Warren Buffet partnership letters: A treasure trove for a value investor

Since last few days, I have been reading and re-reading Warren Buffet's partnership letters written to its limited partners from 1958 to 1969 and oh boy, what a pleasure it has been reading them! These letters gives very useful insights into thought process of this legendary investor in formative years of his investment management career. However what is more striking is the candour and forthrightness coming out of these letters. WB clearly articulates his investment philosophy, sets the expectations and moderates them fabulously while striving to provide a realistic picture of investment operations, its pitfalls and how the performance of such investment operations should be measured. These letters not only demonstrates clarity of thoughts and perseverance to stick with them but also the extremely strong character. My words will sound pale and insufficient to describe the richness of character and knowledge these letters carry. Hence I shall rest my desire to write any further and share the compiled letters from 1958 to 1969 here. 

https://www.dropbox.com/s/g3b89x9zdn08bxg/Warren_Buffet_Partnership_Letters_Compiled_1958_1969.pdf

It would be great to receive views on what are the key learning from these letters? Few pointers from my side

1) He created a basket/portfolio of stocks along different investment methodologies such as

 Generals: Undervalued business when analyzed from how much a private owner would pay; 

Work outs: special situations with specific time tables such as mergers, take over, de-merger etc and

Controls : where they had a management control or say in the day to day operations (resulted out of sustained buying of generals for long period of time)

This "portfolio approach" was very useful in ensuring consistent returns

2) Work out as a category was important factor in ensuring that returns from partnership outperformed the market in down years

3) WB always made it clear that this approach will substantially outperform the Dow Jones in declining market while may just match the market performance or slightly under perform Dow Jones in advancing market! 

4) Warren buffet had set a goal of outperforming index by 10% over long run and in most of the years, he made that goal "look" conservative...!

5) From a diversified portfolio, he moved towards loading up around 1965. This worked out handsomely in favour as Amex investment, single handedly helped partnership significantly outperform the index, in spite of lack lustre performance in other two categories

6) When there is no opportunity in sight which fits the criteria set by him he gave it "pass" and chose not to invest. He rather declared his inability to find such opportunities and liquidated the partnership.. a brave call indeed.

I am sure as you read through, you will gain many more insights and it would be immensely helpful to all, if you can share the same through your comments!

Hindustan Media Ventures Limited: A mispriced bet in newspaper business

Warren and Charlie's fascination towards owning newspaper business is well known to most of us! In 1973, Berkshire bought stake in Washington post and kept on increasing its stake year after year. Washington post has been one of the top holdings and one of the largest wealth creators for Berkshire, over the years. However, Warren's love with newspaper business continues unabated, till date! Berkshire, in last two years, bought 28 daily news papers for USD 344 million. Warren Buffett devoted a large section of annual shareholder letter explaining the rationale for buying newspaper business, especially when, most people in US believe that newspaper industry is on deathbed! Here is the what Warren Buffet has to say about newspaper business

"Newspapers continue to reign supreme, however, in the delivery of local news. If you want to know what's going on in your town - whether the news is about the mayor or taxes or high school football - there is no substitute for a local newspaper that is doing its job. A reader's eyes may glaze over after they take in a couple of paragraphs about Canadian tariffs or political developments in Pakistan; a story about the reader himself or his neighbors will be read to the end. Wherever there is a pervasive sense of community, a paper that serves the special informational needs of that community will remain indispensable to a significant portion of its residents.

...Charlie and I believe that papers delivering comprehensive and reliable information to tightly-bound communities and having a sensible Internet strategy will remain viable for a long time."

So, how about an opportunity to own one of the largest Indian Hindi daily business with respectable management pedigree and excellent performance matrix on very favourable terms? Let's explore it further:

About Hindustan Media Venture Limited (HMVL):

HMVL is the company promoted by HT Media limited, part of erstwhile KK Birla group. The company was part of KK Birla group till 2008, however post Mr.Birla's demise in 2008, the HT Media business was passed onto one of his three daughters, Mrs. Shobhana Bhartia. Mrs. Bhartia is married to Mr. Shyam Sundar Bhartia, the chairman of the Jubiliant group (Jubliant Pharma, Jubilian foodworks etc). As a part of restructuring exercise, the "hindi" print media business was spun off and sold to HMVL on slump sale basis along with all the assets and liabilites in 2009. The idea of spinning of "hindi" print media business was to charter a well defined growth path for the business and provide sufficient management bandwidth. In 2010, HMVL came out with IPO to raise 270 crore to fund the expansion and pre payment of loan. The shares were issued to investors in IPO @ Rs.166. 

Business of HMVL:

HMVL publishes hindi daily "Hindustan", a children magazine "Nandan" and a woman centric magazine "Kadambini". "Hindustan" is the second largest Hindi daily in the country by total readership and the third largest by average issue readership "AIR" according to latest data published by IRS in Q4, 2012.  "Hindustan" is the mainstay of HMVL's operations. Hindustan has 12 editions and more than 110 sub editions spread across the state of Bihar, Jharkhand, Delhi/NCR, Uttar Pradesh and Uttarakhand. According to latest IRS data, Hindustan has total readership of 3.2 crores. 

Hindustan has been an undisputed leader in Bihar and Jharkhand market for many years with 68% and 46% market share respectively, well ahead of the second largest player in both the states by a wide margin. Hindustan is the second largest hindi daily in Delhi/NCR region. HMVL entered UP and Uttarakhand market before 3 years, and have reaped rich dividends from such geographical expansion. HMVL has been growing at brisk rate in both the markets. HMVL has not only emerged as the third largest player but has also inched very close to the second largest player Amara Ujala! According to the latest conference call, HMVL has broke even in UP last quarter and is likely to break even in Uttarakhand in next quarter.

HMVL's business derives its revenue largely from two sources i.e. advertisement and subscription. Currently, HMVL derives 72% of its revenue from advertising, 25% from subscription and rest 3% is from interest/dividend income. However, looking at the past trend, that contribution of advertisement revenue has increased significantly from 60% to 72%. Based on my understanding, currently, in the print media, the typical split between ad and subscription revenue is 70/30. Raw material cost constitutes 40% of total revenue. It is likely that RM cost is likely to stabilize at current level or even decrease in case of newsprint prices decline due to appreciation of rupee. 

Competition:

Daily newspaper market has largely been dominated by two or three players in most of the regions. In all the markets in which HMVL operates, the competitive landscape is no different! However, new players are entering in some of the markets dominated by HMVL especially Jharkhand and Bihar. It is possible that entry of a new player with deep pockets can change the competitive landscape in these markets. 

There are predominantly following players in the market that HMVL operates in 

Dainik Jagarn: Present in UP, Uttarakhand, Deli, Bihar, Jharkhand

Amar Ujala: Present in UP and Uttarakhand

Prabhat Khabari: Jharkhand 

Navbharat Times: Delhi/NCR

Panjab Kesari: Delhi 

Dainik Bhaskar: Jharkhand (2011) and entering in Bihar (2013) 

Follwing is the state wise competitive situation based on company's presentation and IRS data (Presentation to investors)

Bihar: Currently, only two major players in the market Hindustan and Dainik Jagarn. Hindustan has lead of more than 60% in terms of AIR over Dainik Jagaran. DB has recently launched Patna edition and if they expand aggresively(as they have done in other states), it may be the third significant player in the state.

Jharkhand: Highly competitive market with 4 players in the fray. Hindustan is the leader followed by Prabhat Khabar, Dainik Jagaran and Dainik Bhaskar respectively. However interesting thing is that gap between first three players have remained almost constant even after the entry of a new player. 

Delhi/NCR: This market is again fiercely contested market with 4 players. However, market is dominated by Navbharat Times which has been able to hold forte very well in spite of stiff competition. There is hardly any difference between second and third player i.e. Hindustan and Dainik Jagaran in terms of AIR and both have maintained their AIR over last couple of years. However, Punjab Kesari has lost readership consistently and is the only weak wicket!

UP and Uttarakhand: This market, few years back was dominated by Dainik Jagaran and Amar Ujala. However, entry of Hindustan has changed this dynamics. Hindustan has been gaining the readership at the expense of Amar Ujala while Dainik Jagaran has maintained its readership numbers in absolute terms. However both Dainik Jagaran and Amar Ujala has lost market share to Hindustan. Dainik Jagaran is still leading the market by a wide margin while the gap between Amar Ujala and Hindustan is narrowing down fast.

Financials & Ratios:

Here is the link for company's financials (Financials are only comparable from FY11)

Profit & Loss: In H1 FY14 HMVL has reported revenue of around 350 crore with net profit of 55 crore. If we annualize this number, FY 14 revenue is likely to be 700 crores with net profit of 110 crores. This translates into revenue growth of 10% CAGR in last three years while 28% CAGR profit growth. 

Company's EBIDTA margins have consistently increased from 18% in 2011 to 21% in 2013.In Q2, 2014, HMVL reported EBIDTA margin of 23%.

Balance sheet: Company has a very strong balance sheet with 36 crores of debt on total equity of 563 crores (As on H1 FY14).This translates into debt to equity ratio of 0.07. Company has cash and MF investment of around 400 crores (including non current investment of 95 crores). 

Cash flow: Company has consistently generated free cash flow from operations in all the years resulting into healthy cash position for the company.Cash flow from operations have been in line with the net profit or have exceeded the net profit in each of the last three years. Cash flow from operating activity is 57, 72 and 81 crores against net profit of 54, 65 and 84 crores. This not only indicates efficient use of fixed assets but also means that working capital management also has been excellent.

Return on capital employed: Even though company has generated respectable ROCE of 22-24% in last 3 years on the entire capital employed, the number do not reflect the actual attractiveness of the business. If we deduct the cash/investment from the capital employed and count only actual capital deployed in the business, HMVL is likely to generate 110 crore of profit on 220 crore of capital employed (fixed asset + net working capital) which is phenomenal 50%! And according to management, the operational leverage is yet to kick in...!!

Valuation:

Company has current market cap of 800 odd crores which is 7.3 times estimated FY 14 earnings. However, company is sitting on cash kitty of 400 crores which management is planning to deploy for acquisition, use it for expansion, return it to shareholders or a combination of these options. If management rationally deploys this capital and generate even 20% return it will translate into additional earnings of 80 crores, taking yearly earning to around 200 crores. Thus, after cash is deployed, effective P/E will be even less than 7, depending upon the kind of return generated on the capital. 

Moreover, according to management (both in AR and in concall), company in past 3 years have made substantial capital expenditure for upgrading their printing facilities and expanding into new geographies. In next few years, management will focus on maximizing the revenue from the investment made, increasing operational efficiencies and further consolidating its position in existing markets. Management has also indicated that this will result into operating leverage coming in to play resulting in significant increase in bottom line. 

In terms of peer comparison, DB corp, which also operates in vernacular/hindi print media and has similar margin and return ratios is trading at 19 times trailing P/E. As DB Corp covers wider geography and is bigger in scale than HMVL, it will command some premium over HMVL. Even if we assume that HMVL will trade at 25% discount to DB Corp, HMVL shall trade around 13-14 P/E. Currently, the stock is trading at 7 times FY 14 earning without considering cash deployment providing enough margin of safety and substantial upside potential. 

Currently market is punishing the company because it is sitting on large cash pile without utilizing it. This is perceived as key risk for the company as market has burnt their fingers in numerous companies where promoters have siphoned the cash through some very innovative and/or blatant means! I personally feel that given respectable management pedigree and management reiterating its intention to deploy cash in due course provide comfort to shareholders. Management in the last couple of concall, has confirmed that they are keeping cash reserves and evaluating various opportunities for inorganic growth. Management has also indicated that HMVL has a threshold limit of "war chest" in mind which it wants to preserve for inorganic growth. However, once that threshold is reached, company shall redistribute additional cash to shareholders. In latest concall, management also gave hints that company is very near to the threshold cash limit. So, it is possible that we witness some action from management on that front which will act as catalyst towards bridging the valuation gap.

Key investment rationale:

- Newspaper is a sticky business and switching cost/inertia is high 

- Typically, in newspaper business, growth in ad revenue is non linear after a newspaper approaches critical mass and scale as volume of advertisement and pricing power both grow. In UP and Uttarakhand, HMVL is approaching that inflection point. 

- Currently there is large gap between advertising rates of Amara Ujala (second largest player) and Hindustan in UP ( at least 30-40%). If HMVL continue to grow and reaches the scale of Amara Ujala, it can signifcantly increase advertisement rate ( I have compiled a comparison between ad rates from all major hindi dailies for HMVL market and if anyone wants it, I can send it over)

- Increasing literacy rates in Hindi belt is structurally good as new potential consumers will get added hence the potential customer base will expand

- Rural India and tier-II and tier-III towns are considered next growth engines for many businesses. Hence advertisement spend focused on this market is likely to go up. All vernacular and Hindi print media companies are going to be beneficiary of this trend

- There is large gap between advertisement rates charged by english dailies and Hindi/vernacular dailies. However, increasing focus on rural/tier-II/tier-III town by companies will narrow down this gap providing higher yield to hindi/vernacular dailies.

Key risks:

- Competitive intensity in key markets of Jharkhand and Bihar is increasing. any irrational behaviour by the new entrant/competitor can have negative financial impact.

- If management neither deploy cash in business/for acquisition or returns it to shareholder, market will continue to assign lower valuation 

- Management pay too high a price for the acquisition resulting into value erosion for the shareholders

One more interesting aspect! Azim Premji and his investment companies own 2.18% stake in the company.

I believe it is a good opportunity to own a solid and growing business on very favourable terms where odds of winning are in favour of an investor!

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!

Reflective Thinking: Few insights during dormant period

I must admit my failure of not living up to the repeated statements/comments made on this blog that I will start writing posts after a small hiatus. Even though, it was difficult to get enough mind space and time to crystalize my thoughts on any new ideas that periodically crossed my mind, I should have overcome these excuses to live up to the commitment made by me. But as it is said it is better late than never! 

Even though, during past few months, I have remained a passive investor, I have tried to keep track of how the dynamics of the businesses that I part own in my portfolio have changed. As I was spending 2 hours every day on travel, I have utilized this travel time to gain better insights into evolution of Buffet-Munger investing philosophy and  the importance of moving up the value chain by moving from "bargain hunting" to owning superior businesses. As I gained better insights into how and why Buffet has moved from buying "cigar butts" to purchase of "great businesses" by paying up fair price, I started evaluating the performance of my portfolio over last few years and why some of the companies have fared better and are likely to demonstrate superior performance going forward as well. I have drawn some inferences (which may turn into conclusions, after a while if validated consistently for a larger sample size!) which I am putting up for discussion.

Pricing power is extremely important for value creation:

Even though, this may sound like a foregone conclusion where there can not be two opinions, I have ended up buying into companies where I have shown utter neglect for this key attribute of the business. As a result of this, many of these companies which lacked pricing power, when started facing headwinds in terms of tapering demand , rising raw material costs or declining commodity prices, their performance started to falter. In other words, when tides went out, it became clear who was swimming naked! A case in point: Gujarat Reclaim Rubber (GRP). An excellent company with consistent track record and run by capable and ethical management . Even though  the world fell into deep recession post 2008, company was still able to grow its top line at more than 15% CAGR. However. price realization for GRP's product remained almost constant while there was significant increase in the operating cost of the company due to rise in power cost and marginally higher RM prices. Thus, in spite of selling the same volume of reclaimed rubber, company's net profit declined by 15% in last 5 years! On the other hand Amara raja batteries was able to successfully weather the storm of depreciating rupee and increasing raw material prices (over last decade, lead prices have increased four fold!). Amara Raja batteries' top line grew at roughly 15% CAGR but its bottom line grew at almost twice the rate!  This attribute is clearly reflected in the value creation done by these companies in last five years. GRP's market cap increased by 138% in last 5 years while that of ARBL increased by 726%!

Opportunity size can make a big difference in potential for value creation over a long period of time:

Another hypothesis that I want to put forward is: opportunity size can be second big differentiator in value creation potential of the company over a long period of time. The basic premise of the hypothesis is that in order to ensure consistent growth over long period, the business should have enough room to grow over a long horizon. Now,  large opportunity size is not only function of current market size, but expected growth in market size over a period of time and shifting preferences from alternative products. Thus, if a business is operating in benign competitive environment(duopoly/oligopoly) and caters to a growing market size, its earning will have higher predictability hence lower risk. This does not mean that companies having niche market/products addressing specific needs of the customer/market will not create value. However businesses catering to market having large and expanding opportunity can be good places to look out for 50 bagger in next 20 years! Hence, the odds are in favour of a battery manufacturer (Amara Raja) or sanitary ware company (Cera) to sustain earning growth over next 10 years as compared to earning growth of a engineering company selling vacuum system (Mazda) or business making fluid couplings (Fluidomat) (Note: I have given example of these companies to drive the point while I have investment in both these companies currently!).

Asset heavy businesses have odds stacked against them to create large value over a period of time:

Most of us know that while analyzing the business, Warren Buffet (and many other investors) focus on return on equity rather than earning per share. It will be factually more correct to say that these great investors focus on the ROE generated on incremental equity deployed in the business. A great business will generate high return on equity consistently over a long period of time. However, my hypothesis is that quality of ROE is key determinant for sustaining high ROE. To put it simply, ROE is product of asset turnover, profit margin and leverage:

ROE = (Sales/Total Assets)* (Profit/Sales) * (Assets/Equity)

Let's take two businesses A and B. Business A and B both have target of generating ROE of 25% and both of them maintain debt at 30% of assets giving Assets/Equity of 1.42. Now business A generates revenue of 100 Rs. for 100 Rs. of assets created giving asset turnover of 1 while business B generates Rs. 300 revenue for Rs. 100 assets giving an asset turnover of 3. This means that company A has to generate 17-18% profit margins to achieve target ROE while company B an get 25% ROE with 6% margins! Now unless company A is a monopoly with extremely high pricing power, maintaining 17-18% margin over a long term is not sustainable. Thus, eventually, the only way for company to achieve target ROE is to increase the leverage. Thus odds are stacked against company A to maintain leverage at current level over long period of time. 

Businesses operating on asset light business models, over a long period of time,  generate substantial free cash flow  which may be distributed to the shareholders in terms of dividends or may be utilized by management to buy back shares. Thus, even market, assigns higher valuation to companies having high ROE combined with asset light business model than companies having high ROE but low asset turnover! 

It is extremely important to highlight here that, only one of these attributes without looking at the other two can be very damaging.  Hence, one should look for businesses which demonstrates all these three attributes. It is also apt to mention here that some of the conventional checks on consistency of past performance and track record, management integrity and capability should obviously be done before reaching any conclusions. Even though, one may not encounter many such businesses with these three attributes, I believe there are enough if one ardently looks for them. 

Last but not the least, as Charlie Munger puts it, no matter how great any business is, it is not worth the infinite price! So, after we come across such businesses, it is equally important to get a stake in that business at reasonable price ensuring margin of safety! Hence, no matter how good the quality of business is, I personally avoid buying a business trading at P/E of 40 (yes, I admit that I have made a mistake of omission, but I am comfortable living with it!) because two golden rules of Warren Buffet  still serve as guiding lights to me: the first rule is don't lose money and the second rule is never forget the first rule. 

Moving to Mumbai: Will be Back After a Small Hiatus

Dear Readers,

Wish you all a very happy new year and hope all of us continue to reap rich dividends from investing in 2013. New year has started with a new phase in my life as I have moved to Mumbai to take up a new job. I am excited about moving to this immensely vibrant financial capital of India. However, as I am uprooting from my home town and rerooting in Mumbai, there are number of new fronts that have opened up which I am trying to tackle. This leaves me with very little time to ponder over different ideas and do justice to whatever I write on this blog. So, I have decided to take a small break in blogging till I settle down in mumbai on professional as well as personal front.

However, I am determined to be back to blogging for sure, hopefully in a month.

Happy investing to you all at this exciting time.

Playing Second Fiddle: Possibility of First Rate Returns

It is human mind's innate tendency to seek patterns from the past experiences and extend this patterns to predict the future. Even though this innate human trait is very handy on number of occasions,  many a times it leads to visualizing patterns where there exist none! In my opinion, a key differentiator in identifying a useful pattern is the causal relationship or lack of it! In simple words, if our mind visualizes some pattern but there is no logical/rational explanation for why particular pattern exist, more likely than not, pattern may turn out to be misleading. Idea behind discussing this trait of human mind is that this post is related to a pattern that I have observed in some of my investments and there is a common thread binding success of these investments. My personal take is that this pattern can have high predictive value as there are enough logical reasons to explain for the pattern deciphered here.

There is a very interesting thread going on on valupickr forum on identifying success patterns in investment. Donald has done an excellent summary of various patterns discussed on this thread. Do read this thread as some of the patterns there are indeed very interesting.

Let me start the discussion with a question. What is common between Amara Raja Batteries, Cera Sanitaryware and Oriental Carbon & Chemicals? Let me define characteristics which bind them together..

• All these companies operate in duopoly/oligopoly: Organized sanitaryware industry catering to mass market is dominated by three players i.e. HSIL, Parryware and Cera in that order. Similarly, battery industry is dominated by Exide, Amara Raja and to a limited extent Tata. In insoluble sulfur space, there only few suppliers garner more than 95% market share in insluble sulfur supply to all tyre majors across the world.

• They are not leaders in their industry but are second/third largest players in their industry: Cera is the third largest player in organized sanitaryware industry catering to mass market. Amara Raja is the second largest player in battery market (both industrial and automotive combined) and OCCL is third largest player in insoluble sulfur market.

• All three companies have been discussed on this blog based on fundamental and business analysis. (though due to some management actions, I have exited OCCL as I was not comfortable with management quality, however, on quantitative basis, it still looks very good for longer term)

So once I noticed the commonality among these three companies, I sensed that there may be some pattern emerging which may have causal/logical links.

So here is the hypothesis

" Second or third largest players, operating in a consumer-centric industry and increasing/retaining their market shares are good investment candidates if it is acquired before market picks up the thread"

Now the hypothesis seems slightly complicated (may be verbose!), but i put it like that to ensure none of the attribute is left out from the hypothesis!  So what are the attributes one should be looking for in second/third largest players in order to qualify it as good investment candidate?

• Industry should be consumer centric or product should be used in consumer centric industry to ensure steady demand
• Industry should be growing at reasonable pace
• Industry shall have duopoly/oligopoly with market leader enjoying pricing power.
• overall business economics (return ratios and margins) for industry is good  and consistent while second/third largest players enjoy similar economics as that of industry leader (or may be better!)
• Second/third largest players should ideally be increasing its market presence/share
• Second/third largest players trade at significant discount to market leaders.

This may sound like a wish list but the fact that such opportunities existed in the past does build confidence as an investor that one may come across such opportunities from time to time. If one is able to spot such opportunities and invest, it is likely to give first rate returns!

So let me dwell into logical link as to why this pattern makes sense as investment opportunity.

• Typically in an industry, with duopoly/oligopoly, market leaders enjoy pricing power and hence their margins are generally decent and protected. This ensures that second/third largest players also can take advantage of this dynamics and enjoy protected margins. Thus any major fluctuations on RM price is typically passed on to the end user (though some times with lag). This attribute can be very handy as company's bottom line is predictable as long as company is able to sell same/more of its products.
• Another advantage second/third largest players have is that they have to grow from much lower base than market leaders.As we all know it is much easier to grow at faster pace from lower base than higher base. Moreover, since company is growing from lower base, it is possible to maintain growth momentum (of course with right products and strategy) for longer. Thus if company is operating in an industry with reasonable  growth it shall be able to grow at pace comparable to industry growth. Now if we combine these two attributes of reasonable growth in top line and protected margins, it will lead to predictable earning growth for some years. 
• Another interesting fact is that market typically focuses on industry leaders and assigns discount to companies which play second fiddle to leaders. Many a times, this means that one can get opportunity to buy a business which has as good economics as industry leader, higher growth than  industry average (due to lower base) at much lower valuations. It thus may present an opportunity to buy growth companies with superior economics at very reasonable price giving some margin of safety to the investor. 

So apparently, there is some logical link that can explain why investing in second/third largest players in oligopoly/duopoly makes sense. However the moot question here is, does it always work? There may be contrary evidences where in spite of this pattern, playing second fiddle did not work as investment  opportunity. Hence, it is important to recognize that, just spotting an opportunity which fits the pattern is not the end, but the beginning. It shall never be a proxy for fundamental/business analysis that one should perform before making investment decision. Limited point here is that, pattern may be useful in identifying investment opportunities which have higher probability of giving superior returns over a long period of time.

Food for thought: A few other opportunities which can fit in this pattern are Atul Auto, Narmada Gelatines and Fluidomat as all three of them operate in an industry with oligopoly/limited competition. 

Please share your ideas on which other businesses you think can fit into this category. 

Hyderabad Industries Ltd: A Mispriced Bet

I hope all of you had a fabulous time during Deepawali and are eager to make most of the new year that has begun. In last two months market has been topsy-turvy with undertone being on the optimistic side. Any good news on sector/stock specific front is followed by strong rally while bad news are considered to have been discounted. In last two months number of undervalued opportunities discussed on this blog and many other such blogs seems to have caught up and difference between price and value seems to have narrowed (though undervaluation still exists in quite a few). In such a stock specific market, it is generally difficult to spot opportunities which have under performed in spite of strong fundamentals and good performance. 

Hyderabad Industries Limited (HIL) is one such opportunity, which inspite of good fundamental, decent growth record in recent quarters, strong promoters and potential to grow at decent pace, is trading at very cheap valuations. It is  a story which in my opinion is slowly unfolding but is not perceived correctly by the market. It is still considered a cement sheet company which means slow growth and fluctuating margins and hence valued in line with other cement sheet companies at TTM P/E of 4-5. In short to me HIL seems a mispriced bet.

Business Overview: HIL is a CK Birla group company established in 1946 and was a pioneer in asbestos based cement sheet business.Even though fiber cement sheet business still constitutes 80% of the business, HIL has also entered into business of thermal insulation, accessories and recently green building products. It has 12 plants spread pan India covering length and breadth of the country. Following is the key snapshot for major businesses of HIL 

Fiber Cement Sheet Business: It has built formidable "Charminar" brand over the years and has developed extensive sales and distribution network covering even remotest rural areas in the country. It is the largest player in this segment with more than 20% market share. This business contributes around 80% towards revenue however its share in overall revenue mix is decreasing due to increased contribution from green building product division. A peculiarity of this business is that transportation cost is one of the major component of the cost structure. Thus producing end product near demand centers is critical for better margins and cost competitiveness. HIL scores very well on this front due to highest number of plants spread across different states of the country covering all the regions.Other players in the industry are Visaka Industries, Ramco Industries, Everest Industries etc.

Green building products: This business is marketed with the brand of "Aerocon" and has become very popular in recent times. It comprises of two products namely AAC blocks and Aerocon panels. 

AAC Blocks: Autoclaved aerated concrete blocks are made from mix of cement, fly ash, aluminium and other plasticizers. It has number of advantages over clay bricks such as more environmental friendly, much better thermal insulation property, very light in weight, less labor requirements. Even though AAC blocks are costlier than clay bricks on standalone basis, cumulative cost of construction is comparable due to number of advantages AAC blocks enjoy.  In time of increasing focus on climate change and government's focus on improving energy efficiency in building construction sector, green building products have huge potential. Moreover, in addition to "green" tag, ease of use, acute shortage of labor and rising prices of sand/cement and reduced construction time is motivating number of builders to shift to AAC blocks. In Ahmedabad area itself, I have seen many of the new apartment and commercial complexes  using AAC blocks instead of clay bricks.

HIL is one of the leaders in AAC blocks segment with close to 26% market share in southern and western market. Other large players include Siporex (Pune) and magicrete(Surat). It grew its AAC block business by 100% last year and is hoping to maintain good growth in coming years due to increasing demand, its focus on quality and its relationship with large real estate players.

Aerocon Panels: A panel made from recycled waste (fly ash) is a perfect replacement for plasterboard, plywood, particle board and brick wall. It is a green product certified by Indian Green Building Code (IGBC) and has huge number of applications including partition walls, office chambers, office partitioning, mezzanine floors and pre-fab structures. It has low weight, ductility, better thermal insulation and fire resistance. HIL is leader in this segment with 58% market share. Business in this segment grew at healthy 21% in FY 12.

Thermal Insulation Products: HIL is leader in calcium silicate based thermal insulation product. It markets its thermal insulation product in the name of "Hysil". It commands 65% market share in domestic industry. It has application across cement,power, petrochemical and fertilizer industry. Thermal insulation business is too small compared to its building product division. It also is a slow grower and HIL is looking to expand this business in international market by focusing on exports.

Financials and Fundamentals: 

Let me take this opportunity to express my gratitude to Ayush and Pratyush for creating wonderful site like screener.in. It is fabulous and extremely useful  site for creating user defined screens without getting bogged down by only recent years numbers. Here is the snapshot of 10 year financials for HIL. 

http://www.screener.in/company/?q=509675

Before I start analyzing the financials, I want to bring in an important perspective here. HIL till 2006-07 was predominantly a cement sheet manufacturing company with virtually no appetite for growth. It was operating in a mature industry and in tough competitive environment with focus on maintaining its market share instead of growing.Its growth rate hovered around the growth of industry as a whole or slightly better(7-8%). However, management decided to bring in new vigor to the company, HIL brought in Mr.Abhay Shankar as its MD and widened its focus from fiber cement sheet business to become a building product company. This key change is reflected in numbers as well.  Few things which are evident from the analysis of financial statements.

P & L:

• HIL's top line grew 7% CAGR from FY 2003 to FY 2008 while it grew at CAGR 15% from FY 2008-2012.
• HIL's net profit grew more than four fold from 14 crores in FY 2008 to 60.5 crores in FY 2012. This is CAGR 44% in four years. 
• Over last 10 years profit margins have been all around the place and there is no consistency in the margin. However, it seems (may be too early to conclude) operating margins around 12-13% is a reasonable estimate considering improving product mix (higher contribution from green building products).

Balance Sheet: 

• Key takeaway from balance sheet analysis is that HIL has deleveraged its balance sheet over last 10 years. HIL reduced its debt/equity from 1.9 in 2003 to 0.3 in 2012. 
• HIL managed its working capital exceedingly well and improved over last 10 years. WC as % sales reduced from 24% to 12%. 

Cash Flow:

• HIL has consistently generated positive operational cash flow and mostly in line with the profit generated by the company. 

Return Ratios:

• Company's ROE has been fluctuating over the years ranging from   below 15% to above 40%. however in case of normalized margins for HIL, it has earned very decent ROE i.e. in excess of 20%. In FY 12, HIL earned ROE of close to 20%. 
• ROE is contributed equally through margins, asset turnover and leverage. I have preference for businesses that are intrinsically asset light (or rather not asset heavy) and ROE is derived through balancing of all the three factors. HIL surely scores well on this front.
• It has asset turnover ratio hovering around 2 in spite of continuous capacity addition and expansion. 

Key Drivers for HIL:

Even though many a times, history does give important clues to how future may pan out, it is not the case always. Things change, circumstances change, people change and organizations evolve. 

• HIL management has become more proactive for last 4-5 years which is clearly reflected in the numbers. HIL management aims to more than double its top line from current 850 crores to 2000 crores by 2016-17. Please read following article. http://210.212.220.243:111/HIL%20GREEN%20PUSH.pdf

• Moreover HIL is slowly moving from being a pure fiber cement sheet  company to a building product company having larger number of products in its portfolio. Revenue mix is slowly but surely changing with contribution from green building products rising at fast clip. Management plans to change revenue mix of cement sheet/green building products to 50/50 by 2016-17 from current mix of 80/20. Typically green building products have higher margin than cement sheets and hence margin profile may improve further from current levels.
• As I have been working in sustainability area, I see a clear focus by the government in promoting energy efficiency. Government is strongly promoting green and energy efficient buildings by bringing in new guidelines and building codes. Moreover, green buildings are economically  viable if one considers cost metrics in totality and hence no additional burden on stake holders for "green" tag. This makes me believe that there is huge opportunity waiting to be tapped and hence growth expectations of HIL are not misplaced.

Valuations:

HIL currently has market cap of 350 odd crores with PBDIT of 116 crores and has book value of 452. It is trading at TTM P/E of 5 and P/B of 1.05. 

Now there are two scenarios I would like to draw here. First one is the pessimistic scenario. If HIL does not do as well as management has indicated and just grows its top line at CAGR 10-12% for 4 years, it will end up with revenue of roughly 1400 crores. If I take normalized net profit margin of 7.5% (which I think is realistic considering changing revenue profile), it will mean NP of 104 crores and EPS of roughly 140. Even if I take P/E of 5 (which in my opinion very conservative), it will result into price of 700 i.e. CAGR 10%. It is reasonable to expect that company will at least continue to pay dividend equivalent to current dividend, it will add roughly 4% to returns. Thus total returns will be 14% post tax. Thus in worst case, I earn 14% post tax returns which is not bad at all.

However, if company grows in line with what management indicates, it will be earning EPS close to 200. Even if I assign modest P/E of 10 (for a 25%+ CAGR company) it will mean price of close to 2000. This will mean CAGR 40%.

Even though it is too early to conclude anything, HIL has reported excellent numbers in Q1 and Q2 showing 30% + growth in each of the quarters.

So it is one story where odds of losing reasonable returns is minimal while one can make good money without losing sleep!

Key Negatives:

So what all can go wrong in this story? 

• Typically margins have been fluctuating widely and hence it is not unlikely that history repeats. However typically lower margins have been followed by above average margins in subsequent years. It is reasonable to assume that over a 5 year cycle, one would earn normalized margins.
• Management may make pricey acquisitions (as it is mentioned as one of the possible strategies for growth) and not able to manage it well. It will also mean balance sheet may be leveraged and hence things go awry.
• There are no major entry barriers to any of the segments of HIL (including green building products) and hence competitive landscape is going to be flooded with number of players resulting in moderating in margins or price war. This can result into lower margins that company commands today for green building products.

So what's the final verdict? HIL is a bet where odds of winning seems tilted in favor of investor while risk of loss is minuscule from this level.