The number one problem faced by value investors is not a big permanent loss of capital, due to overpayment for growth, but the weak and anemic return from an average business bought at a cheap price.
Let me explain further –
A typical value investor (who are far and few anyway) generally tend to be conservative in paying up for a business. The deep value types go for the really cheap stocks (as measured by low PE or P/B ratios), whereas the others would pay up a bit for the quality of the stock and growth, but not too much.
A deep value investor typically looks for a company which is selling in low single digit PE ratios and in some cases if you back out the cash or other assets on the balance sheet, the core business could be available for almost nothing.
What is a value trap?
The problem with most of these investments is that the underlying business is stagnant with a comatose management who is not interested in either growing the business or ready to return the excess cash to the shareholder. In such cases, the market discounts this cash heavily and refuses to bid up the stock price.
Let me a give a personal example – Kothari products. You can read my earlier posts on this company here and here
Let’s look at the price history for the company below
![]()
Even a savings account would have done better!!
What are the key causes?
There are several causes for such value traps. The primary cause is a stagnant or declining business with a management which keeps pouring capital into the sinkhole. If on the other hand, the business is generating excess cash, the management keeps hoarding it and refuses to return it to the shareholder.
The second reason is that the underlying economics of the business has deteriorated and the market realizes it with a lag. Case in point – the telecom industry. The economics of this industry has gone into a tailspin for the last few years, with almost everyone bleeding money (except probably bharti airtel). In such cases, if you keep looking at the past data and do not understand how the economics of the industry has changed, you can get stuck in a no-win situation
The last category of value traps are the low return, second and third tier commodity players. These companies have a low return on capital over the entire business cycle, and unless you can dance in and out of the stock in time, you can get stuck with very low returns.
How to indentify value traps before hand ?
That’s the tough bit.
For starters, investors like me need to get out of the low PE, cheap stock mindset. A really cheap stock is often cheap for a reason. It makes sense to dig deep and understand the business in detail to figure out why the market is valuing the company at such low valuations ?
If a company has been cheap for the last 5 years, why should it suddenly get re-rated just because smart lil me bought the stock?
One needs to understand the economics of the business in depth and also confirm that the management is creating value for the shareholder and not just twiddling their thumbs. Only if you have a strong belief that that business is doing well and will continue to do so and the management is also good, then should you think of making a commitment to the stock
What if you are caught in value trap?
There are no easy answers. For starters, swallow your pride and sell the stock. That’s easier said than done – ask me!. The unfortunate bit is that people like me take 10 years to realize it :). Luckily for me these mistakes have not been big enough to damage my long term returns.
The risk of holding onto such investments is that although you do not lose money on paper, in reality you are losing the benefits of compounding by not investing the same money in other opportunities. It would be silly to compound your money at 10% in a value trap, when the index itself can give you 15% without any effort.
If you have invested in one of those low return commodity stocks, hope that the commodity cycle turns and market in its temporary fits of insanity, re-prices the stocks. As soon as this happens, sell the stock and never look back !
It is always a constant struggle to avoid value traps, as they come in various shapes and forms. One has to be vigilant and learn to exit them, once you have realized that you are stuck in one
I have discussed about the various factors or parameters in analyzing a bank in some earlier posts (see here and here). In this post, I will use these parameters to evaluate a real example.
A warning before I proceed – The wieghtage given to each factor and conclusions derived depend heavily on the temperament and biases of an individual. If you are an investor who likes growth and are ready to take some risks to get a multi-bagger, you may overweight the topline and bottom line growth and pick a bank which is growing rapidly.
On the other hand if you are conservative in nature, you may overweigh the CAR ratio and may actually get nervous if the bank is growing too rapidly. I personally prefer a middle path – I would prefer a conservatively managed bank which is growing at 1.5-2 times the GDP growth rate and hence is likely to give a 15-20% growth rate.
In my world a 15-20% growth rate is adequate, if it can be sustained for 5-10 years. I am not looking for shooting stars.
I am taking the example of Axis bank for this post to demonstrate the process I go through when evaluating a bank. I do not have any position in the stock.
Profitability and its source
The first factor I would look at for in any company is the Return on capital (ROE in case of banks). Any company earning below the cost of capital (over the business cycle) is out of contention. The bank or the company should have an average ROE in excess of 15% over the last 10 years. Axis bank has had an ROE of around 23% over the last 10 years. The ROE has dropped from 32% in 2001 to around 20%, but has generally been maintained above 18% during the entire time period.
I am also interested in understanding the source of the above average returns. In case of a bank, the ROA (return on asset) is an important number. A number in excess of 1.3% is considered good. Axis bank has improved its ROA from 0.8% in 2001 to around 1.6% in 2011.
The improvement in ROA was driven by higher net interest margins and better other income, resulting in higher net profit margins which have gone up from around 1.8% to around 3.7% . So in effect the bank has improved the profitability, both from lending and fee based sources.
Asset Quality
A bank may be very profitable and showing great results, but may have very risky loans on its books. Asset quality is an important factor in evaluating the quality of the earnings of the bank. Unfortunately there is no easy and direct way of doing it.
I typically look at the NPA number, the level of provisioning of the NPA and profile of the assets. It helps to review the distribution of credit risk by industry in the notes to account, to confirm that there is not too much concentration of lending to any specific industry or borrower.
The truth of the matter is that one cannot get a perfect read of the asset quality and has to trust the management. This is the main reason why a long term track record and culture of the bank is important. If the bank has a past history of conservative lending over the business cycle, then one can expect the same to continue.
I am a bit concerned on this count with Axis bank. The bank has been expanding rapidly, especially on the home loans and other retail assets. One cannot be sure if the bank has been conservative in lending.
Safety
The next factor I would look at is the safety or capital cushion of the bank. The ratio to look for is the CAR (Capital adequacy ratio). The bank has on average maintained a CAR of 12.5% and may need to raise more capital to fund future growth.
The next factor to evaluate the sustainability of the earnings is the gross/ Net NPA and level of provisioning. The bank has a gross NPA of around 1% and net NPA of around .26%. The bank was provisioned around 68% in 2010, which means that 32% of the NPA have not been provided for (and could hurt the profitability if these loans cannot be fixed).
The NPA number is very crucial for the banks. It is difficult to be sure about the true NPA of the bank as a bank can play a lot of games to modify this number and thus come up with a desired profit number. One has to just trust the numbers, based on the overall feel of the management.
Growth
If I am satisfied with the profitability and safety of the bank, I would move on to the growth in topline and net profit for the bank. In case of Axis bank, both the numbers have increased in excess of 30%. Clearly the bank is in a lot of hurry to grow.
In addition to the income and profit, the bank has grown its branch network from 139 to 1390 in 2011 and the ATM network from 490 in 2002 to around 6270 in 2011. The bank is thus expanding the retail network which is healthy growth as it helps the bank on the liability side (gather low cost deposit) and also lend to the retail segment (in the form of home loans, personal loans etc).
Cost analysis
Cost is an important factor in the analysis of any industry and more so in the case of the bank. The two crucial cost elements are the cost of funds and the overhead costs.
The cost of funds in case of axis bank has dropped from around 7.5% to around 5%, due to the increasing current and savings deposits. This is a good trend and has enabled the bank to earn a decent net margin (3.7% currently).
The cost to income (or overhead) ratio has gone up from 30% to around 40% level mainly due to the cost of new branches and other such investments. If this ratio is up due to expansion of the branch network, then I am all for it. Axis bank is clearly investing in expanding the branch and ATM network and is benefiting from this expansion too
Competitive advantage
It is also crucial to evaluate the strength of the bank’s competitive advantage and if the bank is working on enhancing it. The competitive advantage comes from the following factors
- Brand : Axis bank is now a well know brand, especially in the urban areas and is constantly being strengthened through advertising and promotion
- Customer Lockin : The bank is improving the lockin by increasing the number of branches, ATM and by providing a wide range of products. The bank can keep increasing the customer lockin by constantly improving the service levels and adding new products.
- Production side advantage : The bank has been able to expand the branch network and increase the number of customers. This provide the bank, economies of scale in gathering deposits (and lower cost of funds) and reduce the per customer cost of servicing them.
- Entry barrier: There is certain level of entry barrier as RBI does not issue new licenses easily (which may change now). As a result the private banks have been shielded from relentless competition and have been able to grow rapidly and achieve scale. Any new banks will to incur years of investment to achieve the same scale.
Management quality
This is the most important and the most difficult factor to evaluate. In the case of axis bank, I can offer a few view points, but these are just that – views or impressions. Each one of us will come up with their own impressions.
I find the management quite aggressive in expanding growing the bank. In some ways, the bank looks like a version of ICICI bank when it was in the growth phase. Some of you may find that comparison unfair as ICICI grew too rapidly and then had to fix the asset quality issues. I am not implying that axis bank has the same issues, but one cannot sure in cases where the growth has been rapid.
The disclosure levels of the bank are quite adequate and the bank provides a lot of detail about asset profile and distribution.
Overall the management is definitely doing the right things and has strengthened the balance sheet and increased its competitive advantage over the years.
Conclusion
I have covered how I would evaluate a bank based on the various factors. As you can see, there is no checklist or points system where if the bank scores well on most of the factors, then at the end of the exercise you would have neat conclusion to buy or sell.
I find the bank passes most of the checkpoints in terms of fundamental analysis, except for my concern on asset quality. The key reason for not pulling the trigger is price – I find the price higher than what I would like to pay.
