Wednesday, 27 November 2013

Investing in stocks:A much better alternative to starting one's own business - Part I

I have always been fascinated by entrepreneurship all my life. What has fascinated me about running one's own business is that many a times, once  a strong foundation is created for the business, owners don't work for money but money works for them! It has been my dream to start a venture on my own, one day and grow it to a level which is best in class. However, like most aspiring entrepreneurs, I  too had no clue about where to start and what to do. In last 10 years of my career, I have evaluated plenty of ideas and abandoned it for one reason or the other. Some ideas languished on commercial merits, some others lacked the scalability and few others were too big too chase given the limited capital available for investment. 

I never thought, I will find a solution to this dogma, through something called value investing. About four years ago I read about Warren Buffet, his invest style, underlying philosophy and principles of value investing. It has been a fascinating journey of learning  and unlearning (there was lot to unlearn indeed!) since then. At the heart of this philosophy was the principle enshrined by great Ben Graham that stock is not a piece of paper but part ownership in a business! This is a very simple and powerful concept but unfortunately, majority of  the investors never realize this and continue to treat stocks as piece of paper and as a result continue to get mediocre returns from their investment in stock market. However, this simple concept of treating investment in stock as part ownership of business has completely changed my approach towards investing and my urge for starting my own venture. It has dawned upon me that may be it is much better idea to invest in stocks than starting one's own business. I have debated this idea again and again and have reached a conclusion that for many of us, investing in stocks is an excellent way to passively do the business and reap the  benefits similar to running one's own business without getting exposed to disproportionate  risk emanating from vagaries of business! Here is my reasoning:


  • Possibility to part own a business with small investment corpus: For a person coming from middle class, capital has always been a limitation in starting my own business. This is not to say that if there is a good idea, one will not find capital to fund the idea. However, many a times. this is the most challenging part of starting a business. So, if one wants to set up a chemical factory in Ahmedabad of reasonable scale, initial equity contribution required will be of the tune of 40-50 lakhs. This will mean investing one's savings for life in a venture, which may or may not work out. Alternatively, one can invest just a fraction of the proposed investment required for new chemical factory and part own the business of Vinati Organics, one of the largest manufacturer of speciality chemical IBB , a key ingredient for making ibuprofen. Say, if one would have invested 5,00,000 in Vinati Organics in 2009, would have more than tripled in 4 years resulting in annual CAGR of 32%! Even if one compares, return on equity, Vinati would have generate return in excess of 35%! Thus, even with a smaller ticket size, an investor can generate similar or better returns on capital employed as one would have generated by starting one's own chemical factory!

  • Minimizing risk through diversification: Imagine, how many businesses one can start with 40-50 lakh? Most likely one, or may be two at the most! As on date, with the same quantum of money, I part own 12-13 different businesses across various industries. This diversification helps me mitigate the risk of losing capital entirely (which may very well happen if I own only one business for umpteen number of reasons including default on payment by one or two large customers!) as my capital is spread across various businesses and each business also has well established customer mix. Diversification also protects me from downside of generating sub-par returns due to headwinds in one or two businesses. Take example of unexpected depreciation in rupee in last one year. Had I been running one business where large portion of my raw material is imported while there is hardly any pricing power available with me. I have seen many small businesses going broke in last one year due to sheer depreciation in currency. On the other hand, current portfolio of businesses that I own consist of few businesses which are negatively impacted because of rupee depreciation (Cera/Astral) while the other set of export oriented businesses have benefited from rupee depreciation. Thus, in the end overall impact on earnings is minuscule. The moot point here is that many a times, if one has invested in a portfolio of carefully chosen quality business, tailwinds in few businesses will compensate for the headwinds in few other businesses thus, protecting investors from permanent loss of capital. 

  • Access to the best managers for running the business: When one invests in stock run by competent management, one is getting access to the best managers running a business he has put his money on! As an investor one can have an opportunity to side with and ride with people who have complimentary skills, which are unique to them, and has significant value. As an investor in the company, this skill is available to you at minuscule cost, but benefits derived from such skill can be enormous! If one was running his own business, access to people having such complimentary skills is prohibitively expensive and hence the odds of making extraordinary deals/returns are significantly lower. At the folly of repetition, let me give you example of investment in Piramal Enterprise. There was an opportunity with investors to side by one of the best deal maker and wealth creator Mr.Piramal at free of cost! Moreover, the ongoing businesses of PEL were available at throwaway price after he sold his formulation business to Abbott. Similarly take example of Mayur Uniquoter. Mr. Poddar, the founder of Mayur, is one of the oldest hats in the business and has uncanny understanding of the dynamics of business. As an investor in Mayur, I have access to the skill and competence of Mr.Poddar and his team in deploying and managing the capital I have invested in. This kind of access to people would be unthinkable for someone starting his own unit of manufacturing synthetic leather.

  • Buying business ownership on your own terms: This is vital. It is important to choose which battles one fights and ideally one should choose the battles where odds of winning the battle are conspicuously in his favour. Though life doesn't give you an opportunity to choose your battle, but market surely does give you the flexibility of not only choosing the battle one wants to fight but also the option of choosing the battleground and timing as well! We, human beings, are not rational all the time, especially when it comes to matters related to money! Markets, which is confluence of human opinions and sentiments, is a perfect place to look for pockets of irrational behaviour. Fear and greed, both are found, in abundance in the market. This sets a perfect stage for getting great bargains which no owner, in his right mind, would ever offer. As a businessman, this is the best place to look for, if one wants to buy businesses at substantial discount or sell them at staggering premium! So, one can wait to invest in a business at significant discount to one's own perceived value of the business. In private transaction this would have never happened. Just imagine what would happen if you offer to buy a growing and profit making company at value less than cash sitting on the books? Most likely, you will be thrown out of the door! However, as an investor in the market one can get the opportunity to invest in cash bargains of some very respectable companies many times in one's lifetime! 

  • Flexibility to exit: Even if you are running a proprietary company, it takes while to complete all the formalities to close the business and down the shutter. The process is far more involved if it is a private limited company.One has to continue to meet compliance requirements till all the accounts are settled and money distributed to all stakeholders. If the business involves more than one partners,the matter gets further complicated, if some of the stakeholders want to continue the business while you want to exit. While one invests in stock,even though, you are a part owner of a business, you can  exit the business, for whatever reasons, on a click of a mouse and get the proceeds deposited in your account in two days! This, again, is extremely useful, when in your judgement, the business is going down hill, management shows lack of competence or you just have a better business to invest in! 
Having put forward some arguments in favour of part owning a business through investing in stock versus starting one's own business, I do acknowledge that there are some obvious shortcomings of only having part ownership in a business which can negatively impact one's prospects of creating wealth in the long term. But, I will keep those shortcomings and ways around those shortcoming aside as topic for my  next post! 

As always views are welcome!

21 comments:

  1. Dear Dhwanil,

    Thanks for sharing pearls of wisdom with us. I have been reader of your blog since beginning and believe me coz of smart guys like you I have left newspapers and News Channels for investment advise.


    Regards
    Karun

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    Replies
    1. Thanks Karun for your kind words. It is the continued support of readers like you which keeps one motivated!

      Best Regards,
      Dhwanil Desai

      Delete
  2. Dhwanil ji:

    I think you should look at Jayant Agro as an investment based on value investing.
    Jayant is One of the largest processor of Castor oil and castor oil derivatives in India. India is the largest producer of castor in the world producing 70% of total castor production.. Castor oil and its derivatives have a unique position that .. they are established as "Green Chemicals" ie. they replace "Crude oil" in the chemical industry..

    Castor oil is used in Lubricants, coolants, high performance plastics, paints, ink, cosmetics, deodrants, soaps, chocolates and much much more.. (Intravenous - Parentals), jelly filled cables, capacitors, auto parts..

    Jayant has reported 600% increase in profits and 400% increase in sales in past 7 yrs .. the stock price is still languishing at 7yrs old levels..
    Consolidated Sales/NP numbers.
    March 2007 Sales 462.49Cr Net Profit: 6.76Cr Div:1.25
    March 2008 Sales 605.96Cr Net Profit: 9.51Cr Div:1.25
    March 2009 Sales 875.86Cr Net Profit 7.49Cr Div: 1.25
    March 2010 Sales 904.01Cr Net Profit: 12.47Cr Div:1.50
    March 2011 Sales 1,175.26Cr Net Profit: 24.92Cr Div 1.75
    March 2012 Sales 1,832.26Cr Net Profit: 31.35Cr Div: 2.00
    March 2013 Sales 1,624Cr Net Profit: 36.24Cr Div: 2.25
    Consistent dividend paying company since inception..

    Castor oil and its derivatives are used to produce high value end products.. and demand is greater than supply.. Arkema French Speciality Chemicals giant 6 Billion Euro sales company has recently taken a 24.9% stake in 100% subsidiary of Jayant agro for approximately 30Cr..
    Mitsu Chemicals and ITOH Oil of Japan have also signed JV agreements to produce Castor based Polyols in India with Jayant (50% stake)making them cost competetive with crude oil based polyols..

    Market Cap of Jayant is just 112Cr..
    One thing that always concerns investors in Jayant is large debt.. This was raised as a concern with Jayant management in AGM and management said that its nothing to worry as its part of how business is done.. short term debt is secured by the raw material bought during harvest season..

    Annual Report 2013 (Consoldiated)
    Short term Debt: 236.76Cr (less than 12 months)
    Long term debt: 48.40Cr
    Total Debt: 285.16Cr
    so 83% of debt is short term in nature used to buy raw material during the harvest season..

    Total Sales 1625.98Cr debt as percentage of sale is: 17.53%
    -------------------
    in these 7 yrs promoters have increased their shareholding by more than 10% in 2012 promoters bought close to 10Cr worth of share at avg price of 120 per share..

    there are only 5198 shareholders.. promoter stake 64.8%
    --------------
    PN: I have investments in jayant agro.. pls do your own deep dive before investing

    =happy investing
    whatsup-indianstockideas

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    1. Dear Whatsup,

      Thanks for writing and sharing your views. On Jayant Agro, it is too leveraged a business for my comfort especially when the NPM are hovering around 2%. That essentially means that the respectable ROE is largely derived from asset turnover and leverage. I have burnt my fingers, by investing in leverged companies, and observed that when going gets tough, investors pay heavy price for the leverage. Again, these are my personal views from may be 10,000 feet analysis and hence should not have bearing on either prospective or existing investors.

      Best Regards
      Dhwanil Desai

      Delete
  3. Great Words n thoughts.
    Its been my philosophy too. Exiting a business in India is damn difficult.

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    1. Thanks, Vivek. I have experienced some of my close relatives going through the arduous process, so I can vouch for that!

      Regards,
      Dhwanil

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  4. The post presents a different perception to stocks. I do agree coming from a middle class background its difficult to raise capital for setting up an industry. Investing in stocks an easy way to own a business without running around too much....though the difficult part is owning the right business.

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    1. Venkat, sure. I think the key is to own right business run by competent and ethical management at right price. Rest, the time will take care!

      Best Regards
      Dhwanil Desai

      Delete
  5. HI Dhwanil,
    Thanx for reflecting the feeling of lots of tribesman through your sweet post.

    You mentioned about Vinati, i have couple of queries on Vinati --
    Vinati borrowed 16 mil USD in the form of FCCB a couple of years back. In the foot-notes of the latest Annual Report, it is said that these FCCBs have the option of converting into stocks at Rs. 100 each, which using 60 Rs per USD translates to around 1 cr shares, as compared to the current 4.94 crore - representing a dilution of around 20%. Furthermore, the lenders earn only 4% if they hold it till maturity. With the current price at 175, is there a huge risk of dilution? Wouldnt the lenders exercise their option and covert their bonds to stock?

    Sales increased by 33% (in the past 2 quarters), PAT increased by a mere 1-2%.

    Would be glad to know your view on Vinati ...

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    1. Hi Nabendu,

      I had used Vinati for illustration. Though, I was an investor in Vinati, few years ago, I no longer am actively tracking the developments. However, considering their position in the market, I feel it is a good business. With respect to your specific queries, I will need to dig deeper which I will do over the weekend and will get back to you.

      Best Regards
      Dhwanil Desai

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  6. let me try to answer your query. first of all fccb was only $5 mn, rest $11 mn was ecb.

    you are right when you say that the conversion price is rs. 100 per share but the exchng. rate is not going to be the current mkt rate but the rate at which the fccb was taken which was approx rs. 44. so even if the fccb is going to be converted it's not going to make a dilution of less than 5% only.

    with respect to your statement on PAT increasing by mere 1-2%, i can only suggest you to read the footnote of the unaudited results properly. read it and recalculate the adjusted EBIDTA or even the cash profit then you will realize how good the performance was.

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  7. Well written. But still, stock markets in India are a scam when compared with the degree of transparency of the markets in the USA managed by the SEC. SEBI is an evolving organization and has to walk many miles before we can truly apply the data available to Grahams and Buffet's model in India. In India it is reputation of a company and the promoter that makes it an investment grade stock. Rest is all air.

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    1. Hi Kb,

      I acknowledge and partially agree with your view point that authenticity of data of many Indian companies is a question mark. However, I disagree that market is a scam in that sense. It is too critical a view. Instead, I would put it slightly differently. If one is investing in Indian equities, one has to be spend higher effort on due diligence both on numbers and management than one has to do that for companies in the developed world. I personally feel that given the "Age" of Indian equity market, SEBI has done a phenomenal job to serve the objective of bringing appropriate transparency in the market. Though, it is still in work in progress, we are far ahead of the game as compared to lot of developing markets world around.

      Also, I feel that Graham and Buffet principles become far more relevant as the whole "margin of safety" concept provides for the error one would make in the judgement. So, I personally feel that stick to Graham/Buffett core principle actually will make more sense in Indian context.


      Best Regards
      Dhwanil Desai

      Delete
  8. Hi Dhwanil,

    Thanks for sharing your valuable thoughts with us. I agree that there are a lot of advantages of investment business over running one's own business like flexibility to rotate one's capital in the best opportunities available, scalibility, ability to carry out the business from anywhere with a laptop and internet connection etc.

    But one needs a continuous stream of cash flows to take care of day to day expenses and surplus capital for equity investments. One can plan such incoming stream of cash flows in many ways. Job, managing other people's money, passive rental income or profits from a small business. Job and managing other people's money would rob you of your independence. Additionally, job might also rob one's peace of mind and leisure time to relax and think. If one can build a small and successful business like owning a small restaurant which is typically a high margin business and it throws a lot of free cash flow, then one will have a lot of time, independence and capital to invest in the equities. Restaurant business has so much margin that one can also hire a good manager to look after the day to day operations. This would also give a hands on experience of efficient working capital management. If one is able to make some money from this business, then he can also buy commercial real estate and earn rental income where yields are typically between 8-12% annually and around 15% capital gains on the property price. This would provide a diversification among various asset classes and would be good for overall financial and emotional well being as for a full-time equity investor it's very difficult to read for 8-9 hours daily by sitting on a chair. 4-5 hours of morning reading daily is very good and sufficient in my opinion.

    Best Regards,
    Saurav Jalan

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    1. Hi Saurav,

      You are so very right! This is precisely one of the major downside of passive investing that you have paltry cash flow in terms of dividends only and that too at the discretion of the management!

      In terms of how to keep on generating regular cashflow, all the options that you have suggested are valid. However, again in terms of starting a restaurant/owning a real estate will require either large amount of capital deployment or one needs to resort to leverage. So, if one has that wherewithal to start a restaurant ( if my understanding is correct, owning a decent restaurant in a city like Ahmedabad,will cost around at least a crore rupee). In real estate, my understanding is that typical yield is 3-4% from rent. So the question is will if suffice? Here also one needs large enough kitty to match with the large ticket size.

      So, it is a perplexing situation. What I believe could work is either
      1) If you are a professional,do freelancing which helps you meet day to day expenses while giving you enough time and liberty to spend time on focusing on investing.

      2) Do a job and start saving early and make sure you earn decent return by spending weekly 6-8 hrs work on investing largely revalidating ideas generated by other value investors through their websites/blogs/forums (valuepickr/TED) and eventually reach critical mass whereby your are financially independent.

      Though, neither of them are perfect solutions, life is never so simple and straightforward as such!

      BTW: just saw your blog and really liked it. Let's stay in touch and keep sharing ideas and keep debating!

      Regards
      Dhwanil

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    2. Hi Dhwanil,

      Even I have been reading your blog since last few months and really like the way you present your ideas. I enjoy the process of learning and am always enthusiastic to share and discuss ideas with fellow investors like you.

      You estimation about starting a restaurant in a city like Ahmedabad is correct, but I think 1 crore would be required if one goes for the outright purchase of the property on which the restaurant would be sitting. If somebody can rent a decent place at let's say Rs.75 per sq.ft, then his capex would reduce to a great extent, but monthly rentals would be incurred as a recurring cost.
      The leftover capex would be in the form of furniture, construction, equipments, raw materials, legal costs etc. All this could be managed much below 50 lakhs if I am not wrong in my estimation. But I personally feel that rather than taking the plunge to build one’s own brand, taking the franchise of a well established brand can be the easier route. Due to the mushrooming of shopping complexes and malls, renting a place instead of purchasing the property would be less capital intensive and risky for a small businessman in my opinion. However, other numbers should have to be worked out to understand where ROI is getting maximized.
      Rental yields are 3-4% in residential real estate, but in commercial real estate the yield is usually higher than 8%. I have observed this at the micro level, but even if you take a closer look at the high profile deal of Express Towers bought by the Blackstone Group, the math works out like this :

      Total deal size = Rs. 900 crs approx.
      Total Area bought = 3, 84,000 sq. ft
      Average Rent per month at Express Towers = Rs. 300 per sq. ft approx
      Total Annual Rent = Rs. 138 crs approx
      Annual Rental Yield = 138/882 = 15.36%
      If 75% of the total area is leasable and average rent is taken conservatively at Rs. 250 per sq. ft, then also the annual yield would be around 9.6 % .

      I read in one of the interviews of Mr. Rakesh Jhunjhunwala that he bought some land at Secunderabad way back. If he constructs a mall on that land and then lease it to the tenants, the annual yield would be around 25% as per his calculations! That’s the only investment which pleases him apart from his equity investments :)

      Best Regards,
      Saurav Jalan

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  9. Agree to most of the content above!
    Great Info! I have a small value investing calculator based on Graham’s principle. Would welcome your thoughts. Is it too simplistic ? http://www.tankrich.com/stock-calculators/

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  10. Good to see you back Dhwanil.

    I thought you had moved in with your in-laws :-) just kidding.

    Great post. I wonder the same and ask my business friends how much profit/return do they expect after putting in 12-16 hours of work. Somehow I can't justify it.

    I'm happy to make 20% plus annualized return on my investments in fraction of the time they put in :-)

    Vikas






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    1. Hi Vikas,

      Thanks for posting a comment and encouraging in spite of very infrequent and irregular posts on my blog. I wish your assumption was true, and I would have already gained financial freedom..:-)

      Yes, It makes immense sense to partner with competent and ethical managers running great businesses on your terms and I am equally happy doing that...!

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  11. Is Part 2 on the making? Awaiting for the Posts....

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    1. Hi Karthik,

      I must admit that I did miss out on part 2 of the post. But will post that once I post the second part on capital allocation is posted.

      BR
      Dhwanil.

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