – of that investment causing its owner a loss of purchasing-power over his contemplated holding period. Assets can fluctuate greatly in price and not be risky as long as they are reasonably certain to deliver increased purchasing power over their holding period. And as we will see, a non-fluctuating asset can be laden with risk.
Investments that are denominated in a given currency include money-market funds, bonds, mortgages, bank deposits, and other instruments. Most of these currency-based investments are thought of as “safe.” In truth they are among the most dangerous of assets. Their beta may be zero, but their risk is huge.
The second major category of investments involves assets that will never produce anything, but that are purchased in the buyer’s hope that someone else – who also knows that the assets will be forever unproductive – will pay more for them in the future. Tulips, of all things, briefly became a favorite of such buyers in the 17th century. This type of investment requires an expanding pool of buyers, who, in turn, are enticed because they believe the buying pool will expand still further. Owners are not inspired by what the asset itself can produce – it will remain lifeless forever – but rather by the belief that others will desire it even more avidly in the future. The major asset in this category is gold, currently a huge favorite of investors who fear almost all other assets, especially paper money (of whose value, as noted, they are right to be fearful).
Our first two categories enjoy maximum popularity at peaks of fear: Terror over economic collapse drives individuals to currency-based assets, most particularly U.S. obligations, and fear of currency collapse fosters movement to sterile assets such as gold. We heard “cash is king” in late 2008, just when cash should have been deployed rather than held. Similarly, we heard “cash is trash” in the early 1980s just when fixed-dollar investments were at their most attractive level in memory. On those occasions, investors who required a supportive crowd paid dearly for that comfort.
My own preference – and you knew this was coming – is our third category: investment in productive assets, whether businesses, farms, or real estate. Ideally, these assets should have the ability in inflationary times to deliver output that will retain its purchasing-power value while requiring a minimum of new capital investment.
One book recommendation,
I think you’ll also like a short book that Peter Bevelin has put together explaining Berkshire’s investment and operating principles. It sums up what Charlie and I have been saying over the years in annual reports and at annual meetings.
(all emphasis mine)
Azim Premji University gave investors residing in Bangalore a reason to rejoice today, the 9th of January 2012. They had invited George Soros to deliver a talk, as part of their public lectures series. I had obviously subscribed to the event immediately and reached the venue 30 minutes early to grab the best seat. If there are three investors in the world that I wanted to see and interact with in my life, they are Warren Buffett, George Soros and Seth Klarman. George Soros check.
The lecture began in the form of a conversation with the Chancellor of Azim Premji University, Mr. Anurag Behar. Soros in his unimitable fashion took over the conversation with gusto (and without anybody noticing – credit to Mr. Behar not to interrupt like some news anchors would have done). I scribbled down notes as fast as I could and am presenting with what I wrote down. I definitely would have missed some points – so anybody reading this who also attended the lecture – please fill in the gaps. Caution though – investors who follow George Soros religiously will of course find nothing new in here. Notes follow (all italics are statements made by George Soros, emphasis mine) –
Soros talking about his initial days –
A lot had to do with my father. Year 1944. World War II. I was a Jew. Persecution loomed. My father saved me from persecution by taking a lot of risks. If he hadn’t taken those risks, I probably wouldn’t be in this position. That gave me my first insight ‘Sometimes, its more risky not to take a risk and act all precautionary’
Soros talking about his Guru, Karl Popper –
Karl Popper shaped my philosophy. He was a strong proponent of ‘critical thinking’ and idea of a ‘open society’. I was very young when I read him. He influenced me a lot, and I have read all his books.
The big topic. 2008 Financial Crisis –
The theory of financial markets states that markets do not tend towards equilibrium. Boom-bust cycles happen regularly. The problem of this super bubble that led to the crisis of 2008 started in 1980 with the Reagan Administration.
If financial capital is free to move around, that capital will tend to find a place where there is least regulation and taxes. Therefore, globalization and de-regulation always go hand-in-hand. Govt. authorities always come to rescue – whether it was the S&L crisis, the Asian crisis, IT bust in 2001, leading to moral hazard. Growth of credit and leverage led to the super bubble. I thought that the bubble would pop in 1997 during the Asian crisis, but the authorities intervened. Then IT bubble-bust happened, and authorities reacted by reducing interest rates and kept low interest rates for too long, which led to the housing bubble. In the crash of 2008, the authorities let Lehmann Brothers collapse and the financial markets essentially stopped functioning. Subsequently, financial rescue came through and the market was put on artificial support. What the authorities essentially did was to substitute financial credit with state credit. But they did not try to address the underlying imbalances.
On the Euro situation and crisis –
The Euro crisis is a direct consequence of that replacement of credit. Due to that, sovereign credit is in question now. The 2008 crisis revealed the inherent weakness in Euro and the region as a whole. This Euro crisis is larger than the financial crisis.
In case of Euro, there is a Central bank (ECB), but there is no Treasury. Central Banks deal with liquidity. Treasury deals with solvency. There is no Treasury in Europe currently and they are currently in the process of creating it.
When the Euro was brought into existence, the authors (or its creators) knew that there were chinks, but rationalized that with a common currency, political integration would come through and these chinks would be ironed out. But that didn’t happen. Now we realize that only in the time of crisis, politically impossible becomes possible.
Slowly, Treasury will have to be created. We are in a more dangerous situation than 2008. Euro banks failing would be catastrophic because of the current state of financial integration across the world. The chances of failing poses a great risk to the economy of the world.
The point is – if the crisis is brought under control, period of austerity has to begin and creditors will call the shots. Essentially, Germany will call the shots. And Germans might come up with a draconian austerity program. There is a real possibility of a deflationary cycle, hence impacting the real economy. Deleveraging is already happening and I am afraid, there is more to come.
On the Developed vs Developing world debate –
This crisis is hitting the developed world. 2008 crisis was primarily hitting the US. But the repercussions of this crisis will also be felt by the US. Developing world will be affected by the crisis too, but less affected than the developed world. There is an underlying shift from the developed to the developing world happening right now. The rate of growth in the future in the developing world will be positive while in the developed world, it might be negative.
India is a fascinating country, and I am long term optimistic on India.
On Market fundamentalism, Economic theory and Reflexivity –
Market fundamentalism is a political interpretation of the prevailing economic dogma – the economic dogma being ‘Markets left to their own devices will find the optimum outlets…’. I don’t subscribe to it. Financial capital will move to wherever there is less regulation and taxes. It is difficult to globally regulate economy and still ensure that the financial capital moves freely. The regulation of Banking system is not going well.
As they say, Economists predicted 8 out of the last 3 recessions. Economic theory doesn’t resemble the real world. It is just being mistaken to be relevant to the real world. Economic theory tries to imitate Newtonian physics and hence tries to arrive at a equilibrium by modeling the real world using universal laws. This equilibrium is a mirage. Social affairs have thinking participants and hence lead to in-determinant situations.
Reality and people’s view of reality are never equal and are more often divergent. There is always a two way connection between thinking and actual course of events. There are two aspects that everyone is trying to grapple with. One, understanding reality. Two, impacting that reality. These often stretch in opposite directions and creates a feedback loop (termed as ‘reflexivity’). This impacts the state of affairs depending on the type of feedback. Positive feedback reinforces prevailing trend, introduces bias and creates distortion. Negative feedback corrects the reinforcement. Due to the nature of feedback, there will always be booms and busts. Reflexivity disturbs the equilibrium while Economics explains only theory.
On Regulation –
Markets are prone to create bubbles and busts and therefore, you need regulation. Ever since financial markets existed, financial crisis have happened. Every time crisis happened, regulation was created. Regulation is a part of the financial markets. There is always an interplay between Regulation and Financial markets. Both are imperfect and both exhibit reflexive interplay.
This reflexive concept has not been invented by me. It was explained long ago by Frank Knight, in the Knightian Uncertainty. Risk management techniques ignore unquantifiable uncertainty, thereby creating financial crisis (impact of fat tails). We should rebuild economics on imperfect understanding of the markets. I have had an edge and made money by understanding the concept of reflexivity better than others, till I explained it in my book ‘Alchemy of Finance’ (laughter!)
In today’s world, the business of spending some money to create a loophole in the regulation so that it benefits one party is growing tremendously.
On Democracy and his Charity Foundation –
I am less optimistic about democracy in the US than in India due to a combination of financial and political crisis.
There is a theory that poor share more than the rich, and probably the reason why they have remained poor.
I have found, through my foundation that the theory of fallibility and reflexivity work not only in the financial sphere but also in the political sphere. For example, I did not foresee the collapse of USSR, but became more alert as it was collapsing. I immediately set up a foundation for democracy. Similar in Burma, where I was in recently.
Time was running short and Soros seemingly had multiple engagements today that he had to rush to.
I personally wanted to ask a question ‘What are the 2 subjects/industries that you would encourage students of investing to learn today, to be successful investors 25 years into the future’, but never got the chance. Always next time.
Hearing it from the horse’s mouth, as they say, is an experience in itself. Soros walked after a thunderous applause from the audience (the auditorium was jam packed by the way!). Calm, collected, humble and seer-ish. You never could make out he was one of the smartest guys in the world (apart from being one of the richest). Absolutely phenomenal stuff.
So, Deepak Shenoy (@deepakshenoy) was in Bangalore and I took this opportunity to meet some fantastic investors like Sunil Arora (@moneybloke), Prashanth (@Prashanth_Krish) along with a host of others in a tweetup at Koramangala. During the tweetup, discussion did turn to the ailing Kingfisher and how Banks would be impacted by it. There was a bit of confusion around how loans are classified under NPA, and I kept saying ‘There is a matrix to decide that, there is a matrix that’ (we had drawn up a matrix in a room to decide NPAs in my Banking days of the yore), but couldn’t offer anything more concrete. This blogpost is to rectify that vague statement and offer a little more insight into the NPA classification as decided by RBI.
Loans are treated as Assets by Banks. These loans can be classified into two types depending on whether the customer has paid up or not.
1) If the customer pays his EMIs regulary, it is called Standard Asset.
2) If the customer does not pay 3 consecutive EMIs, the Banks have to classify it as NPA (Non-Perfoming asset).
Let’s say a Bank issues a car loan to Mr. A. As along as Mr. A pays his EMI (Principal + Instalment) regularly, without missing a payment, the Bank considers Mr. A’s loan as a Standard Asset and will not provision for the loan.
What is a provision and why provision at all? A bank sets aside certain amount (depending on certain criteria and percentages which are set by RBI) to account for future losses on loan defaults. Banks (as strict as their criteria for issuing loans could be) assume that a certain percentage of loans will not pay up at all/not pay regularly. Banks hence provision for these losses earlier rather than when the loss occurs so that the losses if and when they occur still guarantees a bank’s solvency and capitalization.
In the case above, since Mr. A is paying up his loans regularly, the Bank will not provision any amount against the loan granted to Mr. A. Now, assume the same Bank issues a car loan to Mr. B and Mr. B due to various circumstances (lost his job/can’t pay up/will not pay up) does not pay 3 consecutive EMIs. That is, the days past due (Bankers keep harping on ‘DPD’) becomes more than 90 days. In this case, the Bank is a little skeptical on Mr. B paying up the loan. The Bank recognizes this risk (rather, RBI forces the Bank) and provisions for the loan. NPA itelf is sub-classified into 3 categories – Sub-standard, Doubtful and Loss. You can be a NPA for different kinds of loans. For example,
a) If it is a term loan, if the interest and/or principal remains overdue for a period of more than 90 days.
b) In respect of bills purchased/discounted, the bill remains unpaid for a period of more than 90 days.
c) For agricultural loans –
i) If it is a short duration crop, it will be treated as NPA if the EMIs are not being paid for 2 crop seasons
ii) For long duration crops, the loan will be treated as NPA if the EMIs are not being paid for 1 crop season.
d) In case an infrastructure project term loan, if the project does not start commercial operations (and hence can’t pay up EMIs) in 2 years time, then the loan has to be considered as NPA.
I will draw up a matrix now 🙂
e) For power sector, the provisioning norms are slightly different (I think 10% for sub-standard, 20%,30%,50% thereafter)
and so on and so forth. Nowadays, different sectors seem to have different provisionings and its getting difficult to keep track of them.
The table is self-explanatory. Banks in India have to adhere to the matrix depending on the state of loans they have issued in the past.
Customers usually do various gimmicks to avoid the NPA bucket (well, if you get close to NPA bucket, you can be rest assured that you will be barraged with calls/collection agent will sit in front of your home). They pay every alternative month, thus never getting into the NPA bucket (late fees, penalty fees etc. is a secondary issue). Sometimes, they just pay the interest and not the principal, thereby avoiding the NPA bucket. Greening (give another loan to cover the previous loan) happens very often too, to avoid the NPA bucket.
As you realise, the lower down the rung we go, the greater is the provision that is required and more provisioning hurts profits. That’s the reason why the lower down the rung our loans go, more are the number of calls we get from collection agents.
So, what happens after the loan gets classifed as NPA. Well, there are two options –
i) After the Bank follows up, the customer pays all the EMIs (for which he was due) and starts paying his EMIs more regularly. If the customer pays up for 3 months consecutively, he moves back to Standard Asset.
ii) Banks proceed to recovery money from the customer. The SARFAESI act allows Banks to recover their NPAs without the intervention of the court. They can recover this money either through selling it to Asset reconstruction companies (ARCs) for a discount (and hence book a little loss in their P&L) or enforce the Security/collateral provided by the customer at the time of issue of the loan (the treatment of money recovered this way would depend on whether it was higher or lower than the book value).
Also, in case any money is recovered in the case of loans classified as ‘Loss’ in previous years, this money will be booked as revenue in the P&L of banks.
Now, how is the debt of Kingfisher Airlines treated by Banks? Well, RBI already had a rule for restructured loans (we are being told that KFA’s loans are being restructured, aren’t we?). Restructured loans also get to be classified in Standard and NPA depending on how the loan was restructured. So, the rule is –
For restructured/rescheduled assets, provisions are made in accordance with the guidelines issued by RBI, which require that the difference between the fair value of the loan before and after restructuring is provided for, in addition to provision for NPAs. The provision for diminution in fair value and interest sacrifice, arising out of the above, is reduced from advances.
Now, what would be the fair value, interest sacrifice etc. in case of KFA? Your guess is as good as mine (essentially because the term ‘fair value’ has different connotations for different people). However, in cases of restructured accounts classified as standard advances, the loan provisioning would be 2% compared to 1% in the first two years from the date of restructuring. There is a working paper at RBI underway to have a re-look at the restructuring rules. The tentative date for release of this discussion paper is March 2012.
Just in case you are wondering if similar rules apply to NBFCs, they do. Till recently, NBFC has to recognise a loan as NPA only if it crossed a DPD of 180 days. However, a RBI ruling in Sep 2011 changed all that, and now even NBFCs have to adhere to NPA classification of 90+ DPD. Just because of the change in ruling, Gross NPAs will increase by quite a bit, and the effect is increase in provisioning (and hence lower profits) and hence you see some of the NBFCs getting battered since Sep 2011.
P.S: Some general provisions are also made for Standard Assets in case of loan exposure in countries other than the home country.
P.P.S: There is an additional concept of Provisional Coverage Ratio (PCR). RBI has dictated that PCR should be 70% and most banks adhere to it. It’s basically an additional buffer to protect Bank’s solvency
P.P.P.S: There are about 7 deductions that can be made to arrive at the Net NPA figure that Banks bandy about from the Gross NPA figure. Instead of listing the 7 deductions, I will direct you to a RBI document (slightly dated).
Now that everyone and his uncle are onto the predicting bandwagon in the New Year, I resolved to myself that I shall not let go this golden opportunity to pontificate and predict what might happen in 2012.
Then I said, scratch that. Let’s just see whether the broader market as a whole is undervalued or overvalued right now.
Before that, a review of basics. Over the long term, the broader market (Sensex/Nifty) will grow only at the rate of corporate profits. Corporate profits in turn grow at the rate of nominal GDP (real GDP+Inflation rate). I venture a guess (with a higher probability of being right) that Sensex/Nifty’s growth over the past 10-15 years has been commensurate with the growth in profits of their corporate constituents. Again, that is in the ‘long term’, not year-on-year. But we all want the answer to the question of ‘what about next year – where will the Sensex/Nifty go?’.
Now with this post in mind, and the current Nifty values (P/E: 16.79, P/B: 2.77, Div Yield 1.63), we can deduce that Nifty is in the Low Valuations category. Of course, no one knows how long it will take to move into the high valuations category (or get down to the Very Low valuations category), but in general, it is good sense to start dipping our toes in the broader market by buying the Nifty in parts.
All the above of course was a rehash of what we have spoken on this blog earlier. No new information in there.
In this post, I want to explore a hypothesis on the Sensex (Nifty comprises a broader market as a whole, yes. You can do this analysis for Nifty too).
Refer this post. The summary of that post was, if the Return on a stock (as defined by RoE/RoCE) was equal to the return on a post tax AAA bond yield, then that stock is said to be fairly valued at P/B=1.
For illustrative purposes, if a stock’s RoE = 20%, AAA bond yield is 10%, then the fair P/B would be RoE/AAA bond yield = 20/10 = 2. If the P/B of the stock is 4, then it is said to be over-valued and if it is 0.5, then it is said to be under-valued. (In my discussion with other investors, this seems to be broadly right except when there is pricing power, brand and scale involved).
So, what are the values for Sensex over the past 10 years? (I have taken the 10yr Govt. yield as a proxy for AAA bond yield)
|Year||RoE (%)||Govt. yield(%)||P/B||Sensex|
In the spirit of the illustration above, let’s divide RoE by the Govt. yield, and compare it to P/B.
Over the past 10 years, data emerges which confirms our hypothesis. Whenever RoE/Govt yield was greater than the P/B, the Sensex rallied and whenever RoE/Govt. yield was lesser than P/B, the market tanked (as indicated in the initial years of this dataset) (except for the freak year of 2007-08, which as we all now know in hindsight was the peak of the bull market). Let’s plot a graph then (and due to my poor charting skills, I will have to divide RoE/Govt yield by P/B to arrive at a single figure, say x. If x is greater than 1, then the market is undervalued. If x is lesser than 1, the market is overvalued).
As per our hypothesis then, the Sensex at these levels is still overvalued. So, at what point does Sensex become undervalued? Assuming the Govt. yield remains around the 8.4-8.7 levels (and of course, I am trusting our corporates to be like a hawk on their profits and hence protect the RoE at these levels), the undervaluation in Sensex comes around the 10700-11500 range, which is around a 30% drop from these levels. Even if we give a little premium for the ‘India’ story (I don’t know if this is justified though), the Sensex becomes undervalued at 13000-13500.
And just so that we have some other data point to ensure our hypothesis is not way off, let’s see the 15 year averages for Sensex. The 15 year avg. P/E is 14.7, P/B is 2.6 and RoE is 18.8%. The current Sensex values are P/E 16.5, P/B 3.14 and RoE is 18.2%. This indicates that inspite of a similar RoE to the 15 year average, we are very much above the averages in P/E and P/B indicating overvaluation. Unless of course we ramp up the RoE dramatically in the current year and the next (which I see as a low probability scenario in the current conditions), the conclusion is the market is still overvalued.