Saturday 24 March 2012

Piramal Healthcare: In The Territory of Unknown And Unknowable

Let me start with saying that the whole idea behind this post is not to arrive at any conclusion (as for me, analysis of PHL is still work in progress!). However, what prompted me to write this post is my reading of Dr. Richard Zeckhauser's very interesting paper  on "Investing in Unknown and Unknowable" and Prof Sanjay Bakshi's lecture notes connecting the above article with investment in Piramal Healthcare Limited (PHL). Dr.Richard Zeckhauser is a professor at Harvard Univesity and chairs the program on investment decision and behavioral finance. After reading the article, I could instantly connect PHL with what Dr.Zeckhauser was describing as investing in known and unknowable. 

First thing first! Central premise of Dr.Zeckhauser is that some of the greatest investors have earned extraordinary returns by investing in unknown and unknowable (reffered to as UU) and such decisions are made based on reasoned and sensible basis. The thesis contends that there are ample situations in real world investments where, even possibilities of future state, are not known, leading to "ignorance". This ignorance about future state of events/scenario keeps most of the people/investors away from investing in such situations. What happens is that many a times uncertainty is perceived as "risk" which it may or may not be. However, if one applies a sensible thought process involving probability and payoffs and evaluate expected payoffs, it is possible to gain disproportionately from this uncertainty without assuming disproportionate risk. He proposes that person who has a unique combination of various soft skills termed as complimentary skills (deal making, deep insight into an industry, sense of judgement etc) can take maximum advantage of UU situations. Since all of us can not possess such skills, one can invest along with people who have such complimentary skills to benefit most of UU situations. ( i know many of you must be yawning by now!)

Now let us look at PHL. When PHL sold its generics business to Abbott in 2010, it was 3rd largest pharmaceutical company in India with 4.5% market share. It sold its generic business to Abbott at mind boggling valuation 9X revenue and 36 times EBITDA. The deal was valued at USD3.72 billion where USD 2.12 billion was paid in 2010 while remaining USD1.6 billion was to be paid to PHL in 4 equal installments of USD 400 million beginning 2011. It also sold its diagnostic business to Super religare for consideration of 600 crores. So now, PHL was in a situation where company was flush with cash (10,500 crores  on hand and another 6,500 crores in receivables)

Saturday 17 March 2012

When to Sell Stock: Decision Making Based on Value Investing Approach

I have always felt that decision on when to sell a stock is much harder to make then making a decision about when to buy. Once you have already bought an investment, you are prone to cling on to your decision due to number of psychological biases such as endowment bias where you tend to overvalue your possessions most of times and confirmation bias where you look for confirming evidences to support your initial hypothesis. 

Even though when to sell stock is as critical and complex question as that of when to buy stock, there is relatively very little information available in literature of value investing on detailed methodology or framework regarding the selling decision. one school of thought suggest a "buy and hold forever"strategy. However, the underlying assumption for this approach is that one has followed the central premise of value investing thoroughly and has made investment in an enterprise that is able to increase its intrinsic value consistently over a long period of time.Though it sounds simple and elegant, putting this into practice consistently in all investment decision is very difficult except for some exceptional and legendary investors. Hence, I feel one needs to develop a clear understanding on how one should go about making a decision to sell. The approach/framework shall be as much rational  as one would expect in a decision to buy an investment. 

I can conceive three situation in which you shall exit an investment.

Wednesday 14 March 2012

Updates on Oriental Carbon Chemicals Limited

I am writing this post with respect to my earlier post on OCCL Oriental Carbon and Chemicals: Keeping a close eye. I was circumspect about the sustainability of NPM in the longer run and hence advised caution before taking a plunge. Today I have come across announcement from Schrader Duncan, a company promoted by Duncan group (promoters of OCCL) and Schrader Bridgeport International Inc. OCCL had 12.58% shares in Schrader Duncan. Now, OCCL is going to acquire 50% share from Schrader Bridgeport for roughly 14 crores (as per OCCL announcement on March 05). This will mean that Schrader Duncan will become subsidiary of OCCL.

Schrader Duncan has two divisions namely Tyre/tube valves and accessories and pneumatic products. Schrader Duncan is currently in shambles due to very many reasons but primarily due to lack of pricing power and cut-throat competition. The situation is so bad that company is not able to pass on increase in raw material and operating cost and is incurring operating losses for last 2 years. Company had a plant located in Mulund which has been shut down and land is sold in March 2011 for 42 crore. Company has received 20 crore proceeds from this sale till December 2011 while remaining 22 Crore  is yet to be received. Schrader Duncan incurred extraordinary expense of 15 crore for VRS of its employees at mulund plant which has eroded company's networth substantially. Moreover, in its AR in 2011, management specifically talks about intense competitive pressure and lack of pricing power for its products. Thus management does not expect substantial improvement in business economics.

I am not able to understand the rationale behind management's move.This move raises doubts about management's ability to protect interests of OCCL shareholders.

Saturday 10 March 2012

Applying Capital Allocation Framework: Part 2

In the part 1, I discussed the two building blocks of capital allocation framework  i.e. conviction rating and valuation rating and then drilled down to constituents of conviction rating i.e. business quality, fundamentals, growth prospects and management quality. I illustrated the process with the example of Cera Sanitaryware. For reading Part 1 click here

Following is the overall score rating on Cera on business quality and fundamentals. 

Business Quality: 1.64

Fundamentals: 2.06

Now moving on from there, let's look at other two attributes of conviction rating i.e. growth prospects and management quality. 

Growth Prospects (weightage -30%):

Opportunity Size: This is one the most crucial parameter in the longer term as it determines the outer limit of scalability potential of a company. To give an example, Gillette has opportunity size of selling more than 3 billion razors, considering population of men around the world and hence if caught in early stage, such company can easily grow 100x . In terms of opportunity size, Cera can be considered to have a very large opportunity size considering more than 300 million households (and growing) and replacement demand that can be generated for their products. Hence Cera scores very well on this count Score:9

Monday 5 March 2012

Applying Capital Allocation Framework: Part I - Conviction Rating

First two months of 2012 have been stupendous for the market. Many of the investors(including me) have had the feeling of being left out. At the same time I am reasonably confident that in time to come, market will again create lots of interesting opportunities for value investors. How can we remain prepared to take maximum advantage of such opportunities? I have always struggled in deciding as to what criteria one should adopt while allocating capital to existing stocks or new stocks. Should one buy more of some of the existing stocks in one's portfolio, or reduce positions in existing ones to allocate money to new opportunities that have better risk-reward ratios? Even though most of the investment I have made are based on careful study of business and valuation, relative merit of each stock in my portfolio was elusive and was doing capital allocation on "gut feel" basis rather than  a systematic process. When I come across the forum initiated by veteran value blogger Mr.Donald on capital allocation framework, I was thrilled to find a perfect answers to my quandary. Mr. Donald and fellow forum members have engaged in a very insightful discussion to deliver a fairly robust and methodical approach to capital allocation within one's portfolio and new opportunities.  
Here is the link to this discussion 

What I have tried to do here is take the capital allocation framework suggested by Mr.Donald and try to illustrate the whole process step by step by applying those parameters to one of the stocks in my portfolio Cera Sanitaryware (once again!). This may  be helpful in understanding outlined methodology slightly better. 

In order to keep the post interesting and readable, I have decided to write it in 2 parts. 

Part I- Discussion of basic idea of Mr. Donald's framework and two attributes of "conviction rating" i.e. Business Quality and Fundamentals

Part II - Remaining two attributes of "Conviction Rating" i.e. Growth Prospects  and Management Quality. I will also cover "Value Rating" and arrive at a composite rating for Cera in the second part. 

Before starting the illustration, let me first discuss the basic premise proposed by Mr.Donald. He has suggested that one can broadly rate a stock based on "conviction" and "valuation" on the scale of 1 to 10. As name suggests, conviction rating is based on how convinced one feels about the business attributes of one's investments. It is measured through business quality, management quality, fundamentals and growth prospects.