June 12, 2007

The Gut feel test of investing

The gut feel test may sound totally illogical and irrational, but I have used it several times. I have posted my investment approach earlier here. As I wrote, I run various filters and do a 1-2 hour check on the basic financials of the company. That is followed by reading the Management discussion and analysis.

If the numbers do not look ok, I tend to give the idea a pass. There are no set rules for the numbers to look ok. Let me list a few cases

1. In case of aftek the acqusition of promoter held companies was a red flag for me. Clear case of conflict of interest
2. In case of Dr reddy’s and other pharma companies the valuation of the company seems to be high and I do not have the skills to evaluate the success or failure of ANDA filings
3. In case of JSW holding, more than 60-70% of the value is due to JSW steel. I do not have a specific insight into the steel business. As I could not evaluate whether JSW steel is fairly valued or undervalued, I decided to give JSW holdings a pass.
4. In 2004-2005, I felt bharat forge was fairly valued and could not project with confidence if the performance would continue. Hence gave the company a pass. Clearly a mistake, but a rational and acceptable one.
5. Indraprastha gas limited – Gas is available at a subsidy. Future margins may drop and hence the current price seems to be reflecting that. So no undervaluation although the stock appears to be so by past measures.

A lot of times, I have analysed the company and towards the end a few points keep nagging me. If I cannot evaluate those critical issues with confidence, I tend to give the stock a pass. The risk of this approach is that I tend to miss out on several good opportunities. I however do not agonize over it if the reason was related to my circle of competence, wherein I do not have the necessary knowledge to evaluate the company well.

In a few cases however, the level of undervaluation may be so great that I have a large margin of safety. In such as cases even if I have a few issues with the company, the downside risk is low and the risk reward equation seems to be fine. In such cases I may buy the stock and hold it till the undervaluation dissapears.

7 comments:

Ranjit kumar said...

Hi Rohit,

Today Praj Industries converted warrants equivalent of 8% equity for Vinod khosla, pramod chaudary and all. I have a litte confusion, are these warrants reflected in the total number of shares when they are allocated or when they are converted. In the later case the eps for the next quarter will be hit by 8%. Please can you clarify me.

Regards
Ranjit kumar

Gaurav said...

Have you looked at Britannia. Its margins have been depressed because of high sugar and wheat prices, and competition from ITC. With organized retailing coming in big force in India, top line growth should remain in double digits. Sugar prices have come down but wheat prices remain high. If you take a value approach and bet margins should revert to about 10% (from current mid-single digit and highs of 14%), the stock could touch Rs 2000 in a year, from levels of Rs 1500 today. Disclosure: I own the stock, for the reason I mention.

Rohit Chauhan said...

hi ranjit
warrants are not reflected till the conversion. they behave like options on the equity at a price. so when analysing a company it makes sense to get a handle on the open warrants, options etc and figure out the likely dilution (increase in equity). based on that likely increase in no. of shares, the new EPS can be calculated.

gaurav - i had a look at the britannia and felt that the current price the company may be good , but does not have the margin of safety i want. also as i do not have an insight on how the margins will be impacted, by when and if that reversion to lead to a re-rating. i am not sure if the commodity price alone would cause an improvement in margins if the competition remains high. also britannia's products may not be as impacted by organized retailing as the rural component of their sales is high

Ranjit kumar said...

Thanks Rohit - you have always been a person to reach out

Gaurav said...

Thanks Rohit. I agree that it is not a deep value situation. It is not about re-rating as the stock trades at a good multiple already (I think 31x on trailing), so to that extent there is no margin of safety. This story is more on EPS growth. The way competition impacted the industry over the last few years was that nobody raised prices, so margin pressue was due to increased costs and not due to price cuts. So if (and this is a big if) sugar and wheat prices decline, you will not see any price cuts. I am not sure whether Britannia sells more in rural areas - my uneducated guess would be that trade is more unorganized in rural areas, besides Britania is more expensive than Parle. Are you sure of this?

Have you looked at this company called Kirloskar Oil Engines Limited? It owns 10% of the stake in Toyota India (which makes Camry etc), besides other stakes. I would really like to know what you think of it.

Your blog is very good. Thanks.

Saahir Ekhlas said...

In my opinion the gut feel that Rohit talks about and forms an essential part of the investing process.
The process consisting of finding great companies at reasonable or undervalued prices. This is the half of investing concerned with the figures and opinions derived from figures.
The gut feel forms the other half which consists in evaluating the future of the business from viewpoints of competetive advantage and general growth prospects. There are no definite ways to do this and so one has to rely on 'Gut feel' which is a function of one s knowledge of the business and ability to look into the future to see how it would shape up in the years to come.

Relying on this second half Rohit has rejected companies such as JSW Holding,etc.

Maybe it is to develop this aspect of investing that investors like WB and CM recommend a multi-disciplinary model.

Rohit Chauhan said...

saahir - i think you have hit the nail on the head. i couldnt have expressed the idea better

gaurav - appreciate your comment. i have looked at britannia several times and somehow the company has not had the margin of safety in terms of price i look for. it could be my personal prejudices more than anything else
i own kirloskar oil engines and have posted on it earlier. you can check on this link - http://valueinvestorindia.blogspot.com/2006/10/hidden-value-kirloskar-oil-engines.html