January 29, 2009

NIIT tech: A falling knife ?

I received a question : NIIT tech has dropped from 100 to around mid 50s. Is it a falling knife which one should avoid ?

I have written a post on the
above topic earlier. So the point is how does one avoid a falling knife scenario ? In other words when it is wise to increase the holding as the stock price is dropping versus avoid averaging down.

Two factors
I would answer the above question based on two key factors one should keep in mind when purchasing a stock. The first factor is the intrinsic value of the stock. One should have decent idea of the
Intrinsic value range of a stock. If the stock price is dropping and the stock is more undervalued now, one can look at increasing the holding.

The second factor is position size or risk management. Personally when I am looking at a stock, I make a decision on whether the stock would be a part of my core portfolio or the cheap-graham portfolio. Once I have made that decision, I have pre-set limit on the position size. One can have an amount or percentage of the portfolio - position size. I typically start off with a 50% position (50% of the full position) and keep adding as the stock price drops.

Once I had built the full position, I will not add to the position even if the stock price is dropping. This is the key to risk management. I regularly check my thesis to confirm if any of my basic assumptions are incorrect and if my estimate of intrinsic value is too high. However I will not add to my position even when the stock price falls. There is no averaging down for me, once I have built a full position

70% strike rate
I have read that most of the top investors typically have 70-80% hit rate. That is 20-30% of their stock picks result in losses, either due to bad luck or incorrect analysis. I don’t believe I will do better than that. I have now started working with an assumption that 20-30% of my picks will fail. In such a scenario, the risk management aspect is crucial. To do well on a portfolio basis, my successful picks should do better than my failures.

What about NIIT tech ?
In the case of NIIT tech or any other company, my focus is on intrinsic value and not on the stock price. The stock price can get disconnected from the intrinsic value for sometime, but it eventually converges to it.
My own estimates of intrinsic value for the company have not changed. The current quarter results show a bottom line drop of around 50%, mainly due to forex losses. I do not consider them as core losses (just as forex gains are not permanent gains). I have seen a lot of people get all worked up about forex losses, which does not make sense to me.
Unless the company is speculating on forex (via non effective hedges), I think the forex gains and losses should even out over the period of few years and hence one should be concentrating on the core profits to value the company.

As an example look at the results of the airlines such as southwest (in the US). Southwest airlines has been consistently profitable for the last 20+ years. They have had 2-3 quarters of hedging related losses due to oil price volatility. Do you think they have a problem in their core operations?

Anyway, I digress. Coming back to NIIT tech, I have not changed my estimate of intrinsic value and I have already built my planned position. As a result even if the price drops, I will not add to my position to manage the risk (if I am wrong about NIIT tech).

Management issue
However if you believe that in light of the satyam episode, you cannot trust the management , then the only course of action is to exit the stock.
Personally, the moment I lose faith on any management and cannot trust them, I will exit the stock irrespective of the loss I have to take on my position.

As an aside, my previous post was in jest. I received a few personal emails ‘challenging’ my prediction and one guy asked me why I did not predict the level, if I knew the time . I have no clue where the market will be in the future. However if you want to pay me, I can guess for you :)


Anonymous said...

Hi Rohit
Do you see any opportunity in Tata CCPS. as on 1st Sept 2009, 6 CCPS stocks will be converted in 1 Eq of TISCO.

CMP of CCPS is 27
CMP Tisco is 184

So CCPS is trading at 15% discount.

Can you throw some light on this?


Vic said...

Hi Rohit,

Thanks again for another wonderful post, loved it.

The Southwest example was a good one.

It think I need to take personal lessons from you..:-)


Rohit Chauhan said...

hi ani
i have not seen the details , but arbitrage pricing does not seem attractive...a 15% gap for 8 month period is too low. you will make this return if the difference remains intact or close.
this would work if you could buy CCPS and short tisco

Rohit Chauhan said...

hi vic

a lot analysis on companies does not make sense. most of the times people are analysing the next quarter ..looking at some forex loss and making calls on the stock
that is stupid. a one forex loss is like dropping your wallet ..its a loss but not a permanent reduction in value

that said, does not mean NIIT tech will work out. it could still be a bad idea, but the reasons would not be due to forex losses, but due to weakining core business


Anonymous said...

Hi Rohit,

NIIT Tech have forward hedge contract for 24-30 months @ $=Rs 41.5. If exchange rate moves around 45, they are going to loose money for next 24-30 months (Am I right?).

They are also going into SEZ - looks like primerly for thier use. So they are going to spend quite a bit of money in this.

I invested in this stock as it has MOS and divident yield of around 12%. As money will flow into SEZ business, divident may be reduced.

What are your views on above?


Rohit Chauhan said...

hi prashant
i dont remember the exact numbers, but you are right. niit tech are a rupee appreciation. if the rupee appreciates, the losses will reduce from current level on the effective hedges.
the non effective hedge losses are marked to market and require a p&l impact

the SEZ plan is the quite worrying. i read about it and dont have the details. if it is for thier use, then it is capex and i have no worries. but if this is diversification into real estate, then we have trouble


Amit said...

I think that NIIT Tech's hedge position does warrant a careful look. As per my memory of their latest con call transcript:

There are about 250 odd millions of open hedge positions on USD:Rupee whereas pound:usd positions are not hedged (and they make a lot of their revenues in pounds). So this creates a rather different scenario than normal hedge transaction because effectively NIIT Tech is short on dollars. So whereas a typical IT company that earns dollars will lose out on the forex gains if dollar appreciates above hedge value, NIIT Tech can theoretically find itself in a position where it does not earn enough dollars to cover its short positions and can actually bleed profusely under really adverse scenarios (if both pound and rupee depreciate against dollar and pound also depreciates against rupee). I think they have already provided for about 170 cr or so of MTM losses as hedge reserves which (if currency rates do not change) will be reflected in p&l over the next 2-3 years (so 60 cr per year potential profit will not be made assuming equal distribution). Then, there are potential side effects of this hedge position like temporary loss of competitive position due to inability to compete on prices during the current downturn.

Yet, I think that the market has overblown this issue and NIIT Tech does appear under priced. Management seems to be cognizant of this risk and have tied in future orders (strong order book growth in last 2 qtrs + increase in dollar orders). As for SEZ, NIIT Tech seems to be having one of the highest rental expenses in the business and moving into SEZ will help them continue with tax advantages as well as reduce rental expenses, so I think the move will not really be that bad after all.

Rohit Chauhan said...

hi amit
i agree with your comment 100%. the hedge position is a negative for the company. i read the transcript too. the company has hedged @ around 43 to dollar for the next 2-3 years. So with the current depreciation they have already booked MTM losses in the balance sheet which will flow through to the P&L if the currency remains at the same level. if it depreciates further, one could see more losses or viceversa.

for one, i would have liked to know what management thinks about such a stupid bet. granted no one can predict currency movement, but to take such a unidirectional bet for such a long duration is stupid and someone's head should have rolled.

that said, this bet on its own does not destroy the competitive position of the company and i differ from you on that. it equivalent of someone getting robbed of his cash, that does not reduce his future earning power


Amit said...

This is an interesting observation...

Let me elaborate why I feel there is possibility of a "temporary" loss of competitive position. As you rightly said, it is like getting robbed of cash but the key thing is that you are getting robbed of cash that you will earn in future (since the hedges have not yet flown through the p&l as yet). So this should not be very different than any other cost you have to bear.

So let us look at 2 retailers who earn daily revenues of 1000 rs and retain rs 60 as profit post expenses. Now assume one of them has to pay Rs 60 each day to the local goon for the next 3 years. What would you say of the impact this will have on his ability to win business viz the other retailer even if he might have provided for this outflow in his balance sheet? And add to that an era of recession where everyone is trying to figure out ways of saving the last paisa.

So even though I might be looking at the same impact twice in case of NIIT Tech (by first reducing profitability and then looking at costing impact), it depends heavily on the management maturity as to how they carry through this time. They can potentially turn it around by aggressively going for a much larger revenue so as to reduce the impact of the outflow due to hedges (since that is kind of capped unless currencies move further) but it may be a little difficult given the macro trends.

And sorry if I did not state this earlier, I actually have a position in the stock since I believe that the price has over corrected.

Anonymous said...

Hi rohit,

There is a similar stock idea currently in Nucleus software. Company is trading below it book value and close to its cash value. The forex hedges are minimal and i believe they will benefit from current rupee depreciation.

I like your analysis and would like to know your opinion on nucleus.