February 24, 2010

The art of not investing

You have a lot of cash burning in the pocket and are looking for an opportunity to invest. An old time favorite is now selling for cheap. All and sundry feel that the company is undervalued especially if a series of ifs and buts get resolved. You look at the annual report of the company and it appears cheap by historical standards. Feeling confident, you go ahead and put in a decent amount of money.

Smart decision? maybe, but then maybe not.

Looking forward
Although no one can predict the future, it is an unfortunate reality of the stock market that stocks are priced based on the expected future of the company. I am using the word ‘expected’ as no one knows for sure. If someone claims that they are a 100% confident, then either the person is a complete moron or trying to sell you something.

If you are in the business of stock recommendations and tips, appearing anything but 100% confident is professional suicide. So I would blame the investor more for the garbage sold in the market than the seller. Do you really think all this junk would sell if there was no demand? anyway I digress.

So if one cannot predict the future, how does one invest? There is no surefire approach, though one can improve the chances of success by picking a company in stable industry. If the industry is fairly stable and not undergoing too much change, it possible to guess (all investing is finally a guess ..sometimes a good one or sometimes bad) with reasonable accuracy on how the company will do in the next 3-5 years.

An example
Let’s consider two companies. I am comparing these companies not from a valuation or investing standpoint, but purely trying to contrast their business performance. Stock performance in the short term is a different issue.

Let’s take the example of Gujarat Ambuja and Bharti airtel.
Gujarat ambuja is in the business of manufacturing and selling cement. It has grown at an average CAGR of 13-15%, maintained a net margin of 15% and an ROE in excess of 25%. It is not possible to know the exact profit or sales (many try that though) for the next 2-3 years, but looking at the business and the economics one can make a fair guess that business could clock 5%+ growth and 15% ROE for the next few years. Anything can happen, but the probability of the business achieving these numbers is high.

Bharti telecom is a telecom service provider, which has done extremely well over the last few years. The company has grown the topline at 30%+ and profit at 45% per annum for the last 5 years. The company has maintained an ROE in excess of 25%. These kind of numbers would warrant a PE in excess of 20. However the market is currently assigning a PE of 11 which values it as a commodity business. So is the market wrong? Some would say so looking at the past performance.

However there are certain structural changes and realities in the telecom industry

1. The industry has been witnessing severe price competition for sometime now. All the other companies other than bharti do not have great fundamentals (please look at the complete financial statement for all these companies and not the P&L account alone to understand what I am saying)

2. The industry has faced a lot of change in the past and will do so in the future. Do you really think anyone can be sure how the industry will look like in the next 5 years? What will be the technological changes, new entrants, government regulations etc?

3. Bharti is now expanding internationally via the
Zain acquisition. They are looking at additional acquisitions too. All this activity at the very least introduces more uncertainty into the equation.

The reason I have taken the example of bharti and ambuja cement is because I have analyzed both the companies in the past and gave a pass to both for different reasons. Ambuja cement was not cheap enough for me.

In case of bharti, if i was looking at the just the past data, it would be an incredible buy. However as I said earlier, investing and valuation requires looking ahead and in case of bharti my crystal ball is completely cloudy. It may be my own limitations, but that is precisely the point. If one does not have the confidence of being able to assess the long term economics of a company and its industry, then one should give the stock a pass. The last thing one should do is depend on someone else’s analysis to make a decision.

There is no penalty for missing on a stock idea – there are 5000 public companies and a decent portfolio requires 15-20 stocks at the most. I see no point in buying something where there are too many unknowns and I am not confident on how it will all work out.

11 comments:

Mitran said...

Can you share your thoughts on below scrips wrt to value buy?

1. Punj
2. EKC
3. Gremach

I am sitting with cash as you mentioned in the blog. Can you follow your portfolio scrips? if so, which is good buy with respect to CMP for an entry.

thanks in advance
Karthik

Vic said...

Thanks Rohit, a great learning post as always.

Vikas

Lucky said...

Bharti Airtel, at this price, is a great buy for a well-diversified portfolio of bluechips. This does not necessarily give it a place in a focussed portfolio.

One may expect the company to do better than the average telecom company. Further, the business is diversified (and is profitable in the other segments).

All this is of course from a very basic level of understanding of the company. And I am not so sure about Reliance Communication and Idea Cellular.

Rohit Chauhan said...

Hi karthik
i have not analysed these companies and leave a comment when i do so

vic - thanks for the comment

Rohit Chauhan said...

Hi lucky
i dont agree with the comment. The nature of the portfolio does not matter ..if you have confidence in the company then it works for all kinds of portfolio. also it will give cold comfort if bharti does better than other telecom companies when the entire sector is losing money.

i had a look at Rcom and the annual report is a nightmare. idea is kind of ok ..nothing great

rgds
rohit

anurag said...

Dear Sir,

I do interact with many investors,and I find most of Long Term investors are not buying much,inspite of some sectors/stocks are available at reasonable rates.

If you have any view on "Charlie It is basically over" then pls share.

Regards
Anurag Awasthi

Rohit Chauhan said...

Hi anurag
cant speak for others ..but i am not buying much ..for me to buy the stock has to be cheap and not just reasonable. also depends on one's expectations.

i am assuming you are referring to charlie munger's article ? that kind of gives view on what could happen to the US if they dont fix their casino culture in wall street

anurag said...

Dear Sir,

You have aptly summerised the article by mentioning 'Casino Culture'


Regards
Anurag Awasthi

Anonymous said...

Hi Rohit,
You are absolutely right that the telecom industry is undergoing several changes and has an uncertain regulatory (auction), pricing, consolidation and technology evolution around the corner. But there is a high collective worth to the industry today.
1. Telecom in India is not technology ... it is an FMCG business. 93% of subs are prepaid and buy about 200Rs worth of airtime every month. Even the FMCG industry doesn't command that kind of wallet share. We like to talk and are opinionated!
2. Anyone who ever owns a mobile phone almost never gives it up. I've owned one for the past 11 years and there are ~550Million in India like me. It is deeply ingrained into our social, corporate (biz) and personal lives. Very much like putting on clothes and brushing every day. Can't imagine life without it.
3. So whats the real worth of the telecom Industry as a whole. Over the next 3 years we will have about 80Cr subs in India each contributing about 250Rs (ARPU wars have happened everywhere but they dont last too long) monthly. Revenues of 80Cr*250*12= 240k Crore annually cant be ignored. Even at an EBITDA margin of 20% (currently more than 35% for Bharti), the industry collectively is likely to have EBITDA of ~48k Crore.
4. How much would you pay to owns this industry as a businessman. To simplify lets say 48Rs are deposited yearly into your pocket. I would be happy to dishout Rs500 upfront (3 yrs from today) or about Rs350 today. Thats a collective industry worth of 350kCrore only for wireless.
5. Now add in telecom infrastructure, enterprise business, VAS.
6. And then see whose cost of manufacturing a minute is the cheepest (maybe in the world) and who is capable of projecting its telecom dominance in India overseas.
7. Bharti stands out. At about Rs250 its a great value buy. My intrinsic worth comes in at about 320Rs.
Later,
Khalipililafda

Rohit Chauhan said...

Hi khalipililafda
you may excellent points on revenue and i am in full agreement with you on that. i dont think anyone denies the fact.
the issue is around margins ..a classic 101 question on competition ..in a price based competitive scenario as it is now and where marginal cost is close to zero or very low, the margin revenue is also close to the same number

what stops the competitive madness from eroding margins still further ?

case in point - airlines . the industry the world over has seen growth and still lost money. telecom has even worse pricing strenght ..one of the few products where there is constant price erosion. there has been a 15-20% price erosion per annum for last 10 yrs and is still happening

so my concern is that the industry will grow and we as consumers will benefit, but still lose out as shareholders

another thought - why solve this tough problem when one can make money through easy ones :) ?

rgds
rohit

Lucky said...

Why solve a tough problem when one can make money through easy ones!

I fully and totally agree. And that is why I had excluded Bharti from a focussed portfolio.

Probably nobody would like to spend a lot of time assessing the future of the Indian telecom industry and Bharti's place in it if there are easier ways of making money.

However, when it comes to having a diversified bluechip portfolio which almost mimics the indices (and tries to beat them by 1-2 percentage points), I insist Bharti makes sense below the 300 level.

And I do not agree to the same-stock-for-all-kinds-of-portfolio approach either. There are many "value" stocks which would/should be avoided by a typical conservative investor.

Basically, it boils down to how much effort you are willing to put. If you are an indexing kind of guy, you can do well by selectin two or three companies from each sector. Otherwise, you need to work hard and do a detailed bottom up analysis.

May sound crude but I don't find the strict analysis practicable for everybody.