GSFC Ltd: A Peter Cundill Style Opportunity

I have completed reading "There is Always Something To Do: The Peter Cundill   Investment Approach" by Christopher Risso-Gill. Let me tell you, it is a remarkable book about a extra ordinary value investor. The book has been replete with "investment notes" maintained by Peter Cundill for his investment ideas.Investment rationale for many investment ideas is very succinctly presented with right perspective. Peter Cundill was one investor whose investment style largely resembled to the investing style of Benjamin Graham which relies heavily on tangible assets on book to ensure margin of safety in investment process. This analytical framework is the most conservative way of ensuring margin of safety as it ensures "safety of capital" in the worst case scenario, i.e. liquidation of a company. 

Before I start analyzing the company, let me give you some glimpse of Peter Cundill's investment style. Peter Cundill describes his investment style as "mostly Graham, slightly Buffet and little bit of Cundill". His investment thought process relied heavily on determining "liquidation value" of a company and if the company was trading below its liquidation value, he would seek to invest in a company. He would look for securities that were quoting below book value and carried assets on the books at substantial discount to its fair/market value. He would then determine the fair book value or liquidation value of a company and if the price is below "liquidation" value, he will seriously look at such companies for adding into his portfolio. In my opinion central premise on which Peter Cundill relied was that any business is worth more alive than dead. Based on this premise, if one buys into a business at price which is even lower than its liquidation value, it gives substantial margin of safety to investor. The only caveat here is that, business in which one is investing, should be a profit making venture and should not be burning cash. This approach worked so well for him that he generated 15.2% annual returns compounded over 33 years, a terrific record by any standards. Peter's focus on seeking margin of safety in tangible assets meant that he was insulated from vagaries of growth rates and free cash flows!

With this background, I will try to analyze GSFC Ltd and how it presents an opportunity that Peter Cundill would have surely looked at. GSFC limited is a public sector enterprise promoted by Goverment of Gujarat with the aim of producing complex fertilizers to meet the needs of agrarian economy. GSFC  mainly operates in two segments i.e. fertilizers and industrial chemicals. GSFC is the largest producer of Caprolactum (used for manufacturing of nylon), malamine and amonium sulfate in India. It is second largest producer of di-ammonium phosphate (DAP) in India. It also produces ammonia, nylon, ammonium phosphate sulfate, urea, argon gas and sulfuric acid. It has also entered into production of bio-fertilizers and water soluble fertilizers which is a value added product compared to normal fertilizers. 

I will do a very cursory analysis of P &L and return ratio here, as focus of the analysis is limited to ensure that GSFC's operation will not start burning cash fast enough to erode margin of safety. 

In Fy 2011-12, company reported revenue of 5680 crores and net profit of 758 crores. It increased its sales by 14% while its bottom line grew by 1% from FY 2010-11. In last 5 years company's sales has grown at CAGR 9% while its profit grew at CAGR 26% (mainly due to quantum leap in margins in last 2 years post nutrients based subsidy adopted from April 2010). GSFC's ROE has been oscillating between 17% to 30%. However post NBS, company is able to generate ROE that is much better than that of pre NBS era. It has very little debt on its books as per 2012 balance sheet. So essentially we are talking about a company that is practically debt free and generates reasonably good return on its equity. In each of the last 5 years, cash flow from operations has remained positive and generally in line with net profits. Thus, it is reasonable to conclude that GSFC is not going to be cash burning enterprise in near future. 

So now let give you a glimpse of key components of balance sheet for GSFC as on march 2012. 

Total Shareholder's Funds: 3517 Crores

Long term Debt              : 191   Crores

Total Liabilities              : 3708 Crores

Net Block                      : 1425  Crores

Capital work in progress  : 346   Crores

Investments                  : 433   Crores

Net Current Assets         : 1504  Crores

l

Let us first look at assets that can be easily liquidated and price can be estimated with reasonable certainty. In the entire exercise, even though, I have taken some benchmarks to decide realistic value for various assets/investments, I have tried to remain conservatively realistic on valuation. 

Net Current Assets: based on balance sheet of FY 2011-12, 

Current Assets- Current Liabilities = (3104-1611) = 1493 crores. 

Now we have to determine realizable value of net current assets if these assets are to be liquidated/sold off to some other investor. 

If we break down current assets it comprises of following components, its book value and realizable value based on certain assumptions.  

Asset/Liability Class	Value on Books	Realizable Value
Cash	897 Crores	897 Crores
Accounts Receivables	1426 Crores	1354 Crores (5% Write Off)
Inventory	642 Crores	515 Crores (80% of BV)
Other Current Assets	135 Crores	120 Crores (10% write off)
Short Term Loan	622 Crores	622 Crores
Accounts Payable	492 Crores	492 Crores
Other Current Liabilities	500 Crores	500 Crores

so realizable value of Net current Assets = (2886-1609) = 1277 crores

Now let's look at investments. 

Investments: 

Following link provides view of various short term/long term investments held by GSFC.

GSFC 2011 12 Investments

Non Current Quoted Investments:

Let us start with non current investment in quoted securities  and determine market value of non current quoted investments.

Security Name	No.Of Shares	Book Value (Cr)	Current Share Price	Market Value(Cr)
GNFC	3,07,79,167	58.39	84	258.5
GIPCL	2,23,62,784	36.50	65.75	147
GACL	16,55,040	8.27	122.95	20.35
Total				426

Total market value of quoted security is roughly 426 Crores at current market price. 

Non Current Unquoted Equity investments:

I have done analysis of conservatively estimated value of GSFC's investment in Indian potash limited, bhavnagar energy company, GSPC and GSPC Gas. I have not analyzed other investments as either they are strategic in nature (Gujarat Chemical Port Trust) or enough financial information is not available with me.

1) Indian Potash Limited: GSFC holds roughly 7.87% stake in Indian potash i.e. 11,25,000 shares in IPL, a flagship company promoted by various fertilizer companies and ministry of commerce for importing, marketing and promoting potash in Indian market. According to 2010-11 P &L available on its website, company made profit of roughly 375 Crores on turn over of 20,750 crores. According to FY 10-11annual report, basic EPS is Rs.263 . Even if we assume 10% growth in FY 11-12 and assign P/E of 6 on 2011-12 earnings, it will mean share price of 1740. GSFC's investment of 11,25,000 shares can be valued at roughly 200 crores against book value of 0.61 crores.

2) Bhavnagar Energy Company Limited: It is a 500+ MW lignite based power plant put up near Bhavnagar in Gujarat. BECL is promoted by various state PSU such as GSFC, GNFC, Gujarat Power Corporation Limited, Gujarat Mineral Development Corporation, GIPCL and GACL. Lignite for the power plant is going to be available for GMDC mine near Bhavnagar. GSFC holds 4% share in the company. BECL is at advance stages of construction and project is likely to be commissioned by end 2012. A comparable company for valuation shall be Navyeli Lignite corporation which operates 2750 MW of lignite based capacity and has market cap of 13670 crore valuing company at 5 cr/MW of existing capacity. On a similar matrix, BECL can be valued at roughly 2500-2700 crores. However considering the fact that for BECL project is under implementation and there is no track record of operations, one should consider at least 25-30% discount to Navyeli's valuation. Thus we shall assume 4 Cr/MW for valuing BECL. Hence valuation of BECL shall be around 2000 crores. GSFC's share of 4% will mean value of 80 crores. 

3) GSPC Limited: GSFC holds 2.35 crores share of GSPC at average cost of 64 rs/share (face value of 1 Rs). Total value of GSPC holding is 150 crores. LIC, SBI and IDFC acquired shares in GSPC at 810 rs/share (FV of 10 Rs) so effectively they acquired stake in GSPC share (of Fv 1 ruppe) at roughly 81 rupees. However, to be conservative, let us value GSFC's investment in GSPC at the book value i.e. 64 Rs/share. This will mean valuation of 150 crores for GSPC investment (same as value carried on book). 

4)GSPC Gas Limited: GSPC gas is now the largest City gas distribution operator in India with its wings spread across number of cities in Gujarat. GSPC gas distributes CNG and PNG in many parts of the state catering to natural gas needs of industrial, residential and commercial customers. GSPC Gas is promoted by GSPC. It is currently not publicly listed company. GSFC holds 91,78,800 shares in GSPC gas. According to 2010-11 annual report of GSPC Gas, company reported net profit of 148 crores in 2010-11 registering more than 400% growth in PAT with respect to previous year. If I assume modest growth of 15% in PAT, 2011-12 PAT of GSPC Gas would be around 170 crores. Based on FY 2010-11 report GSPC has issued paid up shares of 5.92 crores in 2009-10 and was under process to issue shares of 10 crores. Hence total paid up shares is likely to be 15.92 crores. Thus EPS of the company would be 170/(15.92) = 10.7. In terms of valuation, GSPC gas valuation can be done based on it's listed peers Gujarat Gas and Indraprastha Gas. GGL and IGL trade at trailing P/E of 15 and 11 respectively. GSPC gas being the largest CGD company and also being fastest growing CGD company can very easily command P/E of 12. Considering this, valuation of GSPC Gas share will be around 129. So total value of GSFC holding in GSPC Gas is around 129 * 91,78,800 = 118 crores.

Joint Venture Company:

GSFC and Coromandel International Limited (CIL) has established joint venture with tunisian firms Groupe Chimique Tunisian (GCT) and Campagnie Des Phosphate De Gafsa (CPG) to establish 360,000 tons of phosphoric acid plant in tunisia.This company is known as Tunisia Indian Fertilizer Company Limited (TIFERT). GSFC and CIL each have agreed to offtake 180,000 TPA of phosphoric acid from this new facility. GSFC has signed 30 year supply agreement with TIFERT. GSFC holds 15% equity in the project. GSFC has invested INR 120 crores in the project and holds 33,75,000 shares of 10 tunisian dinars each. Total project cost of this project is likely to be roughly USD 600 million i.e. 3000 crores. 

Phosphoric acid is a key raw material for manufacturing di-ammonium phosphate (DAP) a very popular phosphatic fertilizer in India. Indian fertilizer companies are facing severe shortage of phosphoric acid and they have to rely on very tight international market for procuring phosphoric acid. Almost all DAP manufacturers have indicated that lower capacity utilization of DAP plants are due to non availability of phosphoric acid. In such situation having 30 years supply tied up is a big strategic advantage. However, it is difficult to quantify such advantage and hence, to be conservative let us assume zero value for this advantage. Hence, value of GSFC's share will be at least equivalent to its book value i.e.  120 crores. 

Equity Trade Investment:

In addition to non trade investment in GACL, GIPCL and GNFC, company also has some investment in following companies. Table below represents market value and book value of these equity investments. 

Security Name	No.Of Shares	Book Value (Cr)	Share Price	Market Value(Cr)
Gruh Finance	1,00,000	.295	777	7.77
IDBI Bank	5,49,440	4.46	95	5.22
Manglore chemical	5,79,000	0.38	51	2.95
Total				15.94

Based on analysis of various type of current assets and investments,Following table summarizes and enlists realistic value of current assets and investments. 

Current Asset Name	Value
Net Current Assets	1277 Crores
Non-Current Quoted Investment	426 Crores
Stake in Indian Potash Limited	200 Crores
Bhavnagar Energy	80 Crores
GSPC	150 Crores
GSPC Gas	118 Crores
Tunisian Indian Fertilizer	120 Crores
Equity Trade Investments	16 Crores
Total	2387 Crores

GSFC's Current Valuation: At today's closing, GSFC's total market capitalization is roughly 2850 Crores. If we add long term debt of 190 crores, GSFC is available at 3040 Crores to a private investor. Out of 3040 crores, company has net current assets + investment of roughly 2400 crores. This implies that GSFC's fixed assets and future cash flow is available for 650 crores. 

Now fixed assets on depreciated basis is carried on company's books at 1425 crores while   capital work in progress is roughly 345 crores. So total fixed asset value on the books is 1800 crores. However, even if we only assign 650 crores ( roughly 35% of book value), investment made by a private investor at current marker price will break even. In my opinion, no sane person/entity will sell its assets at 1/3 of book value, unless company is under financial distress or assets on books are not likely to generate cash flow in future. In case of GSFC, neither of this is true. 

To put the things in perspective further more, if GSFC wishes to monetize only township land, (roughly 850,000 square yard and free hold of land is with the company) at prevailing market price (roughly 10,000/sq.yard)  it will fetch roughly 800 crores, far higher than value assigned to fixed assets of the entire company at current market price. This will leave Vadodara and Sikka plants available for free.

Thus there exist an opportunity to invest in one of India's largest complex fertilizer company at substantial discount to its liquidation value. I am sure, Peter Cundill would have grinned spotting such opportunities.

As icing on the cake, Fidelity Low priced stock fund holds 4.63% in GSFC. Fund manager of this scheme,Joel Tillinghast is noted value investor who follows investing style of Peter lynch and tries to buy "growth at reasonable price". He has achieved enviable record of generating compounded annual return of 14% for 23 years in Fidelity low price stock fund. Mr.Tillinghast has received best fund manager of the decade award in 2009 by highly prestigious Morningstar magazine. Fidelity low priced stock fund has increased its position in GSFC over last 3 years from nil to 4.63%. This further supports my hypothesis of GSFC's value proposition.

In all, I think, GSFC is a very good investment opportunity considering its leadership position in complex fertilizers, diversified product mix, very good return ratios, strong balance sheet and substantial margin of safety at current market price.

Hindustan Zinc: A Value Play or Value Trap?

In this post I am going to share my confusion and dilemma on one idea that appears to be a good value play but may turn out to be a value trap, if value is not shared with the shareholders by the management. 

I am talking about world's largest integrated producer of zinc and second largest producer of zinc in the world. HZL operates Rampura Agucha mine in Rajashtan that has world's largest deposit of zinc and lead. It is the lowest cost producer in the world due to integrated nature of its operations, higher concentration zinc/lead in its ore and highly efficient operations. HZL's cost of production was roughly USD 800/ton in FY 11-12 while world average is around USD 1300. So is HZL a pure commodity play or a business surrounded my strong moat? My answer is that it is surely a business surrounded by strong moat but fortunes of the business are closely linked to commodity cycle. 

Now let's look at cursorily at HZL's  10 year historical performance on P&L, balance sheet and return ratios. 

P&L: HZL's top line grew 1650 crore in 2002-03 to 12000 crore in FY 11-12, registering CAGR of 22%. However, bottom line for HZL grew by staggering 45% in last 10 years taking net profit from 142 crores to 5526 crores.  Revenue growth was led by both volume increase as well as higher price realization from zinc. An extraordinary performance on the bottomline was due to operating leverage kicking in a big way. NPM for the company increased from 8.6% to 45% due to streamlining of operations, increased integration in terms of mining and refining and operating leverage. 

Balance sheet: It is a squeaky clean balance sheet with hoards of cash lazing around there! And like in any wonderful business, the difficulty is always to find avenue to deploy more and more cash in a profitable manner. HZL has no debt and has been that way in last 10 years except in 2003-2006 where, company took some debt (debt/equity of 0.3-0.5). As per FY 11-12 numbers, accounts receivable and inventory together amounts to less than 10% of revenues, indicating very high operational efficiency for the company (or may be very favorable business conditions!). So Currently company is sitting on cash pile of roughly 18000 crores all invested in liquid mutual funds and fixed deposits.

Cash flow and return ratios: Like  all successful natural resource companies, it is a company with very high free cash flow. In FY 2011-12 company generated around 5000 crores of free  cash flow after providing for maintenance capex. Company has ROCE of around 22% even after 18,000 crores of cash sitting in balance sheet earning paltry 10% pre tax! In terms of actual capital employed for operations, company had ROCE of around 48% in FY 2011-12 and has remained in the range of 50% for last 5 years. 

Now, let's do the valuation based on back of the envelope calculation. Currently company is trading in the range of 50,000 crores market cap. Now if we deduct cash and cash equivalent of 18000 crores, HZL is available at roughly 32000 crores net of cash.  

It is important to understand that earning power of the company is dependent on price of zinc, lead and silver and refined metal production for each one of them. In FY 11-12, average price realization for zinc, lead and silver were USD 2098/ton, USD 2269/ton and USD   1200/Kg. USD-INR average for FY 11-12 was 47.95. Production of refined zinc, lead and silver was 759,000 tons, 99,000 tons and 242 tons respectively. For commodities, taking one years' profit or price realization for predicting future cash flow is not appropriate considering cyclical nature of commodity price. In order to arrive at expected price realization for zinc and lead, let me take last 5 year's average price realization for zinc and lead as benchmark. However, story is slightly different for silver. Silver has got rerated in last  3 years and hence I do not think 5 year historical average is good approximation for next 5 years. Based on this approach, average 5 year price realization stands at USD 2132 and USD 2205 per ton for zinc and lead. For silver, I think current price level (you can call this gut feel or speculation!) is appropriate benchmark i.e. roughly USD 1000/Kg for average price realization for next 5 years. If we put all the information together along with current capacity of refined metal production of  759,000 tons of zinc, 100000 tons of lead and average 400 tons of silver (Fy 12-13 350 tons and increasing to 500 by FY 14 and steady thereafter), total revenue realization will be roughly 11000 crores at exchange rate of 48. If we take profit margin of 45%, roughly 5000 crores shall accrue from operations as net profit. This in my opinion a reasonably conservative scenario because of the assumptions like no significant increase in refined capacity, for 5 years commodity up-cycle does not play out, rupee strengthens to 48 etc. 

According to FY 11-12 annual report, HZL possesses mine reserves of 25 years and more exploration work is going on. So one can expect that at least for 20 years HZL will be able to produce at current capacity without depleting its resources. Even if I do not factor in price increase equivalent to world average inflation and consider constant price for 20 years, IRR for investing 31000 crores against 5000 crores of cashflow for 20 years works out to be 16% which is very decent. This does not take into account further cash accumulation and 8-10% return on this accumulated cash.

Now let's look at the upside 

- If HZL decides to deploy 18,000 crore capital in productive assets and especially in mining and natural resource area, it is possible to earn 25-30% return on capital employed. This will mean additional 5000 crores flowing in in addition to HZL's operational cash flow with annual cash flow amounting to  roughly 10,000 crores, making it a huge cash generating machine. Now thus accrued cash earns only 10%, and at  constant price and output, on 20 year basis IRR is 29%. 

-If there is commodity up-cycle in between, and company has invested idle capital in projects generating reasonable returns, or company ramps up its production from current capacity (a very likely scenario considering past track record) it will amount to substantial returns. 

Down side

- Let me be devil's advocate and assume that commodity market plunges and average price realization for zinc lead and silver is at USD 1000/ton, USD 1000 /ton and USD 500/kg and investment on balance sheet earns 8-10% return only. In this case also, on 20 year basis (resource base is equal to 25 years of current production if they don't find any additional zinc/lead resource.), one would typically be able to earn 10-12% IRR. 

So looks like an opportunity where there is significant upside possibility with very limited downside.  So what makes me think that HZL can be a value trap?

- HZL has always been generating considerable free cash flows over the years and hence the staggering pile of 18000 crores has been built up slowly. This is truly worrisome. management should have either deployed cash effectively to generate better returns or should have returned it to shareholders either as dividends or through buy-backs. Management has not done either of them, a clear danger sign. Dividend payout has been paltry 6-8%. This is peanuts for such high free cash flow generating company. 

- Management, in other instances, has used cash on balance sheet of group companies to make large purchases and thereby deploying cash in unrelated and probably pricey acquisitions. A case in point Sesa-Goa's cash reserves were used to acquire stake in cairn India. 

- I get a feel (though i have not done analysis to support this!) that management sometimes carry out restructuring among group companies so as to extract maximum benefits for the promoters and probably at the expense of the best interests of minority shareholders. 

If management engages in such activities, value realization for minority shareholder may not happen and it can fall into value trap! To be fair to management, HZL has been a great value creator. As per HZL's FY 11-12 AR,  Rs.1000 invested in HZL stock at the end of FY 02-03 would have grown to roughly 90,000, a 90 bagger in 10 years! So, what's my take? I am not too sure.  I am sharing my dilemma here and I will highly appreciate your views on the same.

Dissecting Return on Equity: Few Insights from Britannia and Titan

As mentioned in earlier post on significance of return on equity, ROE is one of the most important parameters signifying sustainable competitive advantage of the business and hence investment attractiveness of the company. However, as I dug deeper and gained more insight into the subject, I found that relying just on ROE number may be misleading. It is very important to understand what drives change in ROE and how good is the quality of ROE. In this post, I will try to illustrate the point with two examples. What is common in both the examples is that if one looks at ROE of the company, it has moved in a band has remained in that band. However, in one case, business quality has deteriorated while in the other, business is clearly on the upswing. However, had one relied on just ROE number, one would not be able to get a realistic feel of changing business environment. 

Let me start with defining ROE in terms of equation as suggested in Dupont formula 

ROE = Net profit margin *  Asset Turnover ratio * Equity Multiplier 

So ROE = (Net Profit/Total Revenue) * (Total Revenue/Total Assets) 

                

              * (Total Assets/Total Equity) 

So now, it is clear that three parameters drive return on equity, we can dissect ROE of any company in three components and look at what is driving ROE. This dissection of ROE will help us gain insight which can reveal interesting information about changing business environment for the company. 

Let's take first an example of Britania Industries.

Britannia Industries: Britannia Industries is India's leading food products company having formidable brands such as Good Day, BourBon, Little Hearts,  Marie Gold and Treat in biscuit segment and strong brands in dairy products such as Cheese, Butter, Spread and Yogurt. Let's see what has happened to ROE of the company. 

2006-07	2007-08	2008-09	2009-10	2010-11
18.35	25.76	19.83	36.35	41

So on the first glance it appears that Britannia has increased its earning on its equity hence each dollar put in as equity by the company is earning 41 cents in 2010-11, up from 18 cents in 2006-07. Typically this would suggest that company's business is getting stronger and "moat" around its business is growing. However, let me dissect ROE further into its three core components.

	2006-07	2007-08	2008-09	2009-10	2010-11
Profit/Revenue (1)	4.26	6.28	4.02	2.65	2.84
Revenue/Assets (2)	3.24	2.91	3.55	4.12	4.98
Asset/Equity (3)	1.33	1.41	1.39	3.33	2.90
Return on Equity (1*2*3)	18.35%	25.76%	19.83%	36.35%	41%

Above analysis, indicates that for Britannia, NPM has been fluctuating and has declined substantially in 2009-10 and 2010-11 from 4% to 2.6-2.8% which indicates deteriorating business conditions. On the other hand, company's  Asset/equity ratio has increased substantially from 1.33 to 2.9 indicating substantial increase in debt/equity ratio and hence leveraging. Thus increase in ROE for the company seems to have been contributed to a large extent by leverage and higher asset turnover to a smaller extent. Thus, it is reasonable to infer that in spite of increased return on equity, Britannia's inherent business condition is worse than that of 2006-07. 

Titan Industries: Titan is India's largest watch maker and world's fifth largest watch maker. Titan is perceived as benchmark of quality blended with style in Indian watch industry. Titan has also created immensely popular brands such as Fast-track and Raga catering to youth and effluent class respectively. Titan has entered into branded jewelry segment with "Tanishq" brand, which proved to be an run-away success. It also started "Titan Eye" division catering to style conscious youth by creating a range of stylish eye wear. Let's understand how Titan's business has undergone change and why "wholesome" ROE may not adequately reflect changes in business environment but dissecting ROE into its base components will give a insight into how business fundamentals are changing. 

    

2006-07	2007-08	2008-09	2009-10	2010-11
30	33	29.4	34	41.6

If we look at ROE for last 5 years for Titan, it appears that Titan is operating in a business environment which is stable till 2009-10 (except in 2008-09) and ROE has remained in the range of 30-34% barring 2010-11 when ROE jumped substantially. This gives an impression that Titan operates in a business environment that is neither improving nor deteriorating substantially. Now let's see how drivers of ROE has changed over a period of time. 

	2006-07	2007-08	2008-09	2009-10	2010-11
Profit/Revenue (1)	4.1	4.30	3.96	5.09	5.95
Revenue/Assets (2)	4.17	5.22	5.71	6.13	6.6
Asset/Equity  (3)	1.74	1.47	1.30	1.1	1.06
Return on Equity (1*2*3)	30%	32.99%	29.4%	34.32%	41.62%

Above table clearly indicates that Titan's ROE is incrementally contributed from expanding margins and higher asset turnover. A combination of margin expansion and higher revenue generation/rupee of asset on the book is helping Titan improve its return on equity. However in terms of overall ROE number, this effect is muted as company is consistently reducing debt (reducing leverage) which offsets the effect of increase in margin and asset turnover on ROE number. Expanding margin and increasing utilization of asset for revenue generation and that too consistently, indicates company's improved  business fundamentals which one would fail to notice if the focus is on just "ROE" number. On the other hand company has reduced its debt substantially over a period of time, which has strengthened its balance sheet

To put it differently, had Titan maintained debt/equity at a level prevailing in 2006-07, company's ROE would have looked liked as below

2006-07	2007-08	2008-09	2009-10	2010-11
30	39	39.34	54.3	68.3

Thus, even though Titan's business environment and fundamentals have changed significantly they are so "jumbled up" that overall ROE number would not help investor decipher such changes. 

It is therefore critical to dig deeper into ROE number and understand drivers of ROE which will truly reflect the changing business environment and contributory effect of each component of ROE. 

Value Picks in Turbulent Times: Few Interesting Opportunities

Good times are back again! No, I am not kidding. If you are a value investor who wants to create disproportionate wealth over a long period of time, there can not be a better opportunity than a prolonged bear market. A prolonged bear market gives value investor to do a detailed analysis of interesting opportunities (and there are plenty!) and pick the best and to top it, average it over a period of time! Lots of investor (of course including me!), who were awestruck to see early 2012 rally, must be quite content that they are getting a similar opportunity again! 

Warren Buffet put very succinctly "cash in the time of crisis combined with courage is priceless". So, in this time of crisis, if you have plenty of cash to deploy and have courage to weather a feisty storm and conviction in your analysis, you have an opportunity that can generate phenomenal returns in next 3-5 years. So it's time to work hard and find out businesses that have strong economics, represent some barrier to entry/competitive advantage, have strong balance sheet and available at substantial discount to its intrinsic value. The best thing a value investor can get is business at a value where growth component is absolutely free!

I began with initial screening to identify such opportunities. I put following criteria to arrive at 69 companies with market cap ranging from 7 crores to 50, 000 crores. 

Average 3 year CAGR sales growth: 15%

Average 3 year CAGR net profit growth: 15% 

Debt to equity ratio: less than 0.5

Return on capital employed: 25%

P/E ratio: less than 12

However, list of 69 companies was just the starting point. My ultimate objective of the exercise is to find companies that have steady and sustainable businesses (reflected by consistent profit margins), scalable business models and reasonably good management. I am looking for businesses that are trading at at least 50% discount to conservatively calculated intrinsic value. I could eliminate some of them by cursorily looking at financials for last 5 years as many of them lacked consistency in performance over a period of time. For remaining in the list, I started digging deeper. Based on my initial review, I shortlisted 6 opportunities that seems attractive. Following is a synopsis of investment case for each opportunity. 

I would like to strongly emphasize here that, this list is still "work in progress" and not the final outcome and hence one should not jump to conclusions based on the  investment case outlined here. I have excluded two ideas Cera Sanitaryware and Mayur Uniquoters as I have covered them in separate posts.

1) Atul Auto: A three wheeler commercial vehicle manufacturer having strong brand of "Atul Shakti". Enjoys a very strong presence and brand recognition in the markets of Gujarat,Rajasthan and Andhra Pradesh. Debt free company. Last 5 years sales growth @ 26% CAGR and PAT @ CAGR 65%. Expanding distribution network into Kerala, Karnataka, Bihar and other states. Increasing profit margin and ROCE/ROE.  Available at P/E of 6 on TTM basis. Limited competition (Bajaj, Piaggio and M&M)

2)Amara Raja Batteries: Second largest automotive and industrial battery manufacturer and pioneer for VRLA technology in India. Jhonson's control, world's largest automotive battery manufacturer holds 26% in the company. Operates in a oligopoly market where only significant competition in branded battery market is from Exide.Last 5 year topline and bottom line growth of CAGR 22% and 25% respectively.Strong brand "Amaron" combined with well laid out distribution network.  Increasing demand for new automobiles  combined with increasingly higher replacement demand (every 3 years one has to change four wheeler battery and every two year a two wheeler battery!) is going to create very large replacement market, thus volume growth can be sustained. Nearly debt free company. Increasing ROCE/ROE trend. Even in worst years ROE/ROCE is above 20%. Available at TTM P/E of 11.6.

3) Fluidomat: Pioneer in indigenous manufacturing fluid couplings. It is a niche product having application in diverse sectors such as thermal and nuclear power, cement, steel, mining, paper, fertilizer and chemicals and ports. Marquee list of national and international clients for its products and company's products are approved by all major engineering consultants. Steady growth in sales and profit in last 5 years (CAGR 15% and 18% respectively). Consistently increasing ROCE/ROE (20% to 35%). debt free company and trading at market cap of 16 crores. 20% of market cap is available as cash and  cash equivalent. P/E of 5.45 on TTM basis.

4) Narmada Gelatines: One of the pioneers in manufacturing of gelatin in India and 50 year old company. Gelatin manufacturing is oligopoly with only handful (25-30) manufacturers all over the world. In India only 5-6 large units. Significant barrier to entry due to technology, quality, approval from pollution control and raw material procurement. Current market cap of 43 crores (in last week stock price has rose by more than 15%), 18 crores is cash + liquid investments. Company's sales and net profit has grown CAGR 10% and 32% respectively in last 5 years (indicating strong margin expansion). Increasing ROCE/ROE due to margin expansion. Net of cash, it is trading at P/E of less than 3. Dividend yield of 4%. High promoter holding of 75%. Current management may divest (shaw-wallace group) as many European majors are interested in buying operating unit in India which will a trigger for re-rating. Upward trend in gelatin price due to demand supply gap and capacity expansion (underway) may further increase company's margin and ROCE/ROE.

5) Swaraj Engines: Diesel engine manufacturer for tractors of "Swaraj" brand and high-tech engine component manufacturer for Swaraj Mazda (SML Isuzu now) commercial vehicles. "Swaraj" brand is taken over from Punjab Tractors Limited by M & M, India's largest tractor manufacturer. M & M and Kirloskar Oil Engine are major shareholders, 33.23% and 17.39% respectively. 5 year CAGR for sale and profit is 25% and 30% respectively. Pristine balance sheet. Consistently high and increasing ROE/ROCE. Cash + current investment is 140 crore i.e. 28% of market cap of 500 crores. It is in sweet spot due to free substantial cash flow generation combined with high ROE and debt free balance sheet. It has undertook capacity expansion which will drive top line/bottom line growth

6) Wim Plast: Manufactures plastic molded furniture with brand name "Cello". "Cello" is very popular brand in writing products (pen) and  kitchen products and hence strong brand association. One of the three major players in branded plastic molded furniture other two being Nilkamal Plastics and Supreme Industries. Top line and bottom line growth in last 5 years at CAGR 24% and 61% respectively. consistently improving margins and ROE/ROCE. Debt free company and trading at TTM P/E of 5.6. It is expanding capacity (Daman and Haridwar) and increasing its reach in eastern and southern (presently confined to northern and western market). Consistent dividend paying company since 1998. Promoters are buying consistently since September 2011 and bought shares close to current trading price. 

As I said before, this list is indicative of "work in progress" and I intend to study these opportunities closely before allocating substantial capital to any of the ideas. However, the objective of posting these ideas here is to receive critical opinion (a well researched negative opinion will be even more useful!) from readers. 

I look forward to your comments/suggestions.

Sources of Durable Moats: Building Blocks of Great Business

Warren Buffet has uncanny ability to transform hardcore business constructs into analogies that is very easy for common man to relate to yet effectively conveying the central idea behind the business construct. One such wonderful analogy he gives is about sustainable competitive advantage by comparing it with "moat". 


Moat is nothing but a big ditch, mostly filled with water, constructed around a castle, that acts as primary defense when the castle is under attacks from the enemy. Similarly, sustainable competitive advantage act as protective barrier for the company to retain its business/market share when under attack from competitors. Wider the moat around the castle, more difficult for the enemy to penetrate the defense effectively. 


Mr. Buffet only invests in businesses which have expanding "moats" built around them. However, the million dollar question here is, how does one identify whether a particular business has built "moat" around it or not. As to all million dollar questions, there is no easy answer! Even though, there can be umpteen factors/characteristics that can lead to sustainable competitive advantage for the business, six sources of "moat" can be attributed to 80% of the great businesses we see around us. 

In addition to describing sources of "moat", I will also try to enlist few companies which apparently possess such moat.

Mazda Limited: Engineering A Value Play

In my last post, I wrote about Mr.Pabrai's book Dhandho Investor (Click here to read) and Mr.Pabrai's insistence on making an investment only if it presents an opportunity where Heads you win but Tails you don't lose much. And coincidentally, as I was running through my value screen, spotted a very interesting opportunity befitting this philosophy. 

Mazda Limited is a custom engineering company that is engaged in business of  manufacturing vacuum system and associated equipment, evaporator systems and air pollution control equipment. Since last 4 years, it has also diversified into food business catering to market for instant drink powders, food essence and food colors with brand name of BCool.  However, custom engineering business remains company's main stay as it derives more than 90% of its revenue from engineering business. Mazda has technology tie-up with Croll-Reynolds , a world leader in customized vacuum system design. Croll-Reynolds also holds 6.8% stake in the company (earlier 11%) and has a nominee director on the board. Mazda also claims to be the only company in India to offer one of the world's largest test facility to simulate actual operating conditions. Being a chemical engineer and having worked on process side, I feel this may be a big advantage as simulating actual operating condition will be very useful in optimizing the vacuum system performance and reduce steam consumption to minimum level. As far as my limited understanding, not many players in India have such state-of-the-art set up. 

Mazda Limited is promoted by Sorab Mody and has scaled up significantly in last 10 years. It has grown it's revenue from 12.63 crores in March 02 to 89 crores in March 11, achieving CAGR of 21%. Similarly, net profit has grown ten fold (after deducting extra ordinary profit made in FY 11 on sale of valve division) from 0.86 crore to roughly 9 crores , CAGR of 26%. It is important to mention here that Mazda operates in highly specialized business of custom engineering which is less competitive than general engineering business. Moreover, it is an asset light business which derives its value from intellectual inputs (i.e. design of vacuum system and evaporators which is proprietary/customized). This is clearly reflected in ROCE/ROE performance of the company. Mazda has consistently achieved ROCE in excess of 25% for last many years. ROE of the company has remained above 22% for last several years. High ROCE/ROE indicates that company operates in niche business and can generate superior returns on capital/equity employed. Another glaring fact  is that large part of company's growth has come from shareholder's equity as Mazda has consistently maintained very low debt to equity ratio (less than 20%) throughout 10 year period. Currently, it is a debt free company. 

In 2010, company sold of its valve division to Circor India Limited (subsidiary of US based Circor International) for 22 crores. According to AR for FY09-10, Mazda's valve division had turnover of roughly 10-11 crores (based on equipment wise revenue break up on page -37). Circor International is a fairly large company with its flow technology division having annual revenue of around USD 265 million in 2011 (it has two other divisions as well). A US company of this size buying a division indicates  high level of quality standards/manufacturing practices adopted by Mazda. For the above mentioned deal, Circor India paid 2 times revenue for buying out valve division of the company. Mazda received 18.7 crores as upfront payment while remaining money is to be received in June 2012 (roughly 2.5 crores after working capital adjustment). 

Now, let's look at Mazda's valuation. Currently company's market cap is around 39 crores. Based on September 2011 half yearly filings, Mazda has 13.37 crores in investment (all of it in mutual fund) and cash and cash equivalent of 4.04 crores. Mazda will receive 2.5 crores in June 2012 from Circor India. In all company will have cash and liquid investment of roughly 20 crores. This means, market is assuming discounted value of future earning at 19 crores (Market Cap - liquid investment- cash). According to 9 monthly data, Mazda has net profit of 6.72 crores, amounting to annual profit of 9 crores. Mazda has expanded its capacity by 15-20% and hence FY 13 profit is likely to be at least 20% higher (even though this year, company's margin has been substantially lower than last two years and if it improves in FY13, profit can be significantly higher). Hence likely payback for the investment net of cash+ investment is going to be 2 years. This is a base case scenario, in my opinion, and fairly lucrative one too!

On the other hand, let's assume that company is for sale, what value its peers/competitors will be willing to pay to acquire the company? If I assume company will receive at least as good valuation as that of its valve division, i.e 2x revenue (which in my opinion is conservative as vacuum/evaporator business is less competitive than valve business and possess characteristics of niche business. Moreover, there is substantial real estate value to its factories located in Ahmedabad), FY13 projected revenue of 108 crore (1.2*90 crores due to 20% capacity addition), company will be valued in the range of 200-220 crores. This is 5.5 times current market capitalization! 

So what's the deal? If I win (if things go better than expected or market bridges the gap between intrinsic value i.e. close to private value of the company and price) I can get 4-5 bagger . If I lose (no growth, margin at current levels only), I am making investment having payback of 2 years (not bad by any standards!). 

However,as in any investment thesis, one has to take  facts and figures with a pinch of salt! So let me show you some areas where things can go wrong...

Negatives:

• Promoters have low shareholding (34.19%) which may expose them to hostile take over (even though chances are very less due to un-leveraged balance sheet)
• Mazda's competitive edge is largely dependent on design/know how of Croll-Reynolds. If things go wrong and technology transfer arrangement is discontinued, company may face uphill task of developing intellectual capital comparable to that of Croll-Reynolds .
• Mazda has diversified into food business, which, inherently is a low profit margin business. If company is not able to manage this diversification well and allocates inordinate capital for expansion, company's prospects will be negatively impacted. 

And finally, some icing on the  cake...

Positives:

• Promoters have been slowly buying stock from the market which indicates their belief in future prospect of the business (most recent acquisition at price of Rs.86, not too far from current price!)
• A large part of the export revenue (80%) is derived from Croll-Reynolds. Croll-Reynolds have bought equipment worth 15.5 crores from Mazda in FY11 up from 6.53 crores in FY10. This may indicate Croll-Reynold's confidence in the company.
• Management has consistently maintained/increased its dividend since last 10 years. Moreover, management rewarded shareholders when they received proceeds from the sale of valve division by declaring interim dividend. 
• Management has clearly indicated in ARs that they are operating in custom engineering business which has limited competition. They also indicated that company possesses pricing power which will help it protect its margin in case of increase in raw material costs. This affirmation validates the premise that Mazda possesses sound business economics. 

In all, Mazda represents an investment opportunity to buy a niche business with pristine balance sheet and high ROCE/ROE at dirt cheap valuation where probability of permanent loss of capital is minimal while potential upside can be significant.

Disclosure: Views expressed in this post are individual and shall not be construed as buy/sell investment advice. All the readers are strongly encouraged to carry out their own due diligence. 

The Dhandho Investor: Heads I win, Tails I Don't Lose Much

Recently, I finished reading veteran value investor Mohnish Pabrai's highly acclaimed  book Dhandho Investor: The Low Risk Value Method to High Returns. Mr.Pabrai started managing money in 1999 with Pabrai Investment Fund and has generated compounded annual returns of close to 18% net of all expenses for 12 years. Thus, he has vastly outperformed the S&P and DJIA. 

Dhandho Investor is a thoroughly enjoyable read as Mr.Pabrai very succinctly illustrates how age-old approach of Gujarati and Marwari community to doing business deeply ingrains value investing philosophy. The book starts with how the first Patel family migrated from Africa to USA, decided to enter into motel business which is relatively simple to understand and operate (Investing in existing business, Investing in simple business). Motel industry was going through a tumultuous phase (Invest in distressed industries/businesses) and motels were available at dirt cheap rates for buying presenting enough margin of safety. Moreover, the value proposition on the table was so good that bet will result in to multi-fold returns on success while the downside was capped (Heads I win, tails, I don't lose much). So, Mr. Patel decided to take a plunge and put up entire chunk of saving to finance owner's equity, while rest of the money is lent by banks (Few Bets, Big Bets). Once he is successful in his venture, his relatives also follow same model and copy his strategy, which turn out to be a great success for them as well. 

Key elements of Dhandho framework as outlined in the book are as below. 

• One should invest in existing businesses with long history of operations that has established business model. This will allow investor to analyze the past performance of the business, its profitability and cyclical nature of business. It is much safer to invest in existing operating business than investing in a start-up.
• One should invest in business that is simple to understand and operate. Mr.Pabrai suggests that even though, methodology for arriving at intrinsic value is quite simple, it is not easy to arrive at intrinsic value of business. With an example, he illustrates that even for a simple business, intrinsic value will have range of estimates depending upon assumptions taken to arrive at intrinsic value. If the business is not simple and is fast changing, estimation of intrinsic value will have far more diverse range and prone to sharp change in intrinsic value. He suggests staying with businesses that are very slow changing as one can, with reasonable certainty, predict future cash flow for next 8-10 years.
• According to Mr. Pabrai, investors must continuously scan  businesses and industries under distress. This is essential for getting into great businesses at bargain price, as many a times, market only factors near term negatives in the industry or business while losing focus on long term drivers of the value creation. In general, market does not like uncertainty and hence perceives lack of certainty as risk thus bringing down the price of the stock well below its long term intrinsic value. Thus a business/industry in distress may provide a good entry point for an investor
• Investors shall make investment choices that exposes him to situations where loss on downside is minimal while potential upside is multi-fold. He call this strategy  "heads I win, tails I don't lose much". Typically these opportunities are surrounded by high uncertainty but low risk and clearly reflects mis-pricing by the market. If investor creates a portfolio comprising of handful of such businesses, he will be able to obtain very high returns with minimal risk. A key to identify such opportunities is to find businesses which are surrounded by uncertainty/fear and understand various possible outcomes and assign probabilities to such outcomes for such businesses(which requires primary understanding of the business and industry.) including probability of permanent loss of capital. 
• When investors identify a bet where odds are overwhelmingly in his favor, one must bet big as opportunities which passes all criteria of Dhandho framework ( simple, existing business having strong moat, available at substantial discount to intrinsic value and exposing one to very high potential upside) are very rare. This strategy is essential for maximizing one's returns. In other words, he suggests that developing a focused portfolio comprising of small number of stocks is the best approach to maximizing returns from value investing. He suggests "Few Bets, Big Bets, Infrequent Bets". 
• As a disciple of Mr.Buffet, Mr. Pabrai stresses importance of "moat" or "sustainable competitive advantage" and "margin of safety" as central thesis of investment. 
• As a value investor, I have struggled to understand how long one should hold onto a business, in case if the price does not approach intrinsic value (as perceived by investor) even after a year or two. He suggest, from his experience, 3 years is reasonable time frame. In his experience, most of the market anomalies are taken care of in around 3 years. Hence if in 3 years, price does not approach intrinsic value, it is better to get out of investment as opportunity cost of holding onto such investment may be very high. He also gives rationale behind time frame of 3 years. He very interestingly points out that as value investor, buying a right business is like penetrating a "chakravyuh", however if one does not have exit strategy (i.e. to sell) in place, result may be sub-optimal. 
• Finally, he has an opinion on crucial question for individual investors on whether to invest in index fund or run an actively managed portfolio. Mr.Pabrai, suggests that he would prefer passive investment in stocks selected based on "magic formula" designed by Joel Greenblatt rather than investing in index fund. I am not too sure if that is the right approach as I have not delved into how exactly "magic formula" works. 

In all, Dhandho Investor is worth every penny due to Mr.Pabrai's grasp of the subject, fresh perspective that he brings to central ideas of value investing , crystal clear thought process (no ambiguity at all!) and writing style that truly caters to individual investors. 

Strongly Recommended!