Moat or no Moat – Indian IT

I recently posted the following comment on twitter

Indian IT still earns 30%+ Roe vs. 15-20% for other IT majors. Cannot see any competitive advantage to justify such excess profits 4 long term

This initiated a discussion with prabhakar on twitter. Now, a 140 character space is sufficient to provoke a discussion, but very painful to explore any meaningful topic. So I decided to write a post and share some thoughts (and hopefully carry the discussion with prabhakar and others in the comments section)

I have written about the competitive advantage (moat) of Indian IT companies in detail here. I drew the following conclusion then,

The broad conclusion one can draw from the above analysis is that IT companies do enjoy a certain degree of competitive advantage. The source of this advantage is no longer the global delivery model (everyone does it) or the employees (all the companies source from the same pool). The key sources of competitive advantage can be summarized as follows

• Switching cost due to customer relationships
• Economies of scale
• Small barriers due to specialized skills in specific verticals such as insurance, transportation etc
• Management. This is a key source of competitive advantage in this industry and explains the wide variation of performance between various companies operating in the same sector with the same inputs and under similar conditions.

Let’s look at where we stand on these factors

a.    Switching costs – I personally think switching costs are coming down now. The nature of work is getting commoditized and as a result, companies are less reluctant to switch vendors. Sure, it is a pain to do so, but if the cost benefits are large then a lot of companies are ready to bite the bullet. In addition, the threat to switch to a different vendor is sufficient to drive down prices.

b.    Economies of scale – This is now turning from an advantage to a disadvantage for the larger firms as they continue to grow. A firm with 150000 employees (top IT vendors) will develop diseconomies of scale as it grows further

c.    Specialized skills – this was a weak advantage to begin with and in most cases these skills reside with individuals (who can leave easily) and are not really institutionalized (via a product offering)

d.    Management – It is important to have a good management, but a great management cannot change the competitive dynamics of a company completely.

Weak and strong moats

Let me introduce a new concept here – Weak and strong moats. A strong moat is one which cannot be breached easily by competition. Think about the moats enjoyed by titan industries (brand, distribution), Asian paints or Crisil – these are wide and strong moats which cannot be easily breached by competition.

A weak moat or weakening moat in contrast is a moat which is shrinking and can be breached much more easily by competition.

My hypothesis is this – Indian IT has a weak moat which is shrinking by the day.

Some numbers

Let’s look at the ROIC numbers for some IT companies (Indian and global)

IBM – 15-20 % (based on invested capital including debt)

Infosys – 50% (based on invested capital, excluding cash)

NIIT tech – 25%+ (based on invested capital, excluding cash)

The above numbers are not precise, but sufficient to paint a picture. The mid cap and foreign IT majors have an attractive ROIC (in excess of 15%) and are good businesses. The large cap Indian IT companies have phenomenal return on capital numbers, in comparison to their Indian and global counterparts.

What explains this big difference?

Eliminating some factors

I would like to argue against some points which are put forward to justify the presence of a competitive advantage for the IT majors

Talent – Everyone has access to the same talent (in India and abroad). You can easily pay 10-20% more and hire employees from competition, if you need to do that. So all this talk about differentiated talent and training ….is just talk and does not create any competitive advantage

Intellectual property – Some Indian companies focused on niche areas, do have IP and are able to charge more for it. At the same time, IP is not a sustainable competitive advantage and a company has to constantly invest, to build on it. In addition, if IP was such as source of sustainable advantage, then companies like IBM (which has more IP than a lot other vendors) would be earning a much higher return on their service business (they earn around 10% NPM)

Differentiated model, client engagement etc etc – This is all fluff and good for annual reports and client presentation.

The future

I will take a guess now (which is as good as yours). I think the return on capital  (margins and asset turns) will slowly drift downwards for the top IT companies as the commoditization increases without the presence of a sustainable competitive advantage.

This has already started and you can see it happening with several of the large cap IT companies. If I am even half correct, it is important to be careful in looking at valuations based on the past performance alone.

PSU mining stocks: More than meets the eye!

At first blush, mining stocks are a value investor’s dream. A company with a mandated monopoly, earning around 50%+ net margins and almost 400%+ return on capital should be an ideal opportunity. On top of that if this business sells for 7-8 times cash flow, it is like hitting the jackpot!

Is the stock market nuts to ignore such companies?

Let’s look at the numbers

Let’s look at some of the Government owned mining companies. I will look at two examples in this post – NMDC limited and GMDC (Gujarat mineral development corporation).

NMDC is the largest iron ore producer in India, with an annual production of around 26MMT per annum. The company earned around 12680 Crs in 2011, mainly through the production and sale of iron ore. The company made a net profit of around 50% and earned a return on capital of around 400 % (after excluding the excess cash).

The net profit has grown from around 2300 Crs to almost 6500 crs in the last five years, mainly due to the rise in iron ore prices (as volumes have grown only by around 10% during the same period). The company has around 17000 Crs of excess cash and can easily meet capex requirement from the interest income alone.

The company is also selling at around 6-7 times free cash flow (excluding the cash)

GMDC is one of the largest lignite producer based in Gujarat. The company earned around 375 Crs on a topline of around 1400 crs in 2011. The company made around 25% net margins and around 25% return on capital (excluding excess cash). The company has grown the topline and profits at around 18% p.a in the last 10 years.

As you can see, the numbers look good and are likely to be maintained as iron and Lignite/coal continues to be in high demand (With imports being far more expensive)

Why is the market discounting these companies?

There is more to these companies than meets the eye. The numbers look good for a specific reason – These are government mandated quasi monopolies, which have preferential access to these mineral resources. A private company cannot get license to a mine (other than for captive purposes).

In addition, even if a company were to get a license, it would take a lot of effort and money for the company to get all the clearances to operate the mine. These factors add up to a meaningful competitive advantage.

The flip side of this advantage is that these companies are run by the government as it sees fit and not necessarily for the benefit of the shareholder (or maybe the general public too – which is a different issue completely)

The impact of government control

There are several obvious and non obvious impacts of government ownership . For starters, these companies are not in the business of maximizing shareholder value. These companies exist to serve a specific objective, as decided by the government.

For example, NMDC’s objective seems to be to expand the mining operations to meet domestic and international demand. It has managed to make a lot of money in the process, but the excess capital has not been returned to shareholders. You may argue that this is true in case of a lot of companies. However in all such cases, where the management (private or public) uses the capital inefficiently, the stock market takes a dim view and does not give the company a high valuation

In case of NMDC, the company has now decided to invest in a 3 MTPA steel plant at the cost of around 15000 Crs. You can call this as forward integration, but I see this as a high return business investing in low to average return business – not exactly a value enhancing decision.

In case of GMDC, the company is now expanding into power generation. Power generation in India, is a very tough business with poor free cash flow. In case of the GMDC, look at page 56 of the annual report -  The mining segment made almost 570 Crs on 60 Crs of asset (1000% !),  whereas the power segment made around 57 crs on 1300 (less than 5%).

I hope you can see the pattern here – We have a very profitable business in mining (due to the government policies) and the big profits from this business are being invested into some very mediocre businesses (again due to the government)

Isolated cases ?

The above example may be seem to be a case of related diversification. The problem with such related diversification is that the bureaucrat making these decisions, is doing it with some non financial objective in mind (nation building !!) and does not care about the return on capital

In addition to all these lofty goals, there are smaller cases of waste of capital too. NMDC recently acquired sponge iron limited for around 80 Crs. This is a  30000 TPA producer  of sponge iron with a sale of around 65 Crs and loss of around 10-15 Crs per annum. In comparison , Tata sponge iron has a capacity of 300000 TPA , made a profit of around 100 Crs and sells for around 300 Crs (net of excess cash).

GMDC has several such cases of cross holdings in other PSUs, guest houses and what not!

The above cases are small, but indicative of the way these companies are being run.

Should one avoid these companies?

I am not indicating that these companies are to be avoided at all costs just because they are controlled by the government. On the contrary, there are several PSUs which are run much better , where economics and not politics is the driving factor.

In the case of mining companies one should not get infatuated by the huge cash profits being made by the company, but also look how these cash flows will be utilized. One can expect  to receive decent dividends over time in case of some of these companies, but the intrinsic value of these companies is unlikely to grow rapidly (more likely at around 10% per annum).

The bladder theory is very much at work in these companies – When  management  and more so the government has too much cash, there is a high tendency to piss it away.

What do you guys think? please share your thoughts in the comments

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.

Why I will never buy an airline stock ?

The short answer to this question is – Most companies in this industry never make any money ! Sure they make money once a while, but over a period of time most airlines loose money. As a whole the industry has lost money for its investors over a period of time.

If you don’t believe me, following is the list of airlines since early 90s, which closed down or got bought out by other airlines.

Air Deccan , Air Sahara , Archana Airways , Crescent Air,  Damania Airways , East West Airlines , Himalayan Aviation, Indian , Indus Air , Kalinga Airlines , MDLR Airlines , ModiLuft , Paramount Airways , Skyline NEPC , Tata Airlines , Vayudoot.

Do you think the airlines which have survived such as jet airways or kingfisher are making money ? Kingfisher’s troubles are in the news and jet airways has lost money in aggregate over the last 5 years. The other airlines are not doing much better.

If the above reasoning is not sufficient, read on

Let’s look at the competitive structure of the industry

Entry barriers

There are some entry barriers in the industry in the form of capital requirements and license. These barriers make it difficult for a small time entrepreneur to start an airline in India, but any one with deep pockets and a desire to burn money can get the required permissions to start an airline.

The entry barrier may be tough, but the exit barriers are even tougher. Once you start an airline , it is not easy to unwind it. It is difficult to layoff the employees and sell off the planes.  In most cases, airlines have generally been sold off to competing airlines for a fraction of the cost of setting it up.

Pricing and competition

Competition in the airline industry across the world is Kamikaze  behavior. It is generally a race to the bottom  as airlines compete on the basis of price. The majority of an airline’s costs are fixed  - cost of an airplane, fuel and salaries  do not vary with the number of passengers flown.

In addition the perishable nature of the product (an empty seat on a flight is a lost forever), the incremental pricing is generally based on the marginal cost of revenue which is  the cost of the peanuts or snacks on the flight.

So an airline looses money whether it flies a half empty plane or drops the ticket price to fill it up. Finally in times of peak demand, a hike in the ticket prices has led to a lot of howling and pressure from the government  to cut down the price hike.

In such an environment, is it a surprise that most airlines in india loose money ?

Power of suppliers

Who are the suppliers to this industry ? They are the aircraft manufacturers, the fuel providers and finally the unionized pilots and other employees.  I don’t think most airlines have much leverage with the aircraft manufacturers or can negotiate the price of fuel . In addition pilots and other personnel are unionized, so airlines really cannot fire them or reduce their pay easily.

In terms of the cost  structure, airlines are pretty much stuck between a rock and a hard place

Irrational behavior of the largest airline in India

I now come to an emotional topic (atleast for me ) – Air india !. You will have to excuse me for the rant and can choose to skip the next few paragraphs.

<start rant > Why the ***@@ is the government running an airline ? We are not a rich and developed country with too much money lying around. Air india has always lost money and now has accumulated debt of 45000 Crs and operating loss of 22000 Crs (there is no typo in these numbers !). The government is planning to pump in 10 billion dollars over the next 10 yrs into airindia !

Can you imagine the waste? . In a poor country like india this money can be spent on infrastructure (roads, schools)  healthcare or education. Heck, even if the government decided to just give away this money to people below the poverty line, I would be fine.

The government in its infinite wisdom continues to run the airline run for politicians and babus. At the same Airindia  prices tickets below cost on several route to increase the utilization factor (on which it is measured) without concerning itself with the profitability of such a decision. This kind of behavior has caused losses for the entire industry which has to match the pricing of  the most irrational player.

By the way, an airticket priced below cost is an indirect subsidy to people like me (who don’t need it). < end of rant J >

Future of airlines in india

Any industry with such poor economics is bound to loose money. This has been the case for airlines in the US and other countries. In addition, we have the largest airline in india (air india) which is not run with any profit motive. In such a situation it is difficult to imagine if any airline will consistently make money over the next 10 years .

In investing, sometime discretion is the better part of valor. I will buy a ticket to fly  (kingfisher is my favorite J ), but will never invest in an airline.

Atleast when I fly by  jet or kingfisher the flight is good and the airhostesses are pretty J .  That is money well spent !

A case of ignored liabilities

There is virtue in being patient, more so if you are a long term investor. I got a taste of this lesson again, recently with tata steel.

I had been analyzing tata steel for a few weeks and got extremely tempted when the stock hit 400 Rs a share. I would have pulled the trigger on this one, but decided to follow a time tested approach – Never buy a stock when you are in heat J

I usually spend a few weeks analyzing a stock. Once I have completed the first round of analysis, I leave it and try to come back to it after a few days or weeks. The advantage of this approach is that it allows me to sort of cool down and get a little more rational. It helps in reducing the adrenaline surge I get when I am looking at a good business, which also seems to be quite cheap.

The story behind tata steel

Tata steel is one of oldest steels companies in India. It has a capacity of around 6.8 MMT (million metric tons), mostly in Jamshedpur. In addition the company has a Brownfield project of around 3MMT at the same location, due in 2012 and another Greenfield project coming up in Orissa in around 2014.

Tata steel India is one of the most profitable steel companies in the world with operating margins in excess of 30%. Iron ore and coal accounts for almost 60% or more of the cost of production. Tata steel owns its own mines and thus has been shielded from the rise in the cost of iron ore and coal. In addition, it is also an operationally well managed company.

The Corus acquisition

Tata steel acquired Corus in 2007. You can read about it here.  Tata steel announced its intention to acquire Corus in 2006 and then got into a bidding war with CSN and eventually paid 12 billion dollars (around 55000 Crs) for the company.  You can read about Corus here.

Corus has three integrated steel plants in UK and Netherlands. In addition, the company also has multiple rolling mills and manufacturing locations across Europe. The company had around 50000 employees at the time of acquisition which has come down since then due to layoffs, restructuring and closure /sales of some facilities.

Tata steel invested around 3.7 billion (around 17500 Crs) in the form of equity and bridge loan. The rest was financed via an LBO (the acquired company took the debt on its balance sheet). So at the end of the transaction, tata steel at a consolidated level had a debt of around 54000 Crs against equity of 34000 Crs.

I am not as smart as the Tata steel managers or the banker who advised them, so I still cannot figure how this was a good deal for the shareholders. The Indian shareholder paid around 9 times EBDITA for the Corus. In addition, they used  the stock of tata steel to pay for it, which is a far more profitable company than Corus ( Tata steel India had an EBDITA of 511$/ tonne of steel where as tata steel Europe had an EBDITA of 122$/ tonne in Q12012).

Anyway, after the deal happened we had the financial crisis and the deal which appeared pricey to begin with, now looked like a complete disaster.

So what interested me ?

As I said earlier, the management of the company is very good from an operational standpoint (capital allocation is a different matter). The management has been energetic and proactive in tackling the problems in the European operations.

The high cost structure in Europe is being attacked by closing/ selling facilities. In addition there have been layoffs and work force reduction to improve the labor productivity. As a result of these ongoing improvements, the European operations is no longer losing money and has actually started making some money now. If Europe does not have a severe crisis due to Greece and other PIIGS countries (and it is a big if), then tata steel Europe should be reasonably profitable in the next few years

The management has also gone ahead and improved the capital structure by selling some non core assets such as shares in other tata group companies, interest in Riverdale mining etc. The net Debt to equity ratio is down to 1:1 in the current quarter and is likely to improve further. As a result the balance sheet is much stronger and can withstand a recession better than it could in 2008.

So what scares me?

As I said earlier in the post, the ongoing improvements in Europe and the new capacity in India (which will raise total capacity by 50% in the near future) got me all excited. I decided to cool it down and wait for a few days as I continued to dig further into the balance sheet .

I came across the following , for the post retirement pension plan (pg 218 of 2011 annual report). The numbers below are in crores.

Look at the above number and ponder on it for a minute.

Tata steel has a networth of around 35000 Cr last year and made a net profit of around 9000 Crores in 2011. The pension liability is 3 times the networth and 12 times the annual profit.

I cannot give a lesson on pension liability accounting in this post, but let me give a few points to think about.

The pension liabilities are covered by assets (think money set aside to pay for the pension) .In a happy situation as above, where the assets  exceed the liability, the company gets to carry a positive balance on its balance. If however the market weakens and the assets drop or do not earn the expected rate of return, then the difference is carried as a liability on the balance sheet.

As per Indian accounting, a company has to take this liability through its profit and loss and show a loss if required. However tata steel, very conveniently, decided to opt for UK accounting standards and carries the liability on its balance sheet alone. Now this is perfectly legal and there is no hanky panky in it.

In addition overtime, if this gap keeps growing, the company is required to cover the difference by charging the shortfall to the profits and by adding capital to the assets (set more money aside) . If you are thinking that the company can get away from it, think twice. This is a defined benefit plan – which means the workers have to be paid their pension, irrespective of the returns on the assets.

The liabilities are solid and will grow at a fixed rate. The growth in the assets depends on the returns on the stocks and bonds, which is anything but fixed. Finally this is Europe – you cannot  get away from such liabilities at all (short of bankruptcy)

Where’s the risk

The assets under the pension plan cover the liabilities for now.  However the gap is less than 2% now. How can we be sure that that the assumed returns on the asset (4.25-9.25%) will not turn out to be optimistic ? If that happens, then tata steel has a huge bill to foot in the coming years.

I am personally quite uncomfortable with this kind of an open ended liability. It is difficult even for the management to predict what will happen as it depends on the returns they will get on the assets (stocks and bonds) in the future. If there is a shortfall, the picture could get very ugly for the shareholders

So why is no one talking about it?

I think I know the reason for this. This is a long term, contingent liability. The shortfall may or may never happen. If you are an analyst, recommending the stock for the next 3-6 months, this kind of liability does not matter. If something does happen, you can always say – oops J

If however, you are a long term investor like me, such liabilities can make a big difference, especially if you cannot evaluate it with confidence. I have not given up completely on this – I have uploaded a sum of the parts valuation for tata steel here (pls have a look and leave me any feedback you may have)

Controlling my testosterone

As I said in my previous post, one of the key points for me as an investor is to manage my emotions and first conclusion bias. I generally try to stagger my analysis and purchase so that I can avoid the first conclusion bias and then the commitment and consistency bias, which kicks in after the first purchase.

In the above case, I have found a liability which may turn out to be immaterial eventually. At the same time, even if the probalitlity is low, the downside is very high if it is does materialize. This liability is in addition to the 40000 cr debt already held on the balance sheet and  weak European operations .  All these liabilities are supported by the highly profitable Indian operations. Lets hope they stay strong !

Economics of the brokerage industry

I thought my previous post on the brokerage industry would receive minimal hits as it is quite a dry topic and has no entertainment value. However, I am glad that I have been proven wrong. Considering that a lot of users are interesting in reading such dry topics, I will continue to publish such analysis in the future.

I had given a brief overview of the industry in the previous post. I will try to analyze the economics of the industry in this post

The typical research report (at least the free ones) on industry analysis typically give pages and pages of past and current statistics, without attempting to look at the broader picture or overall dynamics of the industry.

Why is that important?
If one has to make a long term investment in a company, it is crucial to understand the long term economics and direction of the industry and the company in particular. The statistics and various parameters of the industry are just the starting point of the analysis.

Lets try to evaluate the brokerage industry

The brokerage industry is currently characterized by a large number of companies (private or unorganized). In effect it is a fragmented industry with a large number of participants.The industry thus has monopolistic competition (text book term) – a large number of firms selling a slightly differentiated product.

Let analyze the industry based on Michael porter’s five factor model

Barriers to entry
The industry now has a certain level of entry barriers. The primary brokerage firms need to have a certain scale and size as the business involves a high level of fixed costs in the form of technology platform, distribution network and back office operations. In addition brand recognition is also important to attract new customers.

A new entrant in addition to the above also needs a reasonable level of capital to fund the working capital requirements of the business (finance to customers, deposits with exchanges etc).

These scale requirements are increasing constantly and as a result a new entrant will require higher levels of investments in the future to enter the business. As pointed out by ansh in the comments, it is unlikely that we will see many new entrants in the industry. On the contrary, it is likely that the smaller players will exit by selling out or closing shop.
Supplier power – not relevant in most segments except investment banking, where employees control client relationships and hence have to be highly compensated

Buyer power – This is important in the institutional brokerage business which involves high volumes and low brokerage charges. The extent of buyer power is very low to non-existent in all kinds of retail segments

Substitute product – Not applicable

Rivalry determinant – This industry is now in a fairly high growth phase. However the brokerage industry is very cyclical and is impacted by the activity levels in the markets. During the downturns such as 2008-2009 period, the smaller players were squeezed out of the business. As a result there is a constant consolidation happening in the industry.

In summary the industry has moderate to low level of competitive advantage. There is low level of customer lockin and a customer will move his/her business if the brokerage rates are not competitive with the rest of industry. The only competitive advantage for the companies in this sector comes from size and scale which enables them to leverage their size to reduce average costs and thus make a profit on low brokerage margins.

Other points of analysis
In addition to the high fixed costs, the industry has very low marginal cost. As a result the cost of adding an additional customer is low and per transaction costs are limited. Due to this reason, we are seeing a constant pressure on the brokerage rates (similar to telecom which also has a very low marginal cost). This downward pressure on the brokerage rates has intensified the competition in the industry and is resulting in consolidation with the top players.

The basic brokerage business is now sometimes a loss leader to enable the brokerage firm to acquire customers and sell other products such as wealth management services, PMS or third party mutual funds. The agency business is thus a Iow margin, lower risk and a fairly predictable kind of business. This segment will provide adequate returns in the future for a company with scale.

The capital business involving financing is similar to a banking operation and is mainly a lending or a support business for the brokerage operation. This is a high risk and sometimes a high return business. It is easy to grow in this segment by taking large quantities of debt and then investing in high risk assets. However the risk of a black swan or plain old recession wiping out your business is very high.

Finally the treasury business is a trading operation driven by the skills of a select set of individuals. In the same manner business such as investment banking is also a very competitive business driven by key customer relationships. It is difficult to evaluate the competitive advantage in these businesses as it is driven by a few key employees, who can leave and thus take away your revenue streams and profits

I personally prefer low to moderate businesses with above average returns. In view of this preference, I am likely to reject high growth/ high risk businesses in the brokerage space and likely to focus on companies which are focused on the agency business.

Brokerage firms

I have started analyzing financial service companies such as Banks, brokerage firms, NBFC etc to find some attractive ideas in this industry. I think financial services as an industry is likely to do well as the Indian economy grows and the average level of income rises with it.

Globally, the financial services industry forms a much larger part of the economy (in some cases too large) than India and acts as the circulatory system of the economy.

The above insight is not unique and does not mean one should go out and purchase any bank or company in the financial services industry.

I have often been asked why I don’t invest or talk much about banks or financial services company. I don’t have any mind block against this sector. I have invested in Karur vyasa bank, ICICI bank and Allahabad bank in the past.

However, any company which works with a high leverage is not an easy decision. The risk management and capital allocation decisions of the management are very crucial. It is easy for the management to make stupid loans or follow risky trading strategies for a long time, before the whole thing blows up (remember Lehman brothers?). In addition, the management can easily cover up the asset quality and the investor will have no clue about it.

Any investment is a finally a bet on the management, but due to the high leverage it assumes a greater importance in the case of financial service companies.

As part of the above analysis, I have started looking at brokerage and capital market related companies. I wrote about geojit securities in an earlier post (see here). I am detailing some thoughts on this industry below. I will follow it up with an analysis of some of the companies in this space.

The business segments for brokerage/ financial services can split along two broad lines

Agency business – This business does not require high amounts of capital and is based on other assets such as distribution network, client relationship etc. It consists of the following sub-segments

Investment banking : This involves advisory and capital market services such as IPO transactions, FPOs, QIP and rights issues. In addition, this also involves other services such as Merger and acquisition advisory, real estate and infrastructure advisory and capital raising services such as debt syndication.

This business is characterized by high competition, low capital investment and the presence of several global companies such as Goldman sachs, Merrill lynch etc.

The key drivers for this business are client relationships and key personnel who have the experience and the network in the business.

Brokerage – Retail, institutional, Wealth management and third party distribution
The brokerage business involves several sub - segments such as retail brokerage services through online and sub-broker channels. Retail brokerage is a fairly fragmented business with a lot of brokers across the country.

The key drivers for this business are an extensive distribution network and a robust technology infrastructure to handle the online and back end processes of the business.

The institutional business uses the same technology infrastructure, but is driven more by client relationships and research capabilities.

Wealth management also uses the same capabilities – strong research capabilities, client/ customer relationships and technology infrastructure to provide various services to higher networth clients.

The third party distribution is a nice addon as it enables the company to earn additional fees from distributing third party products such as mutual funds and insurance etc by using the same assets.

Asset management – PMS, Mutual funds etc
This business involves private asset management – PMS, private equity and mutual funds. This business is a logical extension for brokerages as they can use their research capabilities, distribution infrastructure and client relationships to expand their AUM (asset under management).

The companies charge a certain percentage of the AUM and hence the key factor is to increase the assets being managed.

Capital business – This is a form of lending/ trading kind of business. This business requires large amounts of capital and is closer to traditional banking

Financing – This involves short term loans against equities, client funding for trading etc. Some of the brokerage companies are now expanding into new areas such as Housing finance etc.

This business involves a higher risk than the agency business as the company is assuming credit risk. However the overall risk is controlled by extending credit against some collateral (shares or real estate). This business was traditionally run by banks and other NBFCs. However in the recent past brokerage firms have taken the NBFC license and have started expanding aggressively into this area.

Treasury operations – This involves trading by the firm on its own account. In my view, this is the highest risk part of the company’s business. This is a basically a black box operation. One cannot figure out the level of risk the company is taking to generate the returns. On the upside the returns and profits are very high, however if the company makes the wrong bets, then it can bankrupt the company (as we saw during the financial crisis).

I have given a general overview of the business and some thoughts in the post. I have not quoted any figure or charts for the industry. You can find these numbers in the annual report of any of the brokerage firms.

I will briefly cover the economics of the industry and some companies in the sector in the subsequent posts

On the previous post and some additional thoughts

I recently made a discovery – The higher the market goes, the more I get a lot of intellectual thoughts. This is exactly reverse of a lot other people who seem to be finding a lot of good ideas to invest in the market. Well I guess I may have to work a bit harder to find something good …sheesh why isn’t it easy to make money in the market :) ?

All IT stocks overvalued?
I was not precise enough in my previous post. I think some of the large cap IT stocks are fairly valued, if not overvalued and hence there is no margin of safety. That is they are priced for perfection.

The same may not be true for several midcaps, though I think one cannot make a general statement. As I have written in the past, general statement such as ‘market is overvalued or undervalued’ are meaningless and the same holds true for IT stocks too. So let me be more precise – companies like Infosys, Wipro and TCS seem fairly valued.

In case of Mid –cap IT companies like NIIT tech, patni or hexaware it is not as clear, atleast to me.

I typically value stocks using 3 different approaches at the same time. The first approach is the discounted cash flow – try to estimate the future cash flow (or earnings) and then discount them to arrive at a net present value. The second approach is to look at past valuations of the company and compare with the current valuation. The third approach is to look at the relative valuation of the company with others in the same sector.

I try to evaluate a stock on all the three approaches and see if they are pointing in the same direction. A stock may appear undervalued in terms of the DCF value and with reference to other companies in the sector, but appear fairly valued compared with its past valuations.

Now such a situation, which is currently present in case of Mid-cap IT and some cement companies, definitely throws up a key question for me – Why should the market value the mid-cap IT companies at a higher level in the future than it has done in the past ?

A typical case where the market values a company at a higher levels than in the past is when the growth or return on capital of the company has increased and the market now thinks that the company has a much better future and prices it accordingly.

In case of mid-cap IT companies and various other mid-caps, I am grappling with the same question – what is it that I know which the market has not considered, that would cause it to value it more in the future. In some cases it is easy to figure that out, but I am not able to figure it out in case of IT companies.

Hence my statement – Some IT-midcaps may be undervalued depending on your point of view. My point of view is that i can’t think of any unrecognized factors which may cause the market to re-price these companies upwards.

On the contrary I can only think of negative factors, several of which are not yet priced into these stocks. You may have a better insight on factors which may cause the market to value these companies higher and so both us are correct from our respective points of view.

The problem with stock tips
Moving on the next general thought – stock tips. Regular readers to this blog know that I am totally against stock tips. Other than the reason that I think that most of the stock tips are given by the unethical to the unsuspecting, I also believe that such tips do not help in the long run.

It is easy to take stock tips and follow them in a bull market. Even a dart throwing monkey can come up with some profitable ideas (unfortunately I am not as smart as this monkey during bull runs :)) and it would not difficult to follow them. How many of us will have the courage to hold on to such stock tips when the market drops or add to such positions? I cannot speak for others, but I definitely cannot blindly follow others when the market is in a free fall.

The only way one can follow stock tips or such a person is to understand that person’s underlying approach and then have some amount of blind faith on the skills of such a person. So the next time you decide to follow someone else stock picks, remember that you are putting some amount of blind faith in that person, which will be tested when the market drops (which it will sooner or later).

How to get decent return these days?
One of the readers asked me a question on the previous post – how do I make decent return these days when a lot of stocks appear overvalued and fixed income options don’t give much returns?

I don’t have an easy answer – if I had one, don’t you think I would be using it?

The first option is to keep analyzing stocks everyday (as I am doing) and hope that you may hit a few good ideas in due course of time. If you can find a few such ideas, you will have to have the courage to buy such stocks, knowing fully well that such stocks could drop if the market were to drop suddenly.

The other option is to do nothing and sit tight. This option is not easy too as you will have to watch your friends make easy money while you sit like a dumb dodo, doing nothing.

Either of the options are not easy – in one you face the risk of losing money (atleast in the short term) if the market drops and in the other you are foregoing easy money. You have to choose your poison.

A bear case on IT companies

It’s not that I have always been a bear on IT companies. I have held NIIT tech, Patni computers and Infosys are various times over the last 5-6 years.

You can see my analysis of NIIT tech here and patni here.

The main reason for my bearishness is simply ‘valuations’. Mid cap companies like NIIT tech or patni and maybe a few others could be slightly undervalued (depending on your point of view), but I find it difficult to see the undervaluation in large caps such as Infosys which are selling over 30 times their current earnings.

A lot of the IT companies are priced for perfection which as we have seen never happens in reality. In the alternative universe of brokers and tipsters, the time to buy IT stocks was in 2000 and now and to sell was in 2008. We do not know how things will turn out in the future, but can clearly say from hindsight that 2000 was the time to sell and 2008 was a decent time to buy.

The advantage (or disadvantage) of having a blog for more than 5+ years is that all your past thoughts and statements are online and can be referred back at any time. In 2008, I felt that IT stocks, especially midcaps were extremely undervalued (some selling for PE of 2 or 3) and hence were a bargain. It was not a macro point of view, but based purely in valuations (you can read the post on it here)

Getting the timing wrong
My decision to start buying into some of the IT midcaps was based on valuations and a belief that the underlying economics of the IT service space was still attractive and the companies would continue to be profitable in the long run.

I had no clue that 2008 and 2009 would be such a disaster ( if I knew, I would have bought put options and retired by now :) ). So clearly, in hindsight the best time to buy was 2009.

However one cannot make investment decision based on hindsight and so mere mortal like me (unlike some of the forecasting gurus ) have to base their decision on current valuations and expectations of reasonable business conditions in the future.

Still no idea of the future
As I have still do not have any special powers of knowing the future, my current view on IT stocks is centered on valuations and some of the long term headwinds faced by the industry such as
- Dollar depreciation : when and by how much …who knows, but more than likely to happen
- Increased costs : If you are an employed with an IT company, a point to remember is that everytime you get a good raise in salary, it comes from the bottom line (no there is no santaclaus paying for your salary)
- Intense competition: From other IT companies which is likely to drive down returns in the long run
- Host of other factors: regulation, slow growth in developed markets etc etc

The point is that the current valuations do not reflect these risks. Ofcourse you can make a point that current valuations for a lot of companies do not reflect the risk – but that is whole different story.

So what to do ?
Nothing much – sell if you think the stocks are overvalued and yes, be prepared to look like a fool if the stocks keep zooming up after you have sold. I have done that for most of my IT stocks and I am fully ready to look like a complete fool.

The secret of high portfolio returns

There is none.

If you were expecting me to share some magic key to super high returns, you must be disappointed. It is amazing that there is an entire segment of the financial industry which is into selling all kinds of special ways of making very high returns with minimal risk and absolutely no effort. I will not blame the seller alone for selling snake oil. They would not be able to sell this garbage, if there was no demand for it.

If one leaves aside the clueless and the greedy, the rest of the investors still live under several myths. Let’s look at some of the prevailing myths

Finding a multi-bagger is key to high returns
The number one aspiration of a lot of investors is to find the elusive multi-bagger or better yet a ten bagger. If one can find and invest in a multi-bagger, then he or she is all set for life.
I don’t deny the thrill of investing in a multi-bagger. However unless one has a focused portfolio (with 3-5 stocks), a multi-bagger will not make a huge difference to the overall returns.

The problem with focusing on multi-baggers is that one loses sight of the main objective (getting good portfolio returns) and ends up confusing the means with the end. A lot of times a mindless focus on multi-baggers blinds one to good opportunities, where one can make good returns (30-40%) in a decent period of time.

In addition to the above problem, new investors become susceptible to fly by night operators and other shady services which promise multi-baggers and quick returns.

Finally multi-baggers are the result of a good investing process, patience of holding the stock over a long period of time and ample luck.

Leverage
I have heard from some readers that they have considerable leverage in their portfolio and it has helped them to get high returns.

I am personally against leverage. High leverage is enjoyable when the going is good and one is making high returns, but it can kill your financial well being when things go wrong. The whole 2008-2009 financial disaster was a lesson in excess leverage, both by individuals and financial institution.

John maynard Keynes said it best – The markets can remain irrational longer than you can remain solvent.

Inside information
The other common myth I have heard is that the markets are completely rigged and the only way to get high returns is to have access to insider information.

That may be true. It is quite possible that there are several shady operators in the market who try to manipulate the market and have been able to make a killing as a result.

It is however incorrect to blame the market operators alone for the losses of the small investor. A lot of time, cheats and con artist are able to take advantage of others due to their greed and fear. This is not limited to stock markets alone and one has heard of such stories in lots of other cases, especially if money is involved.

Super high intellect
The other common myth is that one is born with some kind of ‘finance’ gene. Such super talented investors can make money effortlessly and are destined for greatness. This myth is not limited to finance alone and extends to a lot of other areas such sports and education.

This is an topic is of great interest for me and I have read a lot on it (as I consider myself to have no inborn talent for investing).

The question is this – Is extreme skill, such as being a great investor or great sportsman the result of an inborn talent or something which one can develop over a lifetime?

There are a lot of great books on this topic – talent is overrated and mindset. My personal conclusion for whatever it is worth is this – Extreme skill is the result of a lot of focus and hard work over a long period of time.

There are lot more myths and I could go on and on. The key question is what drives high returns?

The key points which I think drives portfolio returns are quite simple and can be listed in a couple of points

1.Continuous learning with the aim of constant improvement
2.Intellectual humility to learn from one’s mistakes
3.Hard work and intense focus

I don’t have any research to back the above points and state them from my personal experience and what I have read of other super-investors and top performers.

It is true that talent plays a part in one’s success, but intense focus and hard work drives eventual success far more than talent alone. I don’t think there is any great investor out there who has also not worked extremely hard over a long period of time to achieve that level of success. There is nothing natural in picking a good stock.

The counter point to the above statement can be – Do you think that working hard will make you a warren buffett or rakesh jhunjhunwala ?

I think this statement or thought misses the point. I may not become a warren buffett (highly unlikely), but working hard and focusing on this skill over a long period of time will definitely make me a much better and hopefully successful investor.

Competitive analysis of IT companies

Warning: A long post on the competitive analysis of IT companies (low in entertainment value :) ). So please get a cup of coffee or tea before you continue further

I recently received a comment from madhav

The question I have on outsourcing kind of IT companies like NIIT, Infosys, TCS etc is, "where is the moat?".

Every company seems to be into everything that happened yesterday, today or will happen in the future. All companies are generally present in all geographies, across all industry sectors etc. To top up the challenge, the "asset" of such IT companies are their people, but the employees keep hopping between the competitors and there is hardly anything preventing them from doing so. So where is the moat or where is the long term advantage? This also leads to the question - how do you value such a company?

This is an interesting question and there are several ways to answer it. I will try to answer it, by first doing a porter's five factor model analysis on IT companies (for more on this model you will have read this book). I will then use the conclusions from this analysis to answer madhav's question and see if we can value these companies.

The porter's five factor model has the following five factors, on which the moat of a company can be analyzed (by the way, I do this analysis for every investment I do)

• Entry barrier : Level of entry barriers in the industry to a new entrant
  
• Level of rivalry : Level of competition within the existing companies
  
• Supplier power : bargaining power of suppliers
  
• Buyer power : bargaining power of buyers
  
• Substitute product : presence of substitute products

I have a spreadsheet uploaded in Google groups, wherein I had done a similar analysis some time back for multiple industries. It is dry reading, but I think a useful document (for me). I am reproducing some parts below for this post, for the IT industry with appropriate updates.

Entry barriers: This factor can be analyzed in detail based on multiple sub-factors. I have listed the analysis in the table below. The summary of the analysis is in the first row

ENTRY BARRIER - No. 1 Factor deciding industry profitability	Moderate to high switching costs Barriers due to economies of scale especially in the volume business Some barriers due to vertical based competency (BCM / Insurance )
Asset specificity	Low. Mainly buildings and facilities.
Economies of Scale	Economies of scale important in recruitment, training and staffing, especially for outsourcing
Proprietary Product difference	None - IPR / knowledge base for vertical is the only differentiator
Brand Identity	To a small extent for specific verticals. However not too critical
Switching cost	High
Capital Requirement	High now, especially for the mid-size and large deals
Distribution strength	NA
Cost Advantage	High - but available to all. Scale adds to this advantage
Government Policy	NA
Expected Retaliation	High
Production scale	NA
Anticipated payoff for new entrant	Moderate at the low end
Precommitted contracts	High
Learning curve barriers	Moderate
Network effect advantages of incumbents	None
No. of competitors - Monopoly / oligopoly or intense competition (concentration ratio )	Intense competition

The above analysis clearly shows 2-3 main sources of competitive advantage. Scale is critical in this business as the larger companies tend of have cost advantages due to economies of scale and can also provide the requisite resources for large engagements. In addition, these companies can afford to spend higher amounts on marketing and sales. The second source of advantage is customer relationships (long term contracts). This advantage is not set in stone, but it a very critical asset. For ex: After the scandal, the key value in satyam, was existing client relationships and Mahindra paid for that. Ofcourse this asset does not have as much life as fixed assets and can be lost much more easily.

Level of rivalry:

RIVALRY DETERMINANT	Medium rivalry. However firms in the industry due to low exit barriers do not engage in destructive competition. Moderate to high growth has kept price based competition low in the past
Industry growth	moderate
Fixed cost / value added	Low
Intermittent overcapacity	Low
Product difference	Low
Informational complexity	Medium to Low
Exit Barrier	Low
Demand variability	Low

The above analysis shows that the level of rivalry has been high, but not destructive till date. Most companies in the sector earn high return on capital and are fairly profitable. This has been mainly due to high growth in the industry and low fixed costs (they can cut our salary and bonus when the demand drops :)). Due to multiple companies in the industry, the long term returns in the industry are bound to trend lower (read that as profit margins).

Supplier power

SUPPLIER POWER	None - Input is manpower
Differentiation of input	None
Switching cost of supplier	None
Presence of substitute	None
Supplier Concentration	None
Imp of volume to supplier	None
Cost relative to total purchase	None
Threat of forward v/s Backward integration	None

If you work in the IT industry, you are the supplier. Supplier power – zip, nothing..doesn't exist. Yes, companies say employees are their asset etc etc. We all know the reality. Employees are the raw material for the industry like steel and copper (sorry if I hurt your feeling by comparing you to a commodity :)). Most companies pay for this commodity based on what the market prices it.

Buyer power

BUYER POWER	% Sales contributed by Top 5 account. High for smaller companies
Buyer conc. v/s firm concentration	Varies for companies. Tier II companies have higher Buyer conc.
Buyer volume	High for Tier II companies
Buyer switching cost	High for buyers
Buyer information	High
Ability to integrate backward	Low. The reverse is happening

Buyer power is clearly a bigger issue for smaller companies. The large IT companies have consciously tried to diversify their revenue to reduce dependence on any specific client. This is a key variable for a company. If the buyer concentration is high, the vendor can get squeezed and will not be able to make high returns.

Substitute product

Substitute product	Substitution is feasible with another vendor. However switching costs are high. Hence repeat business is key variable
Price sensitivity	High for low end work
Price / Total Purchase	High
Product difference	Low
Switching cost	Medium
Buyer propensity to Substitute	Medium to high

Substitution of one vendor with another is a key competitive threat for each company. Clients typically have multiple vendors to ensure that they can maintain competition and keep the prices low. Till date, the competition has not been destructive and most companies have made decent returns in the past.

Conclusion

The broad conclusion one can draw from the above analysis is that IT companies do enjoy a certain degree of competitive advantage. The source of this advantage is no longer the global delivery model (everyone does it) or the employees (all the companies source from the same pool). The key sources of competitive advantage can be summarized as follows

• Switching cost due to customer relationships
  
• Economies of scale
  
• Small barriers due to specialized skills in specific verticals such as insurance, transportation etc
  
• Management. This is a key source of competitive advantage in this industry and explains the wide variation of performance between various companies operating in the same sector with the same inputs and under similar conditions.
  

Inverting the question

Let's assume for argument sake that the industry does not have a competitive advantage and is similar to the steel or cement industry (which by the way has some competitive advantage). In such as case, the industry would be characterized by intense competition and low returns on capital (low ROE). This has not been the case for the last 15 odd years and most companies especially the larger ones have maintained fairly high returns on capital. This variable alone shows that the industry has some level of competitive advantage – especially the larger ones.

Valuation

The above analysis is clearly a backward looking exercise. Valuation on the contrary requires a forward looking estimate. Can we arrive at any conclusion from the above analysis?

It is difficult to arrive at how each company will evolve over the next 5-10 yrs (the typical duration required for a valuation). However we can arrive at some general conclusions

1. As in other industries, the return on capital for the industry should come down over the course of next 5-10 yrs
   
2. The industry could split in two levels – the large SI (system integrators) such as Infosys, Accenture, Wipro, IBM etc and the niche players. Both these type of players should enjoy a decent level of profitability.
   
3. The industry is likely to diversify and expand into new geographies, but the future growth is unlikely to be as high for the big players.
   

The above conclusions are my educated guess and are as valid as anyone else's. However based on these conclusions I would propose the following

• The large SI like Infosys, WIPRO etc should continue to do well. However, these companies would see only moderate growth in profit. As a result I would be hesitant in giving a PE of more than 25 to these companies.
  
• The attractive returns in this sector are to be made with the small niche players. These companies, if they can be indentified early enough, are likely to have high growth and profit. However this is a specialized form of investing, requiring deep skills in the specific sub-segments.
  

Are you still reading? Wow!! ..If I have not put you to sleep, leave me a comment :)