Wealth Creation Through Elementry Mental Constructs of Value Investing

As we all are about to enter into a new year, I thought it appropriate to share my views/understanding on how one can enhance his/her chances of creating long term prosperity by applying or understanding certain fundamental constructs of value investing. I will try to present these basic ideas with least jargon. What really astonishes me is the fact that, in spite of general sense amongst people that investing is a fairly involved and complex subject, the underlying ideas for successful investing is fairly simple!

Power of Compounding: Even though, most of us are aware about the power of compounding, we rarely are able to appreciate the enormity of the whole idea. Two important variable in the compounding is time and rate of return.

Let us first look at what impact time horizon can have on your returns! If I were to invest Rs. 1,00,000 in 2012 in indexed mutual fund for 10 years with expected rate of return of 12% (average return from market), at the end of 10 years, I will end up with roughly 3.1 lakhs. However, if I increase my time horizon to 20 years, initial investment of 1,00,000 will turn into 9.65 lakhs, multiplying wealth by power of 2! Similarly, if I were wise enough to invest the money for 30 years, I will end up with bountiful of 30 lakhs. So what's the message? Start making investment early in life and you will be able to reap maximum benefit of compounding

Another important factor in compounding equation is rate of interest/return. Let's see how it impacts wealth creation. Let us assume that as in earlier example, I have made investment of 1,00,000 in 2012 in index fund for 30 years, I will end up with 30 lakhs at the end of 30th year. Instead of being a passive investor, I decide to manage my own portfolio of stocks, selected on the basis of value investing principles. Let me assume, hypothetically, that my portfolio outperforms the average market returns by just 1%, i.e. my portfolio yields 13% average return instead of 12%. This slight out performance will increase my corpus from 30 lakhs to 40 lakhs, increase of whooping 33% over investing period. Many value investors, by sticking to value investing principles, have outperformed the average market returns by 5-7% over 25-30 years! This results into astonishing number of multiplying original amount by 100-200 times. On the other hand, if the same amount is invested in a long term FD yielding average 8% return, I will end up with 10 lakhs (only 1/3 of index fund returns) at the end of 30 years. This leads me to conclude that it is worth the time and effort in researching and creating sound portfolio of companies as even moderate out performance can be a significant wealth creator.

Concept of Risk: Risk is an abstract concept.

Sintex Industries: Is Mr.Market Overreacting?

Sintex Industries is synonymous with water tanks, plastic door/windows and many plastic products for building material. It has 95% market share in water tank business and is a market leader in building products and custom moulding. It is also pioneer in developing new applications/products leveraging their know how on plastic technology. Since last 4 years company has developed niche application called monolithic construction technology using plastic moulds that reduces the cost and time of constructing building significantly. Company has capitalized on first mover's advantage in monolithic segment and has current order book of INR 3000 crores in this segment. Company has unmatched history of paying dividends for last 78 years! In last 10 years, Sintex has grown its top line and bottom line at CAGR 17% and 34% respectively.

Now let us look at what has transpired in the last six months for sintex. In June 2011, company was trading at market cap of 5000 crores at P/E of 8-9, while at yesterday's closing Sintex was available at market cap of 1720 crores. In other words, company has lost market cap of whooping 3300 crores. So where did things go wrong for Sintex? Well, the answer lies largely in the FCCB. 

Mayur Uniquoters: Good Business, Better Fundamentals, Great Value

Mayur Uniquoters Limited, one the largest player of PU/PVC leather in India, was established in 1992 by Mr. S.K.Poddar. PU/PVC leather, popularly known as synthetic leather finds applications in variety of industries including footwear, automobile seats,upholstery, furnishings, sports goods, apparels, leather bags and hosts of fashion accessories. Moreover synthetic leather is fast replacing natural leather in most of the industries due to limited availability and high cost of natural leather, increased awareness towards animal rights/cruelty and high polluting production process of tannery. In contrast, synthetic leather offers a great alternative as it is cost effective, less polluting and made from the fabric base.

Quality of Business and Economics:

Market Leader: Mayur Uniquoter is undisputed leader in synthetic leather market in India. It has current installed capacity of 1.4 million meters/month (expansion by 2012 to 1.9 million meters/month), more than twice that of its nearest competitor!

Preferred Supplier: Mayur has built enviable list of customers due to high quality of its product, system oriented approach and its ability to develop customized and high value products due to its in house R&D facility. Following is the client list.

Footwear: Bata, Liberty, Paragon, Khadim's, Action, Carbon

Automotive: Ford, Chrysler, MAruti, Honda, Tata, Nissan, Hyundai, Mahindra,

They are in the process of getting approved vendor list from BMW, Mecedez and GM.

Focus on high value/high margin products: Company has maintained continued focus on developing and marketing high value products by leveraging its strength of quality and R&D. This strategy has paid off well and company has improved its NPM from 4% to 10.13% in last 5 years

Significance Of High Return on Equity (ROE) in Indian Context

Legendary Warren Buffet opined in annual report of Berkshire Hathaway in 1979 that 

" the primary test of economic and managerial performance of an enterprise is the achievement of high earning rate on equity capital employed (ROE) (without undue leverage and accounting gimmickry) and not the achievement of consistent gains in earnings per share. In our view many businesses would be better understood by their shareholder owners as well as the general public, if management and financial analysts modified the primary emphasis they place upon earning per share."

This unequivocal affirmation my Mr. Buffet that ROE is one of the most critical parameters to identify the quality of business is supported by many other great investors.

So let me first start with the definition of Return on Equity.

ROE = Net Income/ Shareholder's average equity during the period.

In other words, ROE signifies the returns earned on shareholder's money, a very important metrics to keep tab of a company indeed!

This led me to dig deeper in the context of Indian market to identify companies having high ROE (>25%) and reasonable market capitalization ( > INR 1000 Crores). I consciously decided to ignore smaller companies, but more on that later! The objective of the exercises was to understand whether there exists any common thread that binds all these companies leading to higher ROE.

Based on the edelweiss database, i found that there are 112 such companies that have market capitalization of 1000 crores and higher and ROE in excess of 25%. Surprisingly, there is a discernible pattern in the list. Around 80% these companies have enjoyed some "moat" or "sustainable competitive advantage" leading to higher ROE and hence premium valuations in most of the cases. 

Cera Sanitaryware: Prospective steady compounder

Cera Sanitary ware is the third largest player in organized sanitary ware market with market share of 20% in this segment. Cera has established its brand pan-India and positioned its products mainly as "value for money" offering. However lately it has entered into luxury/premium segment with very interesting product launches.

Cera currently trades at market cap of around 230 Crores with trailing PE of 7.67 and P/B of 2.06.

Now let me analyse, three important aspects for value investors 

- Quality of Business 

- Intrinsic Value of Business as compared to its price

- Margin of Safety. 

Quality Of Business:

Cera is one of the few sanitary ware manufacturers who has carefully nurtured a very strong pan-India presence with the help of strong dealers network (500+) and retail presence (5000 + retail network). This extensive reach combined with astute brand positioning and focus on quality has meant that company continues to achieve higher net profit margins and consequently higher ROCE/ROE compared to market leaders HSIL.

Value creation by an enterprise largely depends on what return it earns on the deployed capital and how much of free cash flow company is able to deploy for its further growth. For more on this please read  Why Stocks go up?

Cera has maintained average ROE of 20% in last 5 years and ROE has gone up from 18% to 24% in last 5 years. Cera has been able to maintain high ROE in spite of increased competitive environment in the industry. To put this into perspective, ROE for HSIL, largest player in the industry having 40% market share, has declined from 14% to 11%!

Another positive factor to be highlighted here is, that even though company has grown its top line  at CAGR 20% and bottom line at CAGR 45% in last 10 years (top line: 41 crores to 255 crores, bottom line: 0.45 crore to 25 crores) it has managed its balance sheet very very well. According to 2010-11 numbers, debt/equity stands at 0.33, much less than net working capital! This is another sign of a very prudent management...

Interesting Readings From Great Investors

Value investing is a remarkably flexible framework! The beauty of this framework is that even though almost each value investor has its own unique approach to value investing, as long as the "crux" of the framework is preserved, the results obtained are equally impressive.

I have tried here to put to gather some  interesting readings on value investing from some the greatest value investors.

• Super investors of Graham & Doddsville - An edited transcript of a speech delivered by Mr. Warren Buffet at Columbia University in 1984. A great read not only for content, but also for typical buffet style writing!

• What Has Worked in Investing- An excellent compilation from Tweedy, Browne, describing investment approaches and characteristics associated with  exceptional return

• Berkshire Hathaway Letters to Shareholders- Letters written by Mr. Buffet to shareholders of Berkshire every year. These letters have plentiful pearls of wisdom, insights into astuteness of a great investor Warren Buffet and his art of stock picking. A must read for all investors.

•  Factors to make money in stocks- succinctly summarized ,simple yet effective, tips from legendary investor Walter Schloss

• A slide show from Value Investing Congress 2010- A good compilation of presentations made at value investing congress.

• A great resource Page by Mr. Ashwath Damodaran - very very useful resources including some awesome spreadsheets compiled by Prof. Damodaran. A must book mark for finance/investment professional

When I read through such value investing stuff, what startled me was that each investor had tweaked the original philosophy to suit his own style while preserving the basic principles, and all of them achieved spectacular success by beating the market consistently!

Enjoy reading and keep sharing!

JB Chemicals: A Classical Ben Greham Style Stock

Benjamin Graham, a legendary investor and pioneer of value investing, had designed a framework for selecting stocks where inherent value of the business is much higher than the value assigned to the stock by the market. Even though there are very many variations that have been developed and adopted since this framework was designed by the Ben Graham, the framework suggested by him is still considered one of the most conservative way of picking stock. 

Before I try to put JB chemicals into the framework provided by Greham, let me give a small introduction of JB chemicals. JB chemicals is one of the oldest pharmaceutical companies in India founded by Mr. J.B.Mody. It was earlier known as Unique pharmaceuticals and has 11 manufacturing facilities spread across four locations Panoli, Ankleshwar, Daman and Belapur. Over the years, it has devloped some very formidable brands like Doktor Mom (given Superbrand status in Russia and CIS countries), Metrogyl, Rantac  and Nicardia. They have recently sold their Russian and CIS countries OTC business to J&J for approximately 1200 Crores. They have received proceeds from the sale and distributed around 320 Crores as special dividend to shareholders. This indeed is commendable and speaks a volume about the management's integrity and its focus towards shareholders. 

Let me carry out a step by step analysis as suggested by Graham Framework.

Value Investing: Maximizing Investment Returns through Risk Aversion

I am really excited to enter into hitherto uncharted territory for me: blogging. Idea of creating my blog on value investing dawned upon me while reading some very interesting blogs on value investing and the interactive nature of this framework. It is like creating "virtual brainstorming" sessions from some highly talented and like minded people. What an Idea sirji!!!

Since this is my first post, I would like to introduce my self and give little bit of back ground on myself. I have done my chemical engineering from Nirma Institute of Technology, Ahmedabad and completed my MBA from University of Akron, Ohio. I am currently involved in providing consulting services to the energy sector.

I heard about Value Investing some 3 years ago, and it caught my attention instantly! This was because, here was a framework, which claimed to have succeeded in "beating the market" handsomely and consistently for years while I was given to believe umpteen number of times, during my finance courses in MBA that there exists an "efficient market" and it is impossible to beat the market. This led me to researching further on this framework by reading more about some of the greatest investors of all time such as Benjamin Graham, Warren Buffet, Philip Fischer and their investment philosophy. The common underlying principle for them was "buying good business cheap" when market creates an opportunity where inherent value of business is far more than the price determined in the market. This framework revolves around Margin of Safety thus restricting downside even in worst case scenario. Even though such opportunities are not plentiful, they do exist.