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:

Year	Sales	Hire Charges	% of Sales	Operating Profit	% of Sales
2009	684.97	261.62	38.19%	-87.04	-12.7%
2008	705.32	125.64	17.81%	84.63	12%
2001	402	30.47	7.58%	151.93	37.8%

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.

Two years of consolidation?

I was looking at the S&P CNX Nifty statistics today in terms of P/E, P/B, and Dividend Yield as well as Nifty levels. Here are the data for last two years:

Date	Nify	P/E	P/B	Dividend Yield
26 June 2007	4285.7	20.6	5.4	1.11
26 June 2008	4315.85	16.66	3.86	1.4
26 June 2009	4375.5	20.08	3.63	1.14

Can this be called consolidation with the Nifty range varying between 6357.1 (8 Jan 2008) and 2252.75 (27 October 2008)?

Impact of changes in Accounting Standards

RBI changed the accounting standards to report foreign exchange gain/loss directly to balance sheet instead of showing them in P&L account. This has resulted in many companies hiding their foreign exchange losses in balance sheets. There are prudent companies like Infosys, Bharti, TCS and Ranbaxy who, instead of following the new accounting standard, adhered to the old standard and showed the exchange losses in their P&L account. If all the companies in Sensex had followed this practice the Full Net Profit of Sensex companies would have been lower by around INR 10K Crore and Free Float Net Profit would have been lower by INR 5660 Crore resulting in Sensex EPS lower by INR 68 and instead of INR 752, it would have been INR 674 on 25 June 2009. The P/E for Sensex at 14345.62 would have been 21.28 instead of 19.06.

This is not just the case with companies in Sensex. When the going was good, aka there was foreign exchange gains, the companies didn't hesitate to report them as profits in their P&L account. As soon as the standard changed, most of the companies started taking advantage of it. I would suggest investors to keep reading the fine print.

India Inc Dividend Payout decreasing

The historical data available on the NSE website for Dividend Yield of S&P CNX Nifty and S&P CNX 500 shows that even though the EPS of S&P CNX Nifty increased by around three times between April 2003 and June 2009; from INR 74 to around INR 220; the dividend payout increased only by twice from INR 28.45 to INR 55.15. The data is almost similar for S&P CNX 500. The EPS of S&P CNX 500 increased from INR 54.5 to INR 190, i.e. 3.5 times, the dividend payout only increased by two times i.e. from INR 23.15 to INR 45. Even if you consider the impact of DDT (Dividend Distribution Tax), the dividends would have increased to INR 64.9 and INR 52.95 for S&P CNX Nifty and S&P CNX 500 respectively. Are Indian companies becoming stingy?

Can you rely on increasing Margins?

Many renowned investors including Buffett, Philip Fisher prefer buying companies with high margins over low margins and companies with increasing margins compared to decreasing margins. But how good this measures are in the short run? Let's understand this with examples. Britannia had an operating profit margin of 10% and net profit margins of around 5.5% (excluding extraordinary items) in FY2001 and FY2002. This improved to 12.2% and 9.3% in FY2005. But the entry of newer players like Surya Agro (PriyaGold fame) and ITC took this down again to 8.3% and 5.8% in FY2009.

Contrary to this, Nestle had a permanent expansion in profit margins between CY1998 when its net profit margin was around 5.5% and CY2003 when its margin became 12.5%. During these five years, the revenue of Nestle increased from INR 1612 Crore to INR 2160 Crore, i.e. by 34% or 6% CAGR but net profits rose from INR 86.2 Crore to INR 263.08 Crore, i.e. by 25% CAGR. Since then margin expansion has stopped and revenue and net profits are almost in sync. Revenues rose to INR 4358.13 Crore in CY2008, i.e. by 100% or 15% CAGR and net profits rose to INR 534.08 Crore, i.e. by 103% or 15.2% CAGR.

We can conservatively say that Nestle has almost reached a saturation for margin expansion. Conservatively since The Coca Cola Company in the US has net profit margins near high teens, i.e. 17-19%. Britannia's counter part in the US, the Kraft Foods Company also suffers from low net profit margin of around 6-7%.

We can conclude that investors must remain cautious when relying on margin expansion.

Back to where it started?

Sensex has climbed back to the level BC (or BL i.e. Before Lehman). It was almost at this very level at the end of 8 August 2008. But the sectors and other stocks haven't done the same. Here is the list of under/outperformers:

Index	Performance relative to Sensex from 8 August 2008
BSEAUTO	+24
BSEPSU	+18
POWER	+10
BSEBANKEX	+9
BSECG	+5
BSEOILGAS	+3
BSE500	-2.5
BSEMETAL	-7
BSEMIDCAP	-11
DOL30	-11
TECK	-13
BSEHC	-15
BSEIT	-16
BSECD	-25
BSEREALTY	-34

What about individual stocks. See the table below:

Stock	Performance relative to Sensex from 8 August 2008
MARUTI	+60
M&M	+36
ACC	+35
BHEL	+25
HDFC BANK	+20
NTPC	+20
GRASIM	+16
JP ASSOCIATES	+16
RINFRA	+14
STERLITE	+12
LARSEN	+12
TATA POWER	+11
SBI	+7
ONGC	+6
HUL	+6
RELIANCE	+5
ITC	+3
INFOSYS	+3
ICICIBANK	+2
BHARTI	-2
WIPRO	-6
HDFC	-9
SUN PHARMA	-9
TCS	-9
TATA MOTORS	-20
RCOM	-25
HINDALCO	-30
TATA STEEL	-30
DLF	-33
RANBAXY	-44

Surprisingly, 19 out of 30 stocks has outperformed the Sensex, i.e. 63.33%. Thus chances of making money even at 15K last year was very good provided you thought contrarion. Nobody was buying auto in 2008 but it has been a stunner. Can the history repeat? I doubt about it. Investors who were hiding behind FMCG, Pharma and IT also has not been able to beat the index with a huge margin.

How changes in Index constituents affect returns?

I will explain this by the example of Tata Power. As per the BSE website, Tata Power was replaced by RCOM on 12 June 2006. If we consider the market capitalization of both the companies at that time with their respective shareholding patterns of the previous quarter, Tata Power had a market cap of 8668.9 Crore with FF(Free Float) of .7 giving FF Market Cap of INR 6068.3 Crore while Reliance Communication had a market cap of 27018.95 Crore with a FF of .65 giving a FF Market Cap of 17562.32. Thus Sensex's FF Market Cap increased by 11494.02 Crore between 9 June and 12 June without giving any increase to the index (when a new company is introduced to Sensex, the FF market cap of the Sensex for the previous day is increased by difference in FF market cap of incoming and outgoing companies).

Now the same Tata Power entered the Sensex back on 28 July 2008 replacing Cipla but the scenario was different. Cipla had a market cap of 17535.69 Crore with a FF of .65 giving a FF market capitalization of 11398.2 Crore. Tata Power had a market cap of 22419.18 Crore with a FF of 0.7 giving FF market cap of 15693.42 Crore. Thus Sensex FF market cap increased by 4295.22 Crore between 25 July and 28 July without giving any increase to the index.

Thus, the increase in FF market cap of Tata Power company between 12 June 2006 and between 28 July 2008 amounting to 9625.12 Crore didn't contribute anything to the Sensex since it was moved out and then moved in again, which amounts to around 1% of 9 lakh Crore worth of FF market cap for Sensex. This is significant loss to the Sensex Index plan investors.

Competition eating Margins

Most people reading this blog would have seen a lot of posts discussing competition in business. Let me discuss an example of Finolex Cables. Following table shows revenues and profits of the company over last 13 years:

Year	Revenue	Profits	Margin
1996	514.1	55.1	10.71%
1997	480.6	48.4	10.07%
1998	460.9	48.6	10.54%
1999	465.6	62	13.31%
2000	576.1	70.1	12.17%
2001	627.9	72.5	11.55%
2002	675	66	9.78%
2003	518.9	24.7	4.76%
2004	568.9	29.6	5.2%
2005	670.1	30.8	4.6%
2006	889.9	50.4	5.67%
2007	1140	81.18	7.12%
2008	1417.9	88.91	6.27%
TTM	1463.41	-28.23	-1.93%

It is clearly seen that during the last business cycle of 1996-1997 the margins were in double digits but the margins started collapsing in 2003, both due to competition and increase in raw material prices. Even at the peak of business cycle in 2007, margins never went up to the last business cycle. This is due to newer players like KEI, Diamond Cables, Delton Cables and Paramount Communications etc. eating into Finolex brand.

Are we following the footsteps of the US?

I want to bring to notice the shift in investor methods of valuing a company in Indian stock market lately. It seems that too much emphasis is given today on future growth in profits than the current and past earning power of the company, the method followed by value investors. As shown in my previous post, the earnings can become stagnant even though the economy is growing, as happened between 1996 and 2002. During these times, the valuation of the companies do not depend on their growth but clearly on the current earning power of the company. When the growth will evaporate, the P/E ratios of companies will come down near to inverse of after tax yields on bonds, i.e. earnings yield (inverse of P/E) will match the after tax yields on bonds. The CNX 500 clearly shows the shift of P/Es to higher levels over the last 6 years. If we consider the data between 1 January 1996 to 30 April 2003, which includes the P/E ratios of 2001 tech bubble, 53% of the time CNX 500 P/E was below 14 but if you take data between 1 May 2003 and 2 June 2009, that 53% comes at a P/E of 17.5. CNX 500 remained below P/E of 15 for 65% of the time during 1996-2003 and during 2004-2009, only 20%. The other reason for this shift can be low interest rate too, but keeping interest rate too low for long periods of time can also lead to disasters.

How does this shift in P/Es affect an individual investor? As can be seen in American Market, if it is already known that stocks give good returns over all the asset classes in the long run, they will be quoted higher by bidding up the prices and the outperformance will no longer happen. For Indian equity markets too, I feel that the recent shift in investor enthusiasm will erode the gains in future. Anybody who is investing today will after 10-20-30 years realize that they overpaid for growth. People who bought stocks in 1996-2003 period paid for value and are getting rewards for their conservative investment strategy. Investors buying today with a hope of growth are just diminishing their real investment returns of future. Seth Klarman, a renowned value investors had commented recently that stocks in the US were never allowed to become cheap in the last 20 years (average P/E of 24.9 vs 17.2). What followed is that at the end of this overvaluation, stocks underperformed the bonds as discussed here. A similar fate can be seen in Indian markets 10-20-30 years later when people like me are near their retirement age and will feel the same as Baby Boomers generation is feeling right now in the US, 'helpless'.

The only advice is "be cautious".

Let's discuss P/E - Part 2

Extending Part 1 of this post, I would like to discuss P/E ratios of S&P CNX 500 instead of S&P CNX Nifty, the reason being P/E, P/B and Dividend Yield data for Nifty is available only till 1 January 1999 but similar data for CNX 500 is available till as far as 1 January 1996. This makes averaging of P/E etc. for five years possible during the bear market of 2001-2002. CNX Nifty 500 earnings on 1 July of each year between 1996 till 2002 was 59.2, 53, 51.2, 51.95, 41.3, 47.22 and 57.07. Thus the EPS didn't grow at all between 1996 and 2002 and the CNX 500 was trading at 775 on 1 July 2002, the same as on 1 July 1996.

Because of this discouraging performance by India Inc., shares were thrown away by investors for prices not reflecting the true potential of companies with CNX 500 on 1 July 2002 trading at 775 with a P/E of 13.55 and P/E of five year average EPS of 15.75. In September of 2001, when CNX 500 touched 545.85, the P/E ratio was 11.58 and P/E of five year average EPS was at 10.9, i.e. average EPS of five years was higher than the EPS of last year. The last time CNX 500 had reached 545 was in December 1996, five years without any returns.

Let's compare this with the recent data of July 2007 - March 2009. On 1 July 2007, the EPS of CNX 500 was 191.25, 3.22 times 59.3 of 1 July 2002 but CNX 500 was at 3630, 4.68 times 775 of 1 July 2002. This shows that 45% of the returns were due to P/E expansion and not because of earnings. The biggest worry was that due to earnings rising very fast, the five year average EPS was just 108 and P/E of five year average EPS was 33.6, more than thrice that of 1 July 2002. This shows how much investors were overpaying for growth.

Now compare the scenario of March 2009. EPS of CNX 500 is at 175 with average EPS of five years at 155 and CNX 500 at 2000, i.e. P/E of 11.42 with P/E of five year average EPS at 12.9. The recent rally might be taking people by surprise but the valuations do justify it based on P/E. Even P/B and Dividend Yield were similar to the bear market of 2001-2002.

Now compare this with current valuations. EPS of CNX 500 is at 188 with average EPS of five years at 159 and CNX 500 at 3650, i.e/ P/E of 19.4 and P/E of five year average EPS at 22.95, not very cheap but not very expensive either if compared with the valuations in January 2008 when P/E was at 27 and P/E of five year average EPS at 44.

Recommendations Performance

I would like to take stock of my recommendations. Here is the table:

Stock	Date Recommended	Price Recommended	Price Today	Stock Return	BSE 500 Return
Emami	March 13 2008	225	350	55.56%	-9.08%
Auto Axles	June 18 2008	275	160	-41.81%	-9.15%
ZF Steering	June 18 2008	160	145	-9.38%	-9.15%
Gateway Distriparks	June 18 2008	92	98	6.52%	-9.15%
Britannia	July 13 2008	1350	1700	25.93%	5.61%
Savita Chemical	July 7 2008	215	160	-25.6%	6.07%
Banco Products	July 7 2008	29	31	6.89%	6.07%
Indra Gas	July 7 2008	110	140	27.3%	6.89%
CMC	March 21 2009	285	570	100%	69.35%
D Link	March 21 2009	38	67	75%	69.35%
Geometric	March 21 2009	15.3	26.85	75.51%	69.35%
KPIT	March 21 2009	25.65	51.25	100%	69.35%
Nucleus	March 21 2009	46.25	84.8	83.8%	69.35%
Polaris	March 21 2009	46.6	90.7	94.57%	69.35%

The biggest outperformance was from Emami by 64.64% and the biggest underperformance was done by Automotive Axles by 32.66% and Savita Chemicals by 31.67%. Out of 14 recommendations, India Value Invest outperformed in 11, i.e. 78.57% of the time. Who wins? Of course, value investment.