Thursday, May 29, 2008

Reckless Investment by Mutual Funds

I want to show some deals by mutual funds that clearly targets reducing investor returns:

Fund SchemeStockPriceEPSP/E
Tata Indo Global Infrastructure FundMadhucon Projects7501263.53
Tata Infrastructure FundGMR Infrastructure2201.1200

Consider the deal by Tata Indo Global fund for Madhucon Projects. A company was bought with a P/E of 63.5. The company pays just INR 0.60 as dividend, a yield of less than 0.1%. The company's growth over the last 3 years has been impressive at 47% a year but even with that it will take 4 years for P/E to come down below 20. GMR also grew by 45% a year for the last 3 years. It will take 6 years for company's P/E to come down to 20. Madhucon has a profit of 50 crore with a market cap over 3000 crore. Even if after 4 years it earns more than 200 crore, it will be at par with IVRCL and Nagarjuna today. GMR after 6 years will have a profit of 1900 crore equivalent to what L&T has today. Do you think this will surely happen? There are so many ifs and buts.

Do you always have to buy stocks which are at such a high P/E when companies bigger than those are available at a lower P/E than their smaller rivals? IVRCL has a profit of around 300 crore (consolidated) and trading at market cap of 5000 crore. L&T has a profit of 2200 crore and trading at a market cap of 84K crore. Both are at much lower P/E than their smaller rivals. And putting Infrastructure in your scheme's name doesn't tell you that the stocks you buy should also have Infrastructure in their name.

Container Corporation, Asian Paints, Pidilite, Balmer Lawrie, Blue Star are also part of infrastructure trading at a much lower P/E than even the L&Ts and IVRCLs. Every bridge, building and house needs paint, adhesives and water proofing chemicals. Every mall will need an air conditioner. Every power plant needs coal transferred through container cargo. You can buy good infrastructure finance companies like SREI infra which was trading at a P/E of 4 till 2007. What we need is intelligence from Mutual Fund managers not stupidity.
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Tale of a Textile Machinery Company

I will talk about Lakshmi Machine Works. The company had a lifetime high of 12350 (617.5 at today's price) in 1996. The company's price went down all the way to 525 (52.5 at today's price) which is an erosion of 91.5% from top. Then started a big rally and the stock touched a new lifetime high of 4250 in December 2006. The stock is langushing at around 1500 today a correction of 65% from top. Reliance Long Term equity fund bought the stock at 2925 in September 2007 and ICICI Prudential Life Insurance at 2045 in January 2008. Reliance has lost 50% of 66 crore and ICICI has lost 25% of 18.7 crore that it has invested. Now why has this happened? Let's see the profits of this company over the last years:

YearNet Profit

Anybody who has the record only till 1999 will feel that the company has shown degrowth in profits only in 1 year. But if you have a good record till 1990s, you can see that the average profits of the company has grown by just {(242.3013+206.198+148.07)/(42.96+23.78+25.9)}^0.1 = 20.47%. When Reliance bought the stock it was at a P/E of 20 and when ICICI bought it, it was at a P/E of 10. Now the stock is trading at a P/E of just 7. The company earns around INR 200 and pays INR 40 as dividend. The yield turns out to be 2.66%. Why so much under valuation?

Graham has put a lot of emphasis on earnings stability. If you see, the company's earnings went down from 43.31 in 1995 to 8.41 in 1999 which is an erosion of 80% of profits. So if the same situation arises again, the company will earn just 49 Cr and P/E will expand to 35 at current prices. Is this warranted? 1999 was an exceptional year preceded by Asian Financial Crisis in 1997 and the textile exports had gone down and the Indian economy was in doldrums. I don't know if the same will happen again. The rupee appreciation has already cost several lakh jobs in south India and a company with an order book of more than 5000 crore now has got cancellation for many orders. Just like how it has happened for airline companies after crude price rise. Let's see ahead what happens.
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Paying too much for growth

Benjamin Graham while considering P/E, EPS etc. took an average of 3 years. To get an idea of growth of the company over the last 10 years, he will take average earnings of 3 years before 10 years and consider the earnings of last 3 years and then decide the growth rate. We will understand this with examples:
Take L&T, the biggest Engineering & Construction company in India and its net profit:

YearNet Profit

Thus average profit for 1996-1998 was 443.66 and average profit for 2006-2008 is 1960.9. Thus growth over ten years is 16% per annum while inflation rose at a rate of 6.36% during the time 1995-2005 (@ Inflation Index). The same company is commanding a market cap of 83K crore right now at bourses even after correcting 35% from its top of 130K crore. This is a P/E of 35.7 at the current price and 56 at the peak.

If you see, consolidated earnings growth was meagre 4% in the last year (standalone rose by 55% from 1403 to 2173 crore). Even if we assume it grows by 30% in year 2008-09 and 25% in 2009-2010 the P/E will still be 27 and 21 at the current price in 2010. And P/E will surely come down as the growth slows down, as already seen in IT companies.
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Thursday, May 22, 2008

Will History Repeat?

Looking at the recent correction in stock market, I started looking at historical data for benchmark indices to know how low the stocks could go. I was shocked to see the P/E ratios of indices during bear markets of 1999 and 2003.

The previous bull run of indian stock market started in November 1998 and peaked in Feb 2000 a bull run for around 15 months. The P/E range for this bull run was 11-28. The P/E ratio for Nifty was 10.58 at the start of bull run when Nifty was at 810.85 on 28-Nov-1998 and the bull run ended at a P/E ratio of 28.47 in February 2000 when Nifty peaked at 1756 on 11-Feb-2000.

If you analyze the data for the recent bull run between May 2003 and January 2008, a bull run of almost 57 months, also started with a P/E ratio of 10.84 for Nifty in May 2003 when Nifty was at 936 on 12-May-2003 and ended at a P/E ratio of 28.29 in January 2008 when Nifty was at 6272 on 9-Jan-2008.

After the last bull run the correction lasted for around 19 months and Nifty bottomed on 21-Sep-2001 at 854.2 when the P/E bottomed at 12.3. After that was a time based correction, i.e. Nifty earnings kept increasing but Nifty didn't see that much increase and so P/E contracted and bottomed at 10.84 on 12-May-2003 a time of around 20 months. Thus the total bear market lasted for around 39 months.

Nifty movement

The table shows that between 1998 and 2000, the Nifty EPS actually went down. This is in contrast with the current situation when the EPS has grown by 156%. If we assume that the history will repeat but earnings will continue to grow, then after 19 months we can say that at 21.88% earnings growth (which is what we have got over the last 57 months) the EPS of Nifty will be at 303.28. Multiplying this by the last P/E of 12.3, we get Nifty of 3730. This is still 25% below the current Nifty of 5025.

Are we headed for more pain? Two assumptions may change the scenario. Nifty EPS growth which has been only 11% yoy as per Nifty EPS Growth may make things worse since at 10% growth the EPS after 19 months will be 257.8. So at 12.3 P/E Nifty will be at 3171. The P/E may not go down as much as it did last time. It may remain at 15 or more this time due to EPS growth of 21% over the last 57 months. In that case the most optimistic scenario gives 303.28*15 = 4549 which was the recent bottom and the most pessimistic gives 257.8*15 = 3867. Let's see whether it goes to 3171 or remain 4549 in August 2009.
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Thursday, May 15, 2008

Amazing Performance by India Inc

Everybody is cribbing about slowdown of performance of India Inc. Forget about what large companies in Sensex are doing. Look at companies outside Sensex and you will be surprised to see that many of the companies have given their best performance ever in their history. For example

Company NameProfit 07Profit 08% Change YOY
Pidilite 111.7 195E 74.6%
Asian Paints 281.03 409.18 45.6%
Blue Star 71.18 174.09 144.6%
Exide 155.21 250.33 61.3%
Marico 112.9 169.07 49.8%
Nestle 315.1 413.81 31.3%
CRISIL 61.43 83.6638 36.2%

These companies cover sectors ranging from chemicals to food to auto to finance. All these companies have what buffet says is "MOAT" i.e. a strong brand recall, monopoly/duopoly and a long term competitive advantage in my sense. I don't think the bull run of India Inc ends in 2008. This seems to be the beginning.
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