July 5, 2012

A speculative bet

An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative – Benjamin graham, father of modern security analysis and value investing.

Some background
I had written about globus spirits earlier – read here. The stock price has since dropped by around 10% versus the index,  which has  essentially been flat during this period.

So what happened during this period ? Well, the company declared the Q4 results and the market reacted negatively to the drop in operating margins from around 16.8% to around 13%. The company closed the year with a 40% growth in topline and a measly growth of 2.5% in net profits.

This drop in net margins was mainly due to an expansion in the capacity to 84Mn litres and additional new capacity of 40 Mn litres which should come online in the middle of next year. This additional capacity has caused an increase in manufacturing expenses (initial startup costs) and higher interest expenses (due to higher debt to add the capacity). These costs in combination have depressed the operating margins.

So what is my bet ?
I think that the drop in the operating margins is temporary due to the new capacity which is being added in the current and next year. As the new plant stabilizes, the extra costs should reduce and with the extra topline , we should see an  improvement in the margins.

In addition, a decent portion of the additional capacity has been booked by USL for the franchise IMFL bottling (outsourced production)  which should help in boosting the bottom line. The management is targeting a 15% operating margin for the next year.

The management has also indicated that they would be able to grow the topline by 20% or more in 2013 (which appears doable based on past results). If we put all of this together, the company should be able to increase the operating profits from around 73 crs to 100 Crs, with net profits in excess of 55 crs in 2013 (interest costs should also reduce due to a planned reduction in debt)

The company is current selling for around 5 times the current year’s depressed earnings of around 40 crs. The company is thus selling at historically low valuation too (past valuations have generally been in excess of 7-8 times earnings).
In addition, all the other companies in the sector sell for 10+ times earnings, inspite of having much lower ROE and higher debts.

So why is it speculative?
Have I built a good case that the company is really undervalued – from absolute, historical and comparative valuation perspective?  I think I have done that.  At the same time I am still calling it speculative …why is that ?

Please look at the definition in the beginning of the post - An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return.

The key word in the above definition for our example is promise.  I am not confident about the above analysis and think it is a 50-50 proposition. I am still concerned that the industry has extremely poor economics and it is generally quite difficult for a single company to buck the trend of an entire industry.

Speculation is subjective
The key point is that  a stock can be both a  speculation or an investment at the same time and that depends on the investor himself. If you know what you are doing, then it is an investment, otherwise it is a speculation.

The danger is not speculating, but in confusing a speculation as an investment and betting heavily on it.

I am personally not very sure if the above thesis will play out and hence have committed a very small amount of money to it. In effect, this position is just to scratch an itch and not meaningful. If it turns out well, I will brag about it on the blog, otherwise you will not hear a peep on it :)

Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please read disclaimer towards the end of blog.


Ankur Jain said...

Hi Rohit,

How do you define the operating margins ?

If it is EBITDA then the higher interest cost and higher depreciation should have no bearing on the margins ?



Rohit Chauhan said...

Hi ankur
sorry for the confusion. i should have prefixed margin with net margins or operating margins.

i am taking EBDITA as the operating margins and these margins will rise as the management expects to make money on franchise bottling which will raise the operating margins

the net margins are expected to rise due to rise of ebdita and reduction in debt


Inquisitive Stranger said...


Every time i read the analysis i do some research and decide to buy or not, and mostly i haven't bought. This time i did not look at anything after reading this and bought around just small quantity 60 to be precise on the day you posted this post and i see already 23% gain, Now you defiantly can brag about it :).

The only problem is i dont know what needs to be done with this stock, is it a long term bet? or just short term (which usually you dont do!)

Anonymous said...

hi Rohit
can you tell me how did you copy the chart from money control?

Rohit Chauhan said...

hi inquisite stranger

its not a long term buy yet as i am not sure of the economic future of the company ..i may just sell the few shares i have in time. ofcourse if it does well , then i will buy more

on the increase...i think that was coincidence


Rohit Chauhan said...

hi anon

if you have windows 7 you can use the snipping tool to copy and paste into the blog


Anonymous said...

thanks Rohit I have been trying to copy but struggling ...will try what you said