Tuesday, June 30, 2009

Right in the short term Wrong in the long?

Even the value investors face a dilemma when they find a stock whose intrinsic value is decreasing. Even though the investor buys with a margin of safety of 50%, i.e. a stock with an intrinsic value of INR 100 at a price of INR 50, the sentiment of the market plays a huge role in returns. If the sentiment does not change for two years and the intrinsic value decreases at a rate of 15% a year, after two years, the intrinsic value of the stock will be INR 72.25 and the margin of safety will decrease to 30.8% instead of 50% with which the investor started. Let me take an example of one of the company I was researching lately. The company is Dredging Corporation of India. The company at the end of FY2008 (FY2009 balance sheet is still not out) had a net current assets (NCA) of INR 663.6 Crore. In the October 2008 - March 2009 carnage, the stock price reached INR 200 (the low was INR 180) and stayed there enough for a value investor to buy it. The total market cap of the company at INR 200 was INR 560 Crore, less than its NCA. The company gave INR 15 as dividend in FY2008 and is debt-free. The company had generated free cash flows (FCF) of more than INR 150 Crore over the last five years, giving price / FCF of just 3.7. The market was clearly not valuing the company correctly. Then came the pop in stock markets and the share price reached a high of INR 650 with the market cap of INR 1820 Crore, 3.25 times that of the bottom.

Now comes the long term valuation. Even though the company is producing an FCF of INR 150 Crore over the last 5 years, the operating profit margin of the company is under pressure lately due to high hire charges of dredge. Following table summarizes the impact:






YearSalesHire Charges% of SalesOperating Profit% of Sales
2009684.97261.6238.19%-87.04-12.7%
2008705.32125.6417.81%84.6312%
200140230.477.58%151.9337.8%


The operating profit margin has gone down from 37.8% in 2001 to -12.7% in 2009. This clearly is a company with decreasing intrinsic value. It's the INR 145 Crore other income that allowed the company to report profits at net level.

Even though a value investor didn't analyze all these facts and just bought the stock based on NCA, he would have got 150% returns in just six months, not a bad bet I guess.

Remember that Warren Buffet made most of his returns with this kind of investments in the early days but tilted more towards long term approach later.
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2 comments:

Sudheer Gajula said...

Hi Chinamy,
I am Sudheer, now in process of learning the fundamentals by lot of reading, particularly in investopedia.com. I would like to be in touch with you. I would like to learn things. I have read a lot, but finding difficulty in correlating what i learned by reading with the actual figures of a stock. Could you please guide me in general?

Thanks in advance.
Sudheer

Chinmay said...

Hi Sudheer,

I am sorry but I am not a professional financial advisor. I do not have any degree in finance so apart from recommending some books and websites to clear your fundamentals, I cannot help much. The books I recommend are already available on my blog in amazon books widget. I am maintaining this blog to just represent my personal finance and you shouldn't take my advice for your own investments.

Chinmay

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