Wednesday, November 24, 2010

Sometimes number two (or even five) is better than number one

This is a long post with some examples. This post is to highlight the fact that it is not always number one in any particular industry, either in terms of sales or profits, who is the best. There might be special situations when some company down the rank in terms of sales and profits doing better than the leaders in its industry.

I will explain this with two examples. The first one is in organized sanitary-ware industry. There are many players in this industry with leaders like HSIL (Hindustan Sanitaryware and Industries), Kajaria Ceramics, Somany Ceramics and some unlisted players like Parryware, Jaquar etc... But out of these, there is one company that stands apart is Cera Sanitaryware. The company is small in terms of size but if you compare the balance sheet of the company with that of the leaders in the industry, it really is a much better company. Here is a comparison of some of the parameters that really matters to an investor:

Total Income (FY10 Consolidated)818.85545.29736.35193.83
Net Profit(FY10 Consolidated)43.6520.3935.8519.61
Average ROCE13.1413.4113.7822.33
Average OPM17.3510.9516.1317.49
Net Profit Margin7.143.84.8910.11
Fixed Asset Turnover0.781.841.341.94
Interest Cover2.643.712.3312.83
Debt Equity Ratio11.871.390.31

One parameter that has a lot of impact is ROCE. If the ROCE is high, the company does not need to invest a lot of capital. This increases fixed asset turnover, reduces debt/equity ratio, increases interest cover and improves net profit margin. So the company does not need to focus on each and every ratio. Just improving ROCE itself has a lot of impact on the company's balance sheet. Interest cover of 4 or less is considered risky so all the leaders are riskier to invest in at this time than Cera.

Now let us talk about the second company in a completely different sector, paper. The industry has many leaders like Tamilnadu Newsprint, JK Paper, Ballarpur, Andhra Pradesh Paper Mills, Seshasayee Paper etc... But of all the companies, one that stands apart is South India Paper Mills(SI Paper). Here is a comparison of the company with that of leaders:

ParameterTamilnadu NewsprintJK PaperBallarpurAP Paper MillsSI Paper
Total Income(FY10 Consolidated)1079.761260.863818.49657.36128.29
Net Profit(FY10 Consolidated)126.0691.03197.0354.1913.77
Average ROCE13.2711.169.7665.7522.11
Average OPM24.2417.4522.3915.8615.58
Net Profit Margin11.747.175.168.310.75
Fixed Asset Turnover0.470.890.50.611.35
Interest Cover4.23.542.183.5110.86
Debt Equity Ratio1.691.171.60.980.267

Some of the figures may not be very accurate since consolidated figures are hard to find. But the ones given above do give an approximate picture. Except for the last parameter, for all other parameters, the company is better if the parameter is higher. You can see that in both the examples, the smaller companies are having a much better control over their balance sheet compared to their leaders.

This analysis is not true for all the industries. Asian Paints is the leader in paint industry and still has better balance sheet than its competitors like Berger and Kansai Nerolac. Till very recently, Infosys was doing much better than the leader TCS but now TCS has overtaken Infosys in terms of profitability etc... 
An institution with securities of its own to sell cannot be looked to for entirely impartial guidance. - Benjamin Graham
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Anonymous said...

Hi Chinmay,

Have been a long time reader of your blog and thought of asking one thing which has puzzled me for some time now.

While calculating the ROC we take 'C - Capital' as the face value multiple by number of shares issued , right ?

If it is so, then my doubt is why the amount which is normally taken by a company in form of share premium not taken into account in this calculation ?

Typically when comapnies come out with IPO, they take much more than the 10 rs which is the face value of share. So, that premium amount also is in the end used for the returns generated by the business. Then why is not taken into account in ROC calculation ?

I am a newbie trying to learn the nuances of investment. So, pardon in case there is some fundamental mistake in the question.


Chinmay said...

Hi Raja,

As per my understanding, Capital here is Equity (Net worth) + Debt which does include premium too. I am not a financial expert though. You can read more about ROC here


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