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.