A Year into Value Investment Blogging: Time to Do Reality Check!

It has been almost a year, since I started this blog on value investing and let me take this opportunity to thank fellow investors who have not only regularly read the blog but also have provided their suggestions, critique, inputs, questions and insights. This involvement and interactions, with number of fellow investors ranging from novice to veterans, have made this journey an enriching experience for me. I sincerely thank all the readers from bottom of my heart  for their wholesome participation and look froward to more and more interaction in coming time.

Over one year, I have posted number of ideas which I thought made sense from value investing framework and I had highest conviction in. I also tried to write about ideas where I myself will be willing to put money so as to make sure I had complete buy in before putting the idea into public domain. Most of the ideas discussed (not all) on this blog are/were part of my portfolio at some time or the other. As I started the blog, one of the objective of writing a blog was to document my investment rationale/hypothesis behind businesses that I buy and to keep tab on how my ideas perform over a period of time. Even though, in value investing, one year is not an appropriate time frame to evaluate the performance of a portfolio, it does serve as milestone indicating whether one is traveling on a right path or not. It is like a mid term exams! 

I take this opportunity to acknowledge that the idea of evaluating performance of my idea is derived from the work done from Vishal (Valueinvest30) who took pain to put together buy price/date of post for all the ideas posted on this blog. Thanks Vishal for that. This prompted me to think that I should assess performance of the ideas posted on this blog for the sake of transparency and getting a sense on direction . It doesn't matter, how the portfolio performs, but it gives me and blog readers some idea about what went right and where it did go wrong.  I also plan to make it yearly ritual  of evaluating performance around same time frame to keep things consistent from evaluation perspective.

While I do not carry all stock in my portfolio in same proportion in terms of capital allocation, for the sake of simplicity and to generalize the results,I have done my performance analysis assuming roughly 10,000 allocated to each idea. I have assume closing price as average buying price on the day I wrote the post about a particular idea. Today's closing price is taken as CMP and returns are calculated on CMP. 

Security Name	Date  Blog Posted	Buy  Price	Buy           Quantity	Amount  Invested	CMP	Current Amt	%Gain
J B Chem	24/11/2011	68.5	140	9590	69	9660	0.73%
Cera Sanitaryware	29/09/2011	178	55	9790	375	20625	111%
Mayur Uniquoter	11/12/2011	167	60	10020	430	25800	158%
Sintex Industries	29/12/2011	62	160	9920	67	10712	8%
Oriental Carbon	07/01/2012	91	110	10010	160	17600	78%
Shriram Transport	18/01/2012	534	20	10640	605	12100	14%
Gujarat Reclaim	29/02/2012	1398	7	9786	1625	11375	16%
Piramal Enterprise	24/03/2012	455	22	10010	495	10890	9%
Narmada Gelatine	30/03/2012	96	105	10080	134	14070	40%
Mazda Ltd	30/04/2012	93	110	10230	96	10560	3%
Atul Auto	19/05/2012	100	100	10000	111	11100	11%
Amara Raja Batteries	19/05/2012	138	75	10350	224	16800	62%
Fluidomat	19/05/2012	32	310	9920	38	11780	19%
Swaraj Engines	19/05/2012	402	25	10050	440	11000	10%
Wim Plast	19/05/2012	201	50	10050	362	18100	80%
Hindustan Zinc	29/06/2012	112	90	10080	132	11880	18%
GSFC	16/07/2012	71	145	10295	75.5	10947	6%
Total				170711		235000	38%
Sensex	26/10/2011			17289		18625	7.72%

As it is evident from the above table that some of the securities performed extremely well even in over all depressed markets while other did reasonably well. There are few securities which performed worse than benchmark and dampened the overall returns. However, portfolio as a whole did manage to perform well as it generated 38% absolute returns (not annualized as many of the opportunities are less than 6 months old) on amount invested. Now, if one would have invested same amount in nifty/Sensex based index funds, returns will be in the range of 7-8%. Thus, at least for this year additional effort put into finding opportunities seems to be well rewarded.

Even though, these are early days, a pattern emerging from the performance analysis is that combination of undervaluation and great business (Cera, Amara Raja, Mayur, Wim Plast, Oriental Carbon) is likely to fetch far superior returns than finding out business available at deep discount but mediocre/average in nature. However, as I said earlier, these are early days and it is not worth jumping to conclusion. 

Among the under performers, I am very positive on Atul Auto, Piramal Enterprise, GRP and Shriram Transport. 

Mazda and JB chemicals remain value play. However, post JB chemical's announcement about dispute with J&J regarding amount put in escrow account from  sale of Russia-CIS business, margin of safety has reduced. I have partially exited (roughly 50%) at marginal gain, rest 50%,I continue to hold. For Mazda, undervaluation remains. 

Disclosure: Views posted here are personal and shall not be construed as investment advise on buying or selling. One must do his own due diligence before making investment decision. My views can be biased as I hold position in many of the companies discussed here.

Mr.Ajay Piramal - Businessman Stepping In Shoe of A Value Investor

Let me make a confession at the beginning, I am a convert, hence my views are bound to be biased! Yes, over last few months,  I have witnessed a slow but steady transformation in my feeling towards Mr.Piramal from curiosity to respect to awe. As I watch Mr.Piramal conducting the business of now re-named Piramal Enterprise, it leaves me with a feeling of deep satisfaction that i have made a right choice of making "side car investment" with Mr. Piramal. As an avid student of value investing, it is fascinating to watch some one taking the teachings of this highly intuitive and yet effective philosophy out of investment paradigm and start putting it into practice in making business decisions. In order to demonstrate how deeply value investing principles are ingrained in Mr.Piramal's business philosophy, let me analyze some of the decisions made by Mr.Piramal and how they relate to core principles of value investing. 

1) Mr.Piramal's decision to sell domestic formulation business to Abbott:  

Building business from scratch is like growing a baby. It takes continuous effort, unwavering commitment and complete dedication while end result is deep sense of satisfaction. One gets completely engrossed in the process and becomes deeply attached to the business. Hence, it is very difficult for one to let go of this attachment and sell the business, especially a successful one. Consider PHL in 2010, domestic formulations division was the bread & butter for PHL and Mr.Piramal had worked hard to bring it into top-3 in Indian pharma industry. In FY 10, healthcare and diagnostic business constituted roughly 60-65% of revenue for PHL. Moreover, the business had grown topline and bottomline at 17% and 34% CAGR respectively in last 8 years. (pg.11, AR FY11). In short, every thing was hunky-dowry! So what prompted Mr.Piramal to take decision of selling largest chunk of his business to Abbott? Here is an answer in his own words from interview given to HT in June 2012, 

"I have an obligation to my shareholders, to create maximum value for whatever they have invested and that’s what my job is and that’s what I am here to deliver. I don’t carry an egoistic or emotional attachment to the businesses. We did a calculation to justify the value that Abbott paid — I would have had to grow the business for 15 years at 20% CAGR with an operating margin in excess of 35%. Now that’s not possible and therefore, the choice was should I leave aside my ego that it is my business and I created it, or should I do what is in the best interest of shareholders. If you look at like that, that’s what a leader ought to do, in my view. Job of a leader is to act like a trustee."

Now this will  surely sound like music to ears of Philip Fisher or Warren Buffet who puts concept of "management as trustee of shareholder wealth" on top of the list in making investment decision.

 Also note similarity with Ben Graham's advice given in his seminal book Intelligent Investors. He tells that some times Mr.Market is brimming with enthusiasm and  offers ridiculously high price to buy out the your interest in the business. At that time, as prudent investor or sensible business man, you shall oblige and sell the business and take advantage of the deal offered by Mr.Market. Here in this case it was Abbott in place of Mr.Market and as Mr.Piramal describes, he happily sold his interest as in his own sense, price offered far exceeded intrinsic value of business.

PHL decided to buy-back shares instead of declaring special dividend: 

PHL decided to reward shareholders by offering buy-back of 20% of shares at 20% premium to market price. Now market did not like this move at all! Market was more interested in special dividend as it meant "cash in hand" of the shareholders even at the expense of getting less value! In spite of anticipating this unpopularity, management decided to act in manner which was in the best interest of the shareholders. Please refer to slide 7 & 8 for analyst presentation for Q3 FY11

As it is illustrated in the slide, for the same amount of money spent by the company, cash in hand of shareholder is much higher in "buy-back" option as compared to paying dividend due to tax efficiency of buy back. Moreover, it also is beneficial to continuing shareholders as number of outstanding shares go down by 20% (thus decreasing equity base) and help in enhancing EPS/ROE.  As Graham puts it in intelligent investor,

"You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right."

and now read what Mr.Buffet thinks on share buy back. Let's go to 1984 news letter where he penned down his elaborate thoughts on share repurchase and its virtues 

"While we enjoy a low tax charge on these proportionate redemptions, and have participated in several of them, we view such repurchases as at least equally favorable for shareholders who do not sell.  When companies with outstanding businesses and comfortable financial positions find their shares selling far below intrinsic value in the marketplace, no alternative action can benefit shareholders as surely as repurchases.".

So, Mr.Buffet clearly indicates that share repurchase program gives an opportunity to existing shareholders to redeem some of their capital with low tax liability without adversely impacting interests of continuing shareholders. Mr.Buffet puts in necessary conditions for initiating share repurchase (As highlighted) which were met in case of PHL.

PHL's Investment in Vodafone India: PHL bought 11% stake from Essar in Vodafone India at roughly 5800 crores. Mr.Piramal made it very clear that this invsetment was only financial investment and company had no plans to enter into this sector. It was indeed a smart strategy to park huge surplus cash in a way that maximizes return while giving time to PHL to find out good specific opportunities in its area of operations. However what is more remarkable is the deal Mr.Piramal extracted from Vodafone. As he emphasizes that "trust" and "respect" that PHL has created over a period of time that helps him get a better deal than rest of the people.  So here is the deal, 

PHL buys out 11% stake from Essar in Vodafone India in two tranches of similar proportions. PHL has an option to sell its stake in IPO if Vodafone India decides to go public in 24 months from the date of investment. However, if Vodafone decides not to go for IPO, Vodafone will buy back 11% from PHL in the range of 7000- 8300 crores (Vodafone AR, page 59). Now in the worst case, company is getting 10% annualized return at floor price of 7000 crores while PHL will earn 20% return at 8300 crores. So minimum return PHL will earn is 10% CAGR which is still better than money put in fixed deposit. 

Now, if Vodafone decides to come up with IPO by 2014, which is not an unlikely event, considering their plan for expansion and their intent of going public, Vodafone India can at least command valuation similar to that of Bharti (as it is comparable in size with Bharti)  even if one doesn't consider premium for MNC. So, going by FY 12 numbers, Vodafone India clocked EBIDTA of 1.2 billion pound i.e. roughly 10,000 crores. Considering today's situation of  extremely negative sentiments about telecom sector, Bharti is still trading at Market cap of 1,00,000 crores i.e. 10 times last year's EBIDTA (10,300 crores).Hence, it is not unreasonable to assume Vodafone India also getting similar valuation of roughly 1,00,000 crore market cap. This will value PHL's 11% stake at 11,000 crores, cool 80% return in 2 years i.e. 38% CAGR! Reminds you of something? yes,  Heads I don't lose, tails I win big! Low risk- high return game...

PHL's Acquisition of DRG : PHL completed acquisition of DRG in June 2012 at 3400 crores paying 4 times expected revenue for FY 2012. As indicated by PHL management, publicly listed companies engaged in similar business trade at valuation of 3-5 times topline  Hence, DRG was not that cheap by these standards. PHL decided to pay fair price. Now read this sentences from Mr.Buffet 

“It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”  

                                      and 

“A truly great business must have an enduring ‘moat’ that protects excellent returns on invested capital.”

As many of you may be knowing, DRG is in the business of  healthcare information management where they collect "vertical specific" data, organize it into usable information and sell information to customers where information arbitrage is important. Now look at the analyst presentation on DRG put up by PHL. PHL describes reason for acquiring DRG; here are the key points

• Recurring revenue flow  which is tied into budgeting cycle (predictable business) 
• Data gets embedded into client's system ( one of the moat of "high switching cost" mentioned by Pat Dorsey in his extremely useful book "Little book that builds wealth")
• High value of insights; the risk far outweighs the price (of subscription); reputation of source (hence authenticity) matters ( very high switching cost due to potential negative impact)
• Quality, accessibility and frequency of data and sources is more important than price (pricing power a key attribute that quantifies moat)
• High barriers to entry with, 290 analyst with deep industry knowledge and relationship; data collection process with irreplaceable longitudinal data and  network of 125000 advisers and data providers ( again Pat Dorsey's one of the moats, Network effect; difficult to replicate) 
• strong operating leverage ( as company scales up, higher percentage of top-line flows to bottom-line)
• Strong free cash flow ( another key attribute (along with pricing power) of great business) 

As can be seen from the above analysis, DRG demonstrates all the attributes of a great business (having sustainable moat). Hence, DRG is a perfect example of buying a company with sustainable moat (in Pat Dorsey's words strong moat) at fair price. 

I am feeling convinced that given enviable track record of value investing principles of generating above-average returns for a long period of time, journey with Mr.Piramal will turn out to be a one big joyride for PHL investors!

Amara Raja Batteries Limited: A Business Moving Towards Sustainable Moat?

This posting is slightly modified version of the thread that I initiated on Amara Raja Batteries Limited on valuepickr. Even though, over three years, I have been experimenting with various value investing approaches like deep value investing (cash bargains/debt capacity bargains), growth for free and great businesses at reasonable price, I am slowly realizing why Mr.Buffet puts so much of importance on the idea of "durable moat". In my investment journey, though very short by any standards, I am starting to get a "feel" that investment in business with durable moat at reasonable price may give much higher return than buying reasonable businesses at great prices (to read more on sources of durable moat sources of durable moat). Hence, I have been looking to re-balance my portfolio with companies that either have durable moat and are trading at reasonable price (25-30% discount to conservatively calculated intrinsic value) or companies that have a possibilTity to create sustainable moat over next few years and are available at  reasonable bargain price (40-50% discount to intrinsic value). Even though ARBL came to my radar around April 2012 (earlier post on Value Picks in turbulent times), as I dug deeper, my conviction level on ARBL went up considerably. 

I tried to put on skeptics hat and tried to put hole into the story, but could not find any major ones. Then i posted the idea to valuepickr community members (a very vibrant and dedicated community towards value investing to say the least!), essentially seeking views of the community members on what can go wrong. And till now many of very senior members have opined that it is indeed a good business with possibility of having durable moat. So here is the story of Amara Raja.

Commpany Profile:

Amara Raja Batteries Limited (ARBL) is one of the largest battery manufacturing company in India. It has two divisions namely automotive and industrial. ARBL has very popular brands like Amaron, Powerzone and Quantas and very wide distribution network of 274 franchises across the country.ARBL is promoted by Mr.Ramchandra Galla. Jhonsons Control, world's largest automotive battery manufacturer, holds 26% in the company. ARBL has grown from strength to strength over the years and has successfully challenged the monopoly position of Exide in India. ARBL was the first company to introduce advance technology VRLA in India giving exide run for the money in Industrial segment and capturing growing telecom tower market.

Business Environment:

ARBL caters to two main segments namely automotive batteries and industrial batteries. In India, branded battery segment is duopoly with Exide and ARBL dominating the market. Even though Exide garners larger share in automotive market due to its relationship with two-wheeler and four wheeler OEM, ARBL is fast catching up. Over the years, vehicle owners are slowly shifting focus from unbranded battery to "proven and branded" automotive batteries which is helping both Exide and ARBL. Considering the duopoly nature of the business and perecieved value of the "brand", there is moderate pricing power. Typically, companies are able to increase prices with some lag to raw material (mainly lead which constitutes 60% RM cost) price.

Automotive segment

Exide is present in all the segments of automotive batteries namely four wheeler OEM, four wheeler after market, two wheeler OEM and two wheeler after market. ARBL is present in all except two wheeler OEM which it is trying to get foothold in next 2 years. ARBL commands 26% in four wheeler OEM, 34% in four wheeler after market and 24% in two wheeler after market. It has marquee client list like Maruti, Honda, Hyundai, GM, Mahindra, Tata, Chrysler, Swaraj, Ashok Leyland and many other names

Industrial Segment

 ARBL has developed a fairly robust product portfolio catering to needs of various industry including telecom, power, railways, oil & gas and UPS. ARBL introduced VRLA technology in industrial battery segment by leveraging its colloboration with Jhonsons Control. This move changed the competitve landscape by making a big dent in Exide's monopoly.  This early advantage was carefully scaled up by ARBL. As a result, now ARBL has become market leader in telecom and UPS sector with 46% and 32% market share. To give some more perspective: Over 50% of Indian railway's two and three tiered AC coaches are powered by ARBL batteries

to summarize on the business side

- battery manufacturing is relatively simple business (for sure no rocket science!)

- It is a steady and scalable business. every 3-4 years these batteries needs to be replaced and so the demand for the product is definitely going to go up only as they sell more batteries

-Operates in duopoly with moderate pricing power and competitive environment is benign

- Has strong brands such as Amaron, Powerzone and Quantas with well established distribution network across the country. In my opinion business that combines brand, reach and pricing power is very likely to qualify as high quality business.

Financials and Fundamentals:

I am not posting numbers here as 10 year financials are available on its website itself.

http://www.amararaja.co.in/annual_reports.asp

If we look at 10 year history, following can be inferred.

Profit & Loss:

- ARBL has grown its topline and bottom line have grown at CAGR 30% and 40% respectively even though from a lower base in 2001-02. In last 5 years ARBL has grown CAGR 18% on both topline and bottom line. Even though topline has grown consistently in all 10 years, bottom line degrew in two years 2003-04 and 2010-11.

Balance Sheet: 

-Very good management of balance sheet inspite of very high growth rates. Current debt to equity stands at 0.1 while the highest debt to equity was 0.95 in 2007-08. It has also managed its working capital needs well as its net current assets/sales dropped from 0.43 to 0.22. ARBL holds roughly 300 crores as cash on its balance sheet which is deployed in bank FD and liquid funds.

Cashflow:

ARBL has been generating positive operating cash flow for last few years and is typically slightly more than its net profit. Moreover, if we take into account depreciation as maintenance capex, company has been generating substantial free cash flow. ARBL is paying small part of this FCF as dividends while the larger part is redeployed in business for growth. I have no quarrels with this as management is generating very decent return on the capital and as Mr.buffet puts it the best business to invest in is the one where large amount of incremental capital can be deployed at high rate of return.

Ratios:

As warren buffet puts it, any business in the long term can not grow its value at higher rate than return it generates on its equity (ROE) and hence it is the single most critical parameter. ARBL has fairly decent trackrecord on this front. It has improved its ROE from 4.5% in 2001-02 to 29% in 2011-12. Moreover, Since 2006-07, ARBL has consistently generated ROE in excess of 20%. Similarly, ARBL has been able to expand its net profit margin from 4.6% to 9.1%. Both these indicates improving quality of business.

Management Quality:

As I went through ARBL's annual reports, I was impressed. ARs are exhaustive and gives a good sense of where business is going with clear articulation of future course of action. Moreover accounting is standard and I was not able to find major objectionable points. 

Actually, if one goes through AR 2008-09,   their treatment of forex losses indicate that company follows fairly conservative accounting practices. In FY 08-09, company had incurred forex losses of 33 crores (both cash loss and notional) due to unprecedented currency movement. As the forex movement was very sharp and unprecedented, AS-11 was relaxed to allow companies to book forex losses spread over next 3 years, however management decided not use this relaxation and booked whole loss in FY 2008-09 itself, impacting its bottomline considerably. This surely indicates, that company strives to provide "as is" picture of its business in its books too. 

  Management is doing a great job in terms of disclosures. Moreover, Jhonsons Controls 26% equity gives me lot of comfort on corporate governance front. In general, my sense is that ARBL management is competent and transparent with no major negatives.

Valuations:

ARBL is currently trading at TTM P/E of 12-13 times which is fairly decent considering impressive historical growth rate, ROE of more than 25%, free cash flow generation and  simple, steady and scalable business run by reasonably good quality management. Management has given guidance of 15-20% growth in bottom line which if we take on its face value, we are talking about forward P/E of 12. In terms of margin of safety, on a very rudimentary basis, if I assume 10% FCF growth rate for 10 years, 3% terminal growth rate and 12% discount rate, typical margin of safety is around 25%. However 10% growth rate is conservative considering past track record, size of the opportunity and growth plans. I do feel it is a high quality business and hence intrinsic value is going to grow considerably due to inherent quality of business.

Risks:

• Significant rise in lead price is one of the key risk as it directly impacts ARBL's margin. ARBL's competitor (Exide) has its captive lead smelter capacity which typically helps Exide reduce its lead cost. Thus Exide will be able to absorb rise in lead price more effectively with lesser "pass through" to end user. It will be difficult for ARBL to increase price in absence of price increase from Exide in after market segment and hence its margin may get impacted in that particular segment. 

• Another threat I see is  when Exide starts cutting its margin to improve its market share or stop eroding its market share. Even though, it is a distant possibility, it can not be ruled out.

Scuttlebutt:

As we all must have replaced battery one time or the other, I thought it is relatively easy to do a small scuttlebutt to find out whether story has any holes. I went around to various mechanics/garages/ battery dealers (independent and not Exide or Amaron) asking them that I need to replace my battery for the bike, which one should I buy? and to my utter surprise a large majority suggested Amaron ( I expected equal divide between Exide and Amaron). I probed most of them further about why not Exide? they said Amaron batteries last longer, slightly cheaper and comes with higher warranty. Many of valuepickr members too received similar feedback in different parts of the country. So on the ground, things gel in with the story.

Moat: 

For any battery company to succeed, they must create reach across the country not only in cities but even in rural areas as vehicle population is spread all across the country. Moreover, being a critical component, people do prefer brands that are proven. Amaron, Quantas and Powerzone are very very strong brands. It takes years to nurture a strong brand and wide reach. A key attribute of such "moat" is pricing power. Consider this fact, lead prices have increased at CAGR 16% in last 10 years. Lead constitute 60% of the cost of battery. And yet, ARBL has improved its net margins from 4.6% to 9.1%. Thus, clearly company is able to pass on the price increase either through moving up value  chain or increasing prices! Another feature that is often downplayed is the technological edge that ARBL has due to its strategic partner Jhonsons Controls International (JCI). JCI has been instrumental in developing cutting edge technology giving longer life time, better performances and newer applications for many years and has strong R &D focus. Instead of fighting Exide on price front, ARBL has smartly leveraged this advantage to dent big holes into the monopoly of Exide by taking away large market share.

In all, I think ARBL is a high quality business having reasonable moat (and likely to build sustainable moat) which is simple, steady and scalable, run by  efficient and reasonably ethical management, available at a decent valuation.

Psychology of Human Misjudgement and Investing - Part 1

I am sure many of you must have heard about Charlie Munger as vice chairman of Berkshire Hathway and astute value investor who is partner of warren buffet in Berkshire Hathaway. Warren buffet has publicly acknowledged the invaluable contribution that Mr.Munger has made towards the success of Berkshire Hathway. In a sense, Mr.Munger was instrumental in shaping Warren Mr.Buffet's philosophy of "paying for the quality". As Warren Buffet has put it, it is better to buy a great business at reasonable price than buying a reasonable business at great price. However in my opinion, Mr.Munger has made even greater contribution to the discipline of value investing by unfurling how  some very prevalent psychological tendencies contribute towards faulty and ill conceived decision making. I have gained immense insights about our psychological fallies  by reading Mr.Munger's transcript of Psychology of Human Misjudgement. In the essay, Mr.Munger has talked about 25 psychological tendencies/biases that is likely to result into human misjudgement. Most of these  misjudgements lead to faulty decision making without even realizing one has made mistake. I would like to talk about 8 such tendencies which are very prevalent and will try to put forward my point of views on how these biases will cause errors in decision making from investment perspectives. In the first part, I will discuss four tendencies namely reward and punishment super response, inconsistency avoidance, influence from mere association and excessive self regard. In the second part, I will focus on deprival superreaction, social proof, contrast misreaction and availability misweighing.

At the outset, I would like to mention that most of the points discussed here not my ideas and are merely my interpretation of Mr.Munger's essay on the subject. I would like to also mention that Prof. Sanjay Bakshi's hugely insightful lecture notes on this subject has contributed immensely to my understanding of the subject.  

Reward and Punishment Super response Tendency: In very simple words Mr.Munger is talking about power of incentives. According to Mr.Munger, incentives or disincentives are the most important in changing cognition and behavior. As he puts it " I have been in top 5% of my age cohort all my adult life in understanding the power of incentives and yet I have always under estimated that power". Out this enormous power of incentives, arises what is called "incentive caused bias" which drives a fairly decent and good intentioned person, consciously or unconsciously driven by incentives, to drift towards immoral/unethical/unprofessional behavior. Not sure how it works? Remember that insurance agent who sold you ULIP/guaranteed return plans laden with hidden charges, large upfront deductions and meagre insurance covers? What drove and still drives most insurance agents is the commission that they get on policy and ostensibly commissions were highest for ULIP plans. So a fairly decent guy i.e. insurance agent was driven by incentive of "maximizing his returns" without worrying about sub par returns to the policy holder! So how is it relevant in making investment decisions? 

My two cents:

• As Warren buffet puts it, "never ask a barber whether you need haircut". Be wary of trading calls/advise from brokerages/brokers as they would, almost always want you to trade more to earn more brokerage, even in situations when the best action is "no action".
• Management having high shareholding in the company has natural incentive towards value creation and sharing of value. Hence high management shareholding shall certainly be regarded as "positive" 

Inconsistency Avoidance Tendency: As Mr. Munger puts it, the brain of a man conserves programming space by being reluctant to change , which is a form of inconsistency avoidance. If we look at worldly wisdom, "first impression is the last impression" which is a combination of doubt avoidance tendency (another tendency discussed by Mr.Munger in his essay which leads to our habit of jumping to conclusions) and then ignore all the facts/incidences that are not consistent with the initial opinion formed. As lord Keynes put it " it is not intrinsic difficulty of new ideas that prevented their acceptance. Instead new ideas were not accepted because they were inconsistent with old ideas prevailing".  And Mr. Munger comes up with a wonderful metaphor that human mind works a lot like a human egg. When one sperm gets into human egg, there is an automatic shut off device that bars any other sperm for getting in. For human mind, idea is like a sperm which penetrates human mind and shuts off the mind from any other ideas. 

From these tendencies arises "confirmation bias". We tend to over weigh evidences that confirm with our conclusions and under weigh evidences that counter our conclusions/judgement. So how does it impact investment decisions? 

My two cents: 

• This is one of the most potent bias that has ability to cause us huge loss  financially! A typical situation would be to clinging on to stock which was   bought in the first places out of "misjudgements" or "mistakes". As time passes, contrary evidences emerge nullifying   one's investment hypothesis. However, driven by confirmation bias, investors under weigh contrary evidences and do not sell such "losers". Not only one suffers from "loss of capital" from such losers but also suffers opportunity loss (sometimes "huge" due to very attractive investment opportunity) from not liquidating such position and reinvesting it in much better opportunity. I. myself, has fallen into this many a times in the past. 

Influence From Mere Association Tendency: There is a typical tendency in most of us to associate one event with the good/bad outcome in spite of no causal link between event and outcome. Mr.Munger talks about this tendency at length giving various examples. Many a times when people are presented with four or five similar purchase, quite a few of them will select the item with highest price associating the "high priced" item with "highest quality" item even though there may be no causal relationship between price and quality. This tendency is also known as pavlovian association. Another typical example of such tendency is looking for patterns and trends where there are no such patterns/trends. Yet another pitfall that we experience is the extrapolating trends into future which is erroneous most of the times especially in predictions related to business/economics. Stereotypes is also the outcome of such tendency where we associate certain traits/observations with a set of people/communities/nationalities where actually there is no causal link between such traits and people/communities/nationalities and observations/traits may apply to only some identified people/communities/nationalities. 

My Two Cents:

• My hunch is that some good cash bargains  are created arising out of this tendency. A case in point: Piramal healthcare. Market typically views companies that hold large chunk of cash that it received from sale of asset/business/operations very negatively if proceeds from such sale is not fully shared with the shareholders and a large portion is retained with the company to be deployed in the business. This dislike arises from the fact that history is full of examples where in such situation dishonest or incompetent promoters either allocate this extra capital foolishly (by overpaying for acquisitions or unduly expanding aggressively) to generate  mediocre return on capital or stash away money into promoter's account through financial jugglery. However, market treats competent and ethical management (proven through track record) also with same stick and discounts it heavily to the extent that company is available for less than cash on its balance sheet! It is like getting a dollar worth of cash for 80 cents.... This happened with Piramal Helathcare when it sold of its domestic formulation business to Abbott for $3.7 billion by clinching jaw dropping deal. PHL management shared roughly 20% of the sale proceeds with shareholders through buy back program and rest of the proceeds it retained with the company to deploy effectively in existing and new businesses. Piramal management has exemplary track record of capital allocation and integrity over last many years, however market treated PHL in the same way as it would have treated a company of some third rate promoter! At one point in time, PHL was available at 70 cents for a dollar on a balance sheet with all fixed assets and operating businesses coming free on top! So market associated non deployment of cash immediately with "wrong intentions" of the promoter. I am sure if one understands that market has fallen for this "bias", one would be able to use the situation to take a great advantage out of such situations.
• Another example of such tendency is drop in price of all companies in a particular industry which is surrounded by negative sentiments or is in down cycle even though some the companies in the same industry may not have been impacted negatively and may actually be reaping positive results of such situations. 

Excessive Self Regard Tendency: Mr.Munger points out to the fact that most of us misappraise ourselves on the higher side on many of our abilities than objective assessment will reveal. A typical example he shares is that 90% of Swedish drivers consider their driving skills above average! Similarly, one typically values his/her possession more than realistic estimate of the value of possession. As Mr.Munger points out that man's possessions, once owned, suddenly become worth more to him than what he would pay if they were offered on sale to him and he did not own them! How about lottery ticket? Odds of winning a lottery for a randomly selected number is as good as (or as bad as!) the number "chosen" by the purchaser of the ticket. However, lottery company charges differently for randomly selected number versus a lottery ticket with a number "chosen" by the purchaser! They take take advantage of lottery ticket purchaser's excessive self regard in "choosing" a number which has more probability of winning....

My Two Cents:

• A typical folly arising out of this tendency is to over estimating the value of our holdings compared to intrinsic value of our holdings. This over estimation of our holding will not allow us to liquidate the position even when the price of the holding has exceeded its intrinsic value. This trap will lead to a situation where one holds on to investments where margin of safety no longer exist and by clinging onto such holdings one is letting go other attractive opportunities. Prof. Bakshi has suggested a wonderful antidote to this folly. Prof. Bakshi suggests that one should periodically liquidate the entire portfolio mentally to reassess whether one will invest in each holdings if it was a fresh investment decision! I have tried doing this, and let me tell you, it is a wonderful technique to avoid commitment/excessive self regard bis. 
• Most of us believe that we are better at the art of stock picking than our peers. So we will become "active" investors and make stock specific investments. However, if we analyze portfolio returns over a long period of time (which we often don't!),  we may find out that our track record does not support our assumptions of being "above average" stock picker! We may be under performing the index consistently and yet believe that we are good stock pickers! To avoid falling for this bias, one should maintain a close tab on the portfolio returns which if unsatisfactory, shall either resort to index funds or resort to "intelligent" investment adviser (by intelligent i mean an adviser who follows "value based" investment approach)

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.