November 22, 2010

Construction material companies – Visaka and Hyderabad industries

I recently came across this industry as this sector seems to have been beaten down by the stock market. The stocks in this sector are selling at PE of 5 and below. Anything cheap always catches my eye!!

So if the stocks seem so cheap, one should sell his house, his cows and everything else and load up on these stocks? Not really. A low PE does not always mean undervalued and vice versa.

About the Industry
The construction material industry includes cement, steel and various other raw materials required to make a residence. However, I am specially referring to companies such as Hyderabad industries and visaka which are mainly in the business of cements asbestos and other fiber based roofing sheets and flat products such as pre-fab panels and boards

These products are mainly used by the poorer sections of the society in roofing their houses as they move from a tiled house to a better constructed and durable house. In addition the pre-fab panels and boards are used as partitions and in other applications where plywood or particle boards are used. So these products are mainly a substitute for these wood based products.

The macro opportunity
I think it is obvious that there is a macro tailwind behind the industry. The rise in the per-capita income, especially in the rural areas, is resulting in investments in better housing. The rural poor tends to improve the quality of shelter and the graduation is from thatches and tiled roof to better roofs such as asbestos or GI roofs. In addition the government also has several housing related schemes for the rural areas, so there is definitely ample demand in the sector.

A growing demand and large opportunity may be a good starting point for an attractive investment, but it is not always the case. A good investment needs to satisfy several additional criteria.

The industry economics
We now come to the more crucial aspects of the industry. The industry topline is likely to do well (other than the issue of the asbestos ban - more on that later) due to the growing demand, but that need not translate into a bigger bottomline or higher net profit.

Although the industry is characterized by a large number of companies in the sector, the top 4-5 companies account for almost 60% of the market share. The top 2 companies – Hyderabad industries and visaka account for 35% of the market share alone. So the industry is not too fragmented.

At the same time, one can see that the entry barriers in the industry are low. It is not too difficult to setup a plant (takes around a year to do so). The main barriers are mainly the marketing, distribution and branding of the product. However as the product is mainly regional in nature (due to high bulk), a company can build capacity in a small region and build out its sales and distribution network in the region at a reasonable cost.

In addition, although brands could make a difference, I don’t think brands enjoy too much pricing power in the industry. The financial results of the companies show that margins are highly dependent on the demand and cost factors such raw material pricing. A company with powerful brands and high pricing power will have stable margins over a business cycle. That does not seem to be the case with this industry.

Raw material such as asbestos and cement account for more than 55% of the total cost of the product. Transportation and fuel account for further 10-15% or more of the total cost. As a result the industry has been impacted by the rupee-dollar rate (asbestos is mainly imported) and other raw material based cost factors in the past (2008 being one such year).

The industry also has competition from substitute products such as GI roof and other materials and so the demand depends on the price of these substitute materials too.

Due to the part commodity nature of the industry, there is a lot of competition between the multiple players in the industry and hence one cannot claim there is a high competitive advantage for the main players in the industry.

Performance of the top two players

Hyderabad industries
Hyderabad industries is a C K Birla group company and has been in this business for 60 odd years. The company has one of oldest roof brands called charminar.

The company used to have a loss making division –heavy engineering till 2004 and as a result was not a profitable company. This division was sold off in 2004-2005 and the ample cash flows during that year were used to reduce the debt. The company has been able to bring down the debt equity ratio from 1.3 to 0.3. The total asset turns have remained steady at around 2.1, with substantial improvements in debtor turns and additional investments in plant capacity to meet the growing demand.

The net margins of the company has ranged between 5-7% in the last 5 years, with last year’s margins in excess of 12%. The margin improvement has been mainly due to reductions in manpower and interest costs.

Finally the company has been able to grow the topline at around 12-13% and bottom line at around 20%+ levels in the last 6 years.

Visaka industries
Visaka industries is a Hyderabad based company and has been in the business for the last 20 odd years. In addition to the roof and other building material segment, the company also has a textile products division which accounts for 20% of the revenue and is a fairly profitable division in itself.

The company has improved the ROE from 15% levels to 20%+ levels in the last 6 years. The improvement has been mainly due to a slightly improvement in fixed asset turns and an improvement in debtors turns (debtor as % of sales has reduced). The net margins have held steady between 6-7% with slight drop in interest and manpower cost, being offset by increase in raw material costs.

Although the company has been able to bring down the debt to equity ratio over the years, the overall debt has gone up as the company has used a combination of debt and profits to expand capacity and put up new plants across the country.

The company has been able to grow the topline at 20%+ levels and the profits at 30%+ levels.

My current thoughts
The entire post till now has been a narration of the facts and past performance. The past performance of an industry has to be used as a starting point of our analysis to think about the future economics and performance of the industry (not the next quarter!).

It is quite obvious that the companies in this industry do not enjoy a great competitive advantage from current and future competitors. As a result it is unlikely that the industry as a whole would enjoy very high returns as seen in 2009, over a period of time. The high demand is already driving a lot of capacity addition in the industry (both visaka and Hyd industry are adding capacity) and this will have a depressing effect on prices.

In addition, if the demand slows down or if there is any other hiccup, the margins can drop even further. If one looks over the last 6-8 yrs, it looks reasonable that these two companies are likely to make around 6-7% margins over the entire business cycle and an ROE in the range of 10-14%.

If one takes visaka as an example, it seems to be selling at around 5-6 times 2009 cash flow. Hyderabad industries is selling at around the same valuation levels too.

Are these levels cheap? Now that is difficult to say, though prima facie it appears to be so.

Current conclusion
I am still in the process of studying and analyzing these companies. I have on purpose written a post in the middle of my analysis to show my process of evaluating stock ideas and arriving at a decision.

I have already completed the quantitative part of the analysis and read up the annual reports of the two companies. I have completed around 70% of the analysis and 50% of the thinking. At this stage if I have not rejected the idea, I will proceed with my valuation template (download from here) and start a structured thinking process to arrive at a conclusion.

I have several questions in my mind which I need to resolve –
- Visaka industries is planning to invest 5000 Cr in power project. How does that change the risk?
- Hyderabad industries and visaka have had poor profitability in the past (2007-2008 and earlier) when the capacity ran ahead of the demand. Are we in that phase already and likely to see depressed profitability in the coming quarters?

The annual reports and the numbers are always the easier part and only a guide to make a decision. If the past numbers alone were sufficient, then the whole work of fundamental investing could be converted into an automated program. Fortunately for my style of investing, it is not likely to happen anytime soon.

Additional disclosure: I do not have any position in the stock. As I continue with the analysis, I may decide against creating a position due to various qualitative factors. Please make your own decision before buying these stocks.

November 14, 2010

Buy and hold investing

The idea of buy and hold was popularized in the US by warren buffett, the guru of value investing (and if you have realized, my intellectual guru too).

The idea behind buy and hold has been that one should buy the stocks of the really good companies and hold them for the long term (sometimes over decades) without concerning ourselves with the short term swings in the stock market.

A myth on buy and hold
A few commentators project buy and hold investing as a form of investing requiring no thinking and analysis. All one needs to do is to go ahead and buy an Infosys or a levers or titan at any valuations and just hold onto it. One does not even need to check on the performance of the company, even briefly, on an annual basis.

These commentators point out to investors who made an investment in a levers or Infosys years ago , just sat on their positions and are now comfortably rich. This is
survivorship bias. For every levers or Infosys, there is a company which went bust or went nowhere.

Buy and hold is not brainless investing!!

It requires work, even if there is no activity (read – trading). It may sound easy, but it is not. By the way, why should earning a decent amount of money, while sitting on one’s a**, be easy for everyone?

Why are there no such recommendations?
You may wonder, why one cannot find such recommendations from brokers or analysts. Why don’t they indentify such companies and recommend it to investors?

Let me take a personal example. As far back as 2000, inspite of being a novice, I had a decent amount of conviction that asian paints was a good company (as I had worked with them). I invested a decent sum at that point of time in the stock.

Now lets assume you are my client. Let’s say in 2000, I recommend this stock and you pay me a commission.

You come back next year and we have this conversation

You : So Rohit, what should I do with asian paints?
Me : Nothing. The company’s doing well. Just hold on to it. By the way, you will be getting a bill for my recommendation next month
You (thinking) : What ??!! this dude did nothing for me this year and is charging me. I am not coming back

So I assume you get the point why brokers and tipsters cannot make a living by giving out such buy and hold ideas which can make you rich.

Please note that the advisor is still doing work. He or she has to keep analyzing the company and track how it is doing. The only difference is that as long as the company keeps doing well, there is no need to trade the stock.

The unfortunate reality is that most investors believe some activity is needed to make money and on top of that if an advisor is to be paid, he or she should be ‘doing’ something.

Is it relevant now?
I feel like a dinosaur these days, especially when talking to my friends. The holding time spans range from a few months to a year. If I point out to long term stock ideas, the same friends are quick to point out the fantastic returns they have been able to make in the last 6 months on midcaps and microcaps.

Why wait for the long term when one can get instant gratification :)

The problem with a short term approach, disconnected from an underlying philosophy, is that it works till the going is good. If the market turns south, then the same investors would lose their shirt and all their undergarments and would start singing the buy and hold tune.

An investing philosophy should be based on fundamentals and not on the current fads of the market.

How to practice buy and hold?
I personally do not believe in going and buying a stock blindly and then holding on to it forever (hoping it will do well). I think one should be able to identify on the basis of a reasonable amount of analysis and experience a list of good, long term ideas.

What should be the characteristics of such companies?

A decent operating history – The company should have been in the business over 10 years with an above average record of performance.

Sustainable competitive advantage – The company should have a strong competitive position in the industry so it can sustain its above average performance in the long run

Decent to attractive industry with minimal change – It is important to avoid industries with a lot of change (ex: telecom) or currently in a decline (example – jute). In addition, commodity type industries are also not a great place to find such ideas, though one cannot rule it out.

The hit by truck test – If the unfortunate happens, can you leave the stock untouched in your account as an asset for your family?

The key is to identify a list of such attractive ideas and invest a small amount of money in it (if the valuation are not too high). Once you do that, you need to start following the company and the industry on a regular basis. In time, over a few years, you will become more and more comfortable with the long term prospects of the company.

The idea is not keep adding money as you become more confident of the long term prospects of the company (long term being more than 5 years). One needs to be patient and should let the opportunity come to you. When the market drops due to some short term concern, it is time to add a meaningful amount of money to some of these ideas.

The above approach is not easy. It requires effort and patience. However if you can build a portfolio of 4-5 such companies, you are set for life.

I have been able to identify a few such companies over the last few years. The notable ones are asian paints, Crisil and maybe a Gujarat gas. These names are not set in stone, but are fairly good ones for me.

I am planning to look at new ideas such as titan, HDFC bank, ITC etc and start following them closely. The next time a market crash happens, I plan to load up on these stocks, as I did on Crisil in 2008.

November 4, 2010

Some portfolio changes

A few of you may have noticed updates on my portfolio page. I don’t update this page on a real time basis, but it roughly reflects my current positions except for one stock.

I have been reviewing the Q2 numbers of most of my positions and have been satisfied with the performance of most of the companies. The results have come as expected in most of the cases. However there were a few surprises. Let me give a brief rundown on some of the changes in my portfolio and the quarterly results

The reductions
As I wrote in some of the
previous posts, I have more or less exited most of the IT stocks such as NIIT tech, Patni computers and Infosys. Infosys performed better this quarter, growing in double digits. However I personally feel the stock is fairly priced and have exited the stock completely.

NIIT tech came out with decent numbers after a long time – mainly due to their BSF order. In addition they have been able to reduce the impact of their hedge positions. As a result the hedge related losses have reduced and the company posted decent results. I personally think the stock may be undervalued by around 20% at best. However I have reduced my position substantially.

In addition I have sold off Concor completely as I think the company is now fairly valued. I have been reducing the position for the last few years. This is a very interesting position for me. I bought this stock in 2003 when the company was selling at a PE of 5. I had been investing for a few years and could not figure out why the stock was so cheap when it was doing so well.

I created a position inspite of all the doubts. In hindsight I was too timid.

I have also started reducing ashok Leyland as I think the stock is now approaching fair value. The company is doing extremely well and firing on all cylinders. I remember looking at this stock at 11-15 levels and wondering how it could not be cheap?

I closed out my position in mayor uniquoters as I feel it is fully priced and my position was too small to begin with anyway. I have also been reducing my position in clariant chemicals as it is now close to fair value

Finally, I have started reducing one of my largest positions – Lakshmi machine works. The company is doing well, but is now close to fair value.

In case of all the above stocks, it is not divorce, but a temporary separation. If the price drops or the valuation becomes attractive, I will buy again.

The additions
This is a small section. I have been adding to my positions in Balmer lawrie, hinduja global, Patel airtemp, Ricoh india and FDC. The additions have happened over the last few months. However I have been a net seller than a buyer. The only major buying has been for Diwali :)

The disappointments
BEL (bharat electronic limited) had a fairly poor quarter where their topline and bottom line dropped by double digits. I am however not too disturbed as they have quite a bit of a monopoly in the defence business and the revenue is not evenly distributed in each quarter (due to projects nature of the business).

I was also disappointed after I read the annual report of facor alloys. The company has passed several special resolutions to invest to the tune of 300+ crs in other sister firms, which are expanding into power and other businesses. I get fairly mad with this kind of diversifications. Needless to say, I plan to exit the stock in time irrespective of what happens to the business or the stock.

I had written about mangalam cement recently. As I was not confident enough, I never bought the stock. I was quite surprised to see a sudden 90%+ drop in the bottom line for the second quarter. This was a learning for me – companies with high operating leverage can see huge spikes in their bottom line. The fundamentals of the company are still intact, except that I would like to buy the stock at a time of extreme pessimism

Response rate
A few of you may be disappointed with my response time to emails and comments. Unfortunately like others, I also have a limited time and hence cannot devote more than a few hours a week on responding to comments and emails.

I will definitely read and respond to your email, but would ask you to be patient with me on that count.

A happy Diwali to all the readers