Context of the article

Increasingly, we observe that during debates on financial matters, folks with technical knowledge of the subject matter are able to emphasize the superiority of their logic, even though it does not jive with the common sense interpretation of the world of the other party.

This is the second article in the series of 2 articles I am writing to try and explain, with my limited knowledge,

Article 1: How the nature of money is itself going to change in the coming days?

Article 2 (this one): How one can avoid obvious mistakes while planning one’s investments?

This is meant for folks who would like to understand but are not too keen to look at hardcore business news for the same.

In this article, we are examining what are the obvious mistakes one can make today while investing money and how one can guard oneself against those. The topics below relate to the investments in Stocks/Gold/Bank FDs as I understand these better than other avenues.

What I mean by Savings and What I am excluding from the discussion

In the article below I repeatedly talk about the investments we are making from our own SAVINGS THAT WE HAVE GOT IN CASH/EQUIVALENTS OF CASH. By savings, I mean the amount of money we have kept for ourselves AFTER ALL OUR OBLIGATIONS ARE MET. It is important to emphasize such a mundane point because the discussion below is not geared to meeting the requirements of folks for whom investment is their primary source of income. Such folks will be served better by following the investment strategy that they have been following as they obviously know better than this writer. The discussion below is only for those who have managed to save money or their future and are desperately looking for ways to improve on their current cash/liquid holdings, but will be gutted if they lose what they have got.

Also, in the article below, I am excluding the topic of Real Estate altogether. The reasons are that a) the real estate market is very local and very speculative from my point of view and I profess no expertise on the same and b) most of us make the below investments on the savings we have got after meeting all obligations, including real estate.

Let’s Recall What We Discussed

In the previous article, I had concluded that we are going to see:

a)      Cheap money in the rest of the world,

b)     The currencies of the rest of the world are sure to lose their value

c)      A period of high inflation in India,

d)     Whether Indian rupee will gain as compared to others will depend on how better we can control our finances (very low chance) and how long can we prevent interest rates from going down (Hail our RBI governor for this!).

The above points bring a couple of very logical question to the fore: When cheap money is available, where does it go? What is the problem if nearly every currency is losing its value? Will the whole thing not average out for all cash that we hold and hence isn’t this an irrelevant point in the larger scheme of things?

Where Does the Cheap Money Go?

In the previous article we discussed that most of the governments in the developed/developing world are printing their own money in the hope that this will be made available to the citizens of their country and those citizens will spend it or will create businesses from it so that economic prosperity and financial security returns to all. Though this is a practical step, this does not solve the basic problem because of the whole mess was created.

Our financial systems started to face issues because the customers to which banks had lent their money to were not worthy of that money. By this I mean that the banks (which are backed by Governments) had only given loans on the basis of short term business prosperity and not on the basis of long-term credit worthiness of the customers. Either the customers were too weak financially to deserve large loans (USA) or were experiencing a temporary business boom that was not to be sustained (Spain) or were simply defrauding the banks by wrong reporting (Greece) or were dependent on health of the rest of the world  for their business (China/Brazil/Australia/Japan) or had a sustained period of economic boom and the business cycles were about to turn bad (UK) or were asking for loans on the basis of super rosy business projections (India) or were hoping to generate business returns by colluding with other industry partners (India, at least!).

Fundamentally, none of the above problems are solved yet. ANYWHERE!      However, because as humans we have repeatedly encountered and solved these problems in the past history we have started to believe that we can speed up the recovery process. That is where the governments are increasingly releasing larger and larger tranches of money believing that they can control each and every other variable of the recovery strategy (like policy/investments/trade restrictions etc) and so more money will simply help.

This is where, according to me, the governments are erring. As mentioned earlier, the governments are lending the money to banks assuming the banks will pass on that to the customers. But there are 2 reasons why that will not happen so easily: a) Banks know that the basic problems with the borrowers have not gone away and so there is no guarantee that old mistakes will not be repeated and b) The officers in these banks have seen VERY RECENTLY the after effects of their bad decisions and so will be doubly hesitant to lend money freely.

So net-net, cheap money will REACH BANKS BUT WILL NOT GO TO CITIZENS IMEDIATELY. It will go to citizens only after the banks have exhausted all the other possible investment options or if the government explicitly mandates these banks to do so.

So again… where are the other investment opportunities where everyone’s messing up to some degree? Let’s investigate!

What Happens When Each Currency Is Losing Its Value

Normally in an interconnected world where one country/geography is doing better than others, nearly everyone with money knows where to invest to get good returns. But our present is pretty peculiar. All the countries are tripping over to prove that they can do worse than others! In fact, if it were a race than anyone who simply stands his/her ground will win because everyone else is running backwards.

So if all currencies are losing their worth and nearly every government is messing up to some degree, does it mean that nobody loses relatively in the process? In short, NO.

Let us recall that all of us are humans. There are always some things that are more important to us than others. These are the things that we have been taught are more valuable than the rest and those who taught us themselves learnt so from their experiences or their elders! Some of these things are family, relationships, knowledge, values and GOLD.

When everything is losing value (i.e. running backwards) the one thing that is considered inherently valuable (standing his/her ground) becomes more expensive (wins the race). This is where Gold comes in.

All of us inherently know that even when one cannot buy anything from a piece of paper, one can buy the same thing using a piece of gold as gold has a) a ready cash equivalent and b) a market determined rate. This is the one aspect that makes sure that Gold retains its importance as its investment option.

When a country needs money from international market it can either a) sell its own gold holdings or b) print its own money. The first option reduces the general prices of gold in the world. But that is not happening as the countries know that all currencies are losing value and so there is no point selling Gold to get those external currencies. In other words, nearly everyone who is in a position to dictate the financial fortunes of economies knows that Gold is more valuable to hold than a currency (say Dollars/Euros/Rupees).

Same is the case with banks and other financial institutions. All of them know that the cheap money that they are getting from the governments cannot be kept idle (as it loses value) and cannot be given back to customers freely (as that restarts the whole money destruction cycle for the time being) and cannot be invested elsewhere on the planet (as everyone has the same problems in economic terms). SO ANY SPARE CHEAP MONEY IS INVESTED IN ASSETS THAT ARE CONSIDERED INVESTMENT WORTHY BECAUSE OF THEIR INHERENT PROPERTIES, AND GOLD FITS THE BILL PERFECTLY.

In short: WHEN EVERYTHING LOSES ITS VALUE THEN GOLD WINS IN RELATIVE TERMS.

If Gold, Then Why Not Silver, Oil, Copper, etc…

Recall why gold was gaining in the first place! It was gaining because none of the economies are certain of their inherent strengths over the medium to longer term. They are not sure that the business activity in their countries is going to pick up soon and so Gold is a SAFE OPTION.

Other commodities that have their inherent worth are Silver, Metals like Copper, Oil etc. All these commodities have one key difference with respect to gold. All of them are tied less to a human notion of importance and are tied more to their inherent use in industries/business activity. For e.g., you and I are not likely to hoard tankers of Oil in our homes in hope of gaining from price appreciation! Same is the case with Silver (though some of my fellow Indians will disagree!) Silver, has a much bigger usage in industries than in homes!

This difference is what separates Gold from all others. Since the industries that need these metals are not doing to demand these metals in the short term, the cost of these metals not likely to appreciate

Net –net, apart from Gold no other commodity (that we normally talk of) is as certain to retain its value because their value is more determined by how much it is wanted by industries and due to lesser economic activity happening they are not likely to appreciate.  

Before we proceed… One more question. If Gold, then why not Diamonds? Simple, it’s because Diamond is not a commodity. It cannot be exchanged over the counter for Cash and there is no easily accessible standard benchmark for its value upon conversion to cash. So it is considered valuable but is not an investment option and so banks are much less likely to buy diamonds from the cash they are getting from government because they do not know how much they will get back when they sell it.

Ok… So I should Start Hoarding Gold Right?

Yes, if you are American or European, but No if you are Indian. Let me explain! See, if you earn and spend in Dollars or Euros, then you already know that your currency will depreciate and gold will appreciate in comparison but there is another aspect that is to your advantage which you may not be appreciating. The countries with surplus money and the organizations/individuals with cheap money more often than not belong to US/Europe and so the inherent trades that dictate the price of Gold are all in these currencies. So basically you are risk free w.r.t. currency fluctuations.

However, if you are Indian then there is another aspect to the same story. The inherent trades deciding the value of gold will happen with cheap money as available with financial organizations/investors in the developed economies and those currencies are in US/Euros. But when you and I go out to buy gold, we pay in Rupees. So if you have a situation where gold prices are increasing in dollar terms but rupee is gaining with respect to dollar, then the overall price movement may not be beneficial.

For e.g., if today the price of Gold is 1 USD per 10 grams and the cost of dollar is 55 Rs per dollar, then the price of gold is 55 Rs per 10 grams. If in one year gold appreciates by 10% in dollar terms then it price will be 1.1 USD per to grams. So for an American investor there is a gain of 10%. But in the same year if your Rupee appreciates with respect to dollar (because say our finances become better in short term due to government selling stakes in government owned profitable enterprises) and becomes 50 Rs. per dollar then the cost of gold will be = 1.1*50 = 55 Rs. per 10 grams. So an Indian investor will not gain anything.

Above example is extremely dumbed down and simplified for the purpose of making a point. And that point is: to invest is Gold; we also need to see how our rupee is doing with respect to the global currencies.

Before going ahead I reiterate the question: Should we start hoarding Gold now? Hold on!

How Will Indian Rupee Fare W.R.T. Global Currencies?

There are 2 perspectives to this question: short term and long term perspectives. In a shorter term (say 6 months) the finances of the country are invariably going to be better because of recently announced ‘reforms’ as these ‘reforms’ have helped the corporate decision makers the most. And remember… these are the same folks who hold the most amount of spare money!

So with improved investments in India and by selling of government share in profitable companies our country’s finances are going to be better in the short term. This, combined with the fact that there will be unlimited Dollar/Euro in the market for some time to come, means that our Rupee will appreciate with respect to these currencies. Plainly this means that exchange rate will be closer to Rs. 50 per Dollar than to Rs. 55 – Rs. 60 per Dollar.

However, as the horizon expands we are going to see one of the 2 events in India. Either our government survives until 2014 or our government collapses in early 2013. If it’s the former, it is GOING TO ANNOUNCE a lot of welfare schemes for vote preservation for 2014 (I am not waging a bet here… This will happen given the historical trends!). If it’s the latter then budget in 2013 won’t matter as new government will present a new one and until then governance will drag on. If we agree that a new party will make the government then nearly all of them other than Congress are against retail FDI. No matter whether they agree or not with the present policies the investors are not going to like it and our financials will be in a mess for some time to come. Given this, either of these 2 variables is pointing to a longer term future (1-2 years) where the financials in India are not going to go bad and so Rupee will start its descent all over again.

So net-net, in the near term rupee is going to gain with respect to global currencies and in longer term it is going to lose.

So Again… What Should We Do About Gold?

I say… embrace it! From my point of view gold is going to appreciate with respect to global currencies and those currencies will depreciate with respect to Indian rupee. With these 2 combined we should have decent returns on gold in the coming year.

However, by above I do not mean that there won’t be days when the price won’t dip. See, it’s a trader’s marked and there are times/spots when prices go up or go down. However, the longer term indication for me for the next 18 months or so is positive and so I suggest each time one hears news of gold dropping in its value one should buy it.

Finally, one should remember than the same factors that are driving the price up will drag the price down. So when the global economy sees recovery and when Indian rupee gains its strength back we will see a reversal. But I do not see that happening for the next 18 months at least and so I think we will be covered until then.

Before We Proceed… Do You Know Where We Get The Cheapest Gold In India?

It is in our Post Offices! Private Banks sometimes give discounts on prices but when you compare you will find that the price even after discounts are more than some of the government banks and the Indian Post Office! So if you are like me who banks on his/her bank and is planning to do an auto-debit on the bank’s website for monthly gold purchase… DON’T! Please walk to the nearest post office and enquire about the price.

OK We Agree About Gold… Is There Anything Else Worth Considering?

Stocks! See, the reason why gold is going up is because there are not many good and reliable investment opportunities for those with money. But at the same time those investors are not going to invest 100% of their money in Gold! They will look at alternate investment opportunities. That is where stocks come in!

Er… Did I Just Not Say That Economy Is Not Picking Up?

Yes I did, but still I am advocating stocks. See… there are 2 reasons why stock prices go up. One reason is that the inherent economy does well and the other reason is that there is sufficient confidence that the inherent economy is going to do well in the near future. To the extent that one agrees that the recent wave of ‘reforms’ in India are targeting the investors, one will agree that the inherent stock market will do well as well because these investors  are not getting good news from many other sources.

In the absence of good news from elsewhere and of any other plausible investment opportunities, those with cheap money are going to the next place where one can invest and get out most easily and where news is good for the short term. That is our Indian Stock Market!

So net-net, I believe that our general Indian Stock Market is going to do better in the short term before the investors can take the money out to invest in other opportunities around the globe.

Say What Now! Should We Invest or Not Invest in Stocks?

We should, but with a caveat! See let’s ask ourselves how we understand the stock market. From my experience those with little interest in numbers invest in stocks by one of the following approaches:

1. They listen to the experts in the market and pick stocks as suggested by those experts
2. They choose an industry they know sufficiently about and then buy the stocks of the company that they believe is doing the best in that industry
3. They go by their gut feeling about various companies and pick the ‘large’ or ‘famous’ companies that they have good feelings for!

Because of the inherent nature of the economy and the interest of global investors in making a quick buck, we are living in a time where the valuations of industries and companies within the same industry are varying a lot! Without a proper analysis it is extremely difficult to find out the good companies worth investing because one does not know: a) which company is extremely overvalued because it is in good news already or b) which company is overvalued today because it will be in a scam tomorrow.

So if you are an investor who approaches the stock market in any of the above methods then PLEASE DON’T! As of today, that is the worst decision you will be making!

For a lay investor like you and me, the best approach today is to try and invest in market as a whole and not in one/two selected companies. It is nearly certain that the overall BSE Sensex/NST Nifty is going to go up as the general interest of global money will be towards India.

So how does one invest in stock market as a whole but not in individual companies?

Index Based Mutual Funds

All the banks we talk to have mutual fund schemes for their customers. In these schemes they take the customer’s money and invest those in the stock market or government bonds or both. Normally they tell the customer at the time of taking money about the overall approach they will be following to manage the fund and what are the fees they will charge for the same.

One such scheme is the Index Funds. In these funds the mutual fund company simply takes the money from you and me and invests it into the same stocks that comprise the BSE Sensex or NSE Nifty and in the proportion in which those stocks appear there. So in basic terms, these funds are the closest proxy we have if we want to invest in Stocks as whole without investing in individual companies!

Another advantage of these funds is that in general their fee is the lowest because the people who manage these funds do not have to apply any logic from their own end while managing money. They simply have to buy and sell stocks that appear in the Sensex/Nifty and in the proportion they appear in those indices. So w.r.t. fees too, if we invest in these funds we get the maximum investment from the money we give to the mutual fund company.

So net-net, someone who does not want to lose money and is skeptical of buying mutual funds/stocks because he/she does not understand them well should be decently confident of getting decent returns with minimum losses by investing in an index fund right now. Any moment when the market dips will be a decent time to buy the fund.

Should We Invest In Futures and Options Market

Please don’t, unless you really know what is going on with the underlying business variables of the company. See in F&O segment, we get into an agreement to seal the deal (sale/purchase of a share at a pre-determined price) at a given time in the future. As I have mentioned above the overall broad economic environment in which companies operate are going to change a lot in the coming days and just like it is foolish to make long term commitments on investments, it is foolish (in my personal view) to commit to a sale/purchase at a predetermined price if one is really banking on one’s sixth sense.

So net-net, I would not personally invest into futures and options segments of the stock/commodities trading markets. Agents say that there is real money to be had in these markets, but I have observed entire Banks getting wiped out because of wrong deals and there is so much to lose here as it is most speculative.

My Banker Tells Me That a New Insurance Policy is such that Premium Can Be Invested and Returned in 5 Years… Should I?

For the love of God… DON’T! If you are buying an insurance policy then please buy a pure play policy with no funds attached to it. For e.g., if you are buying a Life Insurance policy then please buy a policy that pays your dependents money after your death and not the one that pays you money back after 5-20 years!

See, the basic point of right investing is that one should not mix 2 investment decisions together. There are too many variables that interplay and it is nearly impossible for a lay investor to take note/control of all of them at all points in time. Two of these variables are premium amount and lock-in period. If you are buying an insurance policy, please buy a policy that does ONLY THAT… which is providing you insurance. This ways your premium will be very less and the money you save can be invested elsewhere by your own choice. Also, an insurance policy clubbed with investment has its own locking period and my only contention throughout the article is that life will be different in long term than short term. There is no point giving money to someone for 5 years when you can a) not give that money and b) invest that money somewhere else and take it out at your own will.

So net-net… If you are planning insurance then please invest in a pure-play investment policy and not in a policy clubbed with investment option! Such policies are available in the market.

On a side note, there is a pretty neat article on Firstpost (here) on how the insurance companies in India are actually expensive mutual funds.

What about Bank Deposits/FDs?

We have just discussed that no matter what happens the economic variables are going to change a lot in a longer term. Also, the inflation in India is not going to come down any time soon and so it is basically a wasteful idea to invest in anything for a long time where we have no option to wait when everything else is getting so expensive! So if we need to make sure that we invest in an opportunity if it is very easy for us to take the money out on short notice. Hence, with this regards I suggest that we refrain from making any FDs for longer terms (say over a year). If we have decided to make a FD, please ensure that we do it for shorter terms and not for longer terms as it will be a bigger loss on longer term horizon due to inflation and misses in alternate investment opportunities.

In any case, this should be the last option for you when all the other options are explored. I am not saying this because of the returns but because we are not able to extract money out immediately in times of need.

What about Government Bonds?

Our government floats tax saving bonds where which we can buy from our regular salary. The basic idea is that when we pay for these bonds, the government will pay the whole amount back in some number of years and along with that it will pay a fixed additional amount. The rate at which it pays back is the similar in concept to interest rate that we get from any other money that we lend to someone else.

Should you and I do it? I think this is one way of getting assured returns from the government at confirmed and tax free rates.  It is directly in contrast with the FDs we talked about in Banks as then we only got fixed returns but we were not getting tax free returns and were not able to save taxes. Because of these added advantages, investing in tax free bonds is a decent option if we want to invest for longer term duration. However, I suggest that these should be the option only and only if we have decided that we have to have some long term investment of say more than 5 years. We need to understand that these bonds will surely cause us some losses (due to high inflation in India) but those losses will be much lesser if our money is going to be left altogether untouched in banks or is invested in a bank FD.

So net-net, only and only if we have decided that we need to invest somewhere and then forget about it for 5 years at least, we should  look at tax free government bonds. This is the only option of a long term investment of an investor who wants to minimize his/her losses.

Conclusion

From my point of view, the first instinct of a salaried struggling to enhance the savings should be to make sure that he/she does not lose what is earned already. We are sitting at a juncture where some of the broader economic trends are clear in short to medium term and there are many ways in which we can lose our money. Also, the messages that we are getting from the world are so many that sometimes it is not easy to differentiate between a good and a bad investment.

Below is what I am suggesting to myself because we are going to have a period of continued high inflation, low economic productivity, currency depreciation and FDI inflows into the country in short term.

• Invest in gold each time you hear the price dipping
• Invest in index based mutual funds instead of individual stocks
• Avoid FDs
• Buy pure play insurance policy, not insurance scheme bundled with mutual fund
• Keep investing in avenues where it is easy to take the money out on a short notice
• If a long term investment cannot be avoided, then government bonds are the most rewarding… relatively

At a time when our ability to save is reducing on a daily basis, we need to ensure that we take all precautions to avoid any reduction in the worth of what we have already got. We live in a time when our economic future is going to be determined by larger economic forces, and this shift from taking risks to make money to ensuring money is not lost is the key to a safe and painless future. Understanding these forces is the first step towards gaining better control. This article tries to explain the nature of future to come.

Context of the article

Increasingly, we observe that during debates on financial matters, folks with technical knowledge of the subject matter are able to emphasize the superiority of their logic, even though it does not jive with the common sense interpretation of the world of the other party.

This is the first article in the series of 2 articles I am writing to try and explain, with my limited knowledge,

Article 1 (this one): How the nature of money is itself going to change in the coming days?

Article 2: How one can avoid obvious mistakes while planning one’s investments?

This is meant for folks who would like to understand but are not too keen to look at hardcore business news for the same.

In this article, we are examining how the policies of the rest of the world are impacting their currency and Indian rupee. In the next article, I will mention the implications these changes have on our personal investment approaches.

Recall a heist movie first

All of us have seen many heist movies where the hero (in reality the anti-hero) is keen on stealing the plates using which he can print money at will. The most recent examples have been Don 2 in Hindi and The A-Team in English where the plot revolved around the stolen plates.

In nearly all the plots, the main reason why someone was stealing these was either:

• He/She was in need of money due to personal crisis/blackmail or
• He/She simply wanted to live a peaceful life next to some beautiful beach and not have a worrisome bone in the body.

Once the plates were stolen, the basic idea was the same: PRINT YOUR WAY OUT OF THE PROBLEM AND LIVE HAPPILY EVER AFTER….

Now Assume It’s Not a Movie At All

Imagine that this is indeed what is happening, but not illegitimately! It is actually happening with gay abandon across the world! Let us look at various geographies that matter to India:

• USA: The country entered into severe recession sometime in 2008 and then their government did something called “Quantitative Easing or QE”. It sounds important, but essentially what happened was that their central government said, “Look! I will release a lot of money into our internal financial system so that people can get easy loans and using that they can kisk start their business and the economy rebounds back!” Also, their government bailed out a lot of companies in their times of crises.

One year ago, I had documented their issues here.

US government did QE in 2 phases – QE 1 and QE 2. So in essence they tried to release limited amount of money in 2 different phases as per their assessment of the need to do so. Despite these, their situation did not improve completely!  Their jobs are not picking up and some industries show some sign of improvement but that does not last. So as a final resort, earlier they have announced QE 3. So how will this help if 1 and 2 did not help? Well it’s easy… This time they are releasing unlimited amount of money into the system for an indefinite period!

And where will they get with money from? Of course, they will print it silly!

• Europe: If you have been reading bad financial news for a few years now, you would know Europe had been constantly featuring in it. What’s wrong with it? Well.. as it turns out plenty! One year ago, I had documented their issues here.

In essence, they have a problem and each time they try to solve it the problem becomes bigger. Their problems started because they had a common currency but different policies on governance across the Euro Zone. The real solution lies in tackling that problem of removing the difference in approaches of various countries. Instead, each time as a solution they release some money into the European financial system by the way of bail outs (which is like giving money to sick economies as grant) or by the way of bond buying programs (which is like lending money at extremely low interest rates to sick economies as help). As I said the problem only keeps bigger. Each time they do this for one country, some other country says, “Look here! I want the money too. I did not tell you earlier but I am too sick too!” And the gravy train keeps coming.

So what they are trying to do as their final solution to take care of their problems? Well it’s easy… This time they are lending unlimited amount of money to those who need in Europe at extremely low interest rates though a bond buying program! Unlike USA there is indeed a case in Europe to increase this supply of money to those who have been absolutely crippled by a long time of austerity, but this is still a wrong solution to the original problem of having a dysfunctional system!

And where will they get with money from? Of course, they will print it silly!

• China: For a long time now, China’s economy is slowing. Their manufacturing orders are slowing and they have built a lot many more homes than what people can buy. So their industry is struggling.

One year ago, I had documented some of their issues here.

Since China is a country that exports more than it imports, if the rest of the world is not doing well then it will face the biggest crunch in terms of inventory and finished goods lying in its warehouses. To help this situation, it is allowing its domestic small companies and individual citizens to borrow more and more money at lower and lower interest rates. They believe that when people get cheap money they will spend more and so their economy will avoid something called a hard landing (rapid slowdown in our terms!)

So in essence, this money they have decided to release more money into their system at lower interest rates.

And where will they get with money from? Of course, they will print it silly!

• Brazil and Australia: When China coughs, Brazil and Australia catch severe cold. This is because most of the minerals that China imports for its manufacturing are imported from these 2 countries. Apart from revenue from mining, little is going strong in Brazil and Australia that can really support them. For e.g, in Brazil rest of the economy is made up more of agriculture and tourism and in Australia rest of the economy is made up more of tourism and sports!

So in essence, these 2 countries are also going to slow down a lot because of China. To help their situation, they are also doing what the rest of the world is doing! In Brazil, they have already decided to release more money in to the system by reducing bank interest rates to a record low and Australia may do the same in coming days.

And where will they get with money from? Of course, they will print it silly!

• Japan: Same story.. Another country. Japan followed the path of China and released a lot of money into their system earlier this month.

And where will they get with money from? Of course, they will print it silly!

Please note… In all the above cases, we are not talking about some petty thieves! These folks who are making decision are in charge of the financial health of their respective countries! All of them know something that we do not realize: that the health of global economy is not improving for some time to come and the only way to make more money is to print it!

The basic intention remains quite noble in all cases: print enough money so that those who need it can get it quite cheaply and then are able to do something worthwhile with it. And when they pay us back, all will be good! They are acting like those heroes who have to resort to desperate measures are desperate times!

Can anyone regulate human nature?

The basic premise of globalization is that anyone can invest in any part of the world freely and expect to get fair returns on the investment. That means that if there are right incentives, then people who get this money from government may not actually invest back in their own countries but will invest elsewhere to get more returns. It does not necessarily mean that everyone is hell bent on cheating but this statement is simply made to keep us aware that such a possibility exists.

So is that beach house even possible?

Not sure yet! Let’s investigate.

In my childhood, I used to wonder why the government cannot print more money and give for free to all to remove poverty. Now it turns out, I was not the only one to have that dream. Reserve Bank Governors from all over the world have the same dream and are printing their money to get out of bad times!

Will it succeed? To answer, let’s ask ourselves first:  if we make one lakh per month while our needs are met by forty thousand, then what do we do about the remaining money? I dare say, we start by thinking that we will save all of that but we lose that discipline over the coming days and the 1^st habit we lose thereafter is the habit of bargaining! In other words, we are more prone to pay a little bit extra for each thing we buy simply because we can afford it. In other words, the utility of the same money in our wallet is lesser in our eyes as we know there’s more where this came from!

So if you and I change our behavior in times of cheap money, why will other countries and their citizens not do the same?

Before going further, let’s dive into how economics follow common sense.

Question 1: What drives price points in any economy? (In essence how things become expensive in such times of plush money)

Answer: If money is available more easily or if it exchanges hands more easily, then price levels in any economy are likely to increase. The only way to reduce those price levels will be make sure that people spend more and on buying stuff which will keep general prices low. Simply put, in times when money is easily available or when money exchanges hands very easily the only way to control price is to make sure people spend more and more frequently buying real goods which need to be made available more and more easily.

So as a bottom-line, till the times people continue to spend, inflation won’t jack up but when money is available easily but people don’t spend on buying real goods from real world then inflation will go up. Typically, this happens a few days/months/years after cheap money is made available when all the people have all the things they need and the only thing they invest anymore are on luxurious goods/value added services. Since all of us feel naturally satisfied after our needs are met, all of us naturally get into a situation where we don’t mind spending on irrelevant stuff and so prices increase.

BOTTOM-LINE 1: PRICES ARE GOING TO INCREASE IN THE WORLD IF UNLIMITED CHEAP MONEY IS MADE AVAILABLE FOR UNLIMITED TIME!

Question 2: What determines exchange rates between 2 currencies?

Answer: Each country has to transact with the external world. If a country borrows more from the world than what it produces (trade deficit), then has to spend more of its own money to pay for external obligations. So in essence, the value of its currency decreases. Similarly, if a country has higher inflation as compared another country, then the purchasing power of its currency reduces as compared to the other country and so the value of its currency decreases. Finally, if the interest rates in a country are higher than the lenders in that country will prefer to invest within the country itself as they will get higher return.

There are other factors too that determine exchange rates, but the bottom line remains the same that the value of a currency as compared to others will reduce if there is:

• High inflation
• Low interest rates
• High trade deficit

I am sure we recognize where all this is leading us to.

BOTTOM-LINE 2: CHEAP MONEY IS BRINGING THE OUTSIDE WORLD TO A SITUATION WHERE THERE COULD BE HIGH INFLATION COMBINED WITH REDUCING INHERENET WORTH OF THE CURENCY THEY ARE PRINTING.

So what about that beach house?

I think we can all agree that if one can get such currency printing plates then temporarily one can get out of pains and can buy a beach house. But as time progresses, one will realize that the same money one is printing day in and day out will lose its worth and everything else will seem so damn expensive! Eventually, By The Time One’s Children Grow Up One Won’t Be Able To Afford The Same Lifestyle As The Printing Plates Will Be Nearly Worthless By Then!

This, in popular parlance, is called: ‘Kicking the can down the road!’ No wonder soccer/football is the most popular sport in most of these countries!

Hey Bhagwaan! What about India then?

A year ago, I had documented about our country, which was like a train wreck. Many of the factors I had mentioned in the initial part of that article still hold true to me. A discerning reader is asked to make his/her own judgment.

Despite all the chest thumping we do about how strong we are, we are not the most important economy in the world. We are still in our pre-teens as compared to the near mature growitth of many of our competitors. We are not the biggest investors within India itself, let alone the world. Strength of the manufacturing sector of any big country determines the inherent strength of that country. That is the ONE SECTOR that generates real wealth in the country. In India, manufacturing is a much smaller component of our economy (less than 20%) as compared to any other developed country (60% at least). On a side note, this is one reason I believe one should oppose FDI and should explore an alternate set of reforms that will help our economy.

Net-net, we don’t contribute enough back to the world to be compared a serious player. We retain the world’s interest as we have enough opportunities for them to explore.

From our own side, we continue to spend more and earn less. We have tried a temporary fix by earning money by selling some of our profitable government firms (divestment) and by making sure we don’t invest when the rest of the world can do so on our behalf (reforms), but as I said.. That’s temporary. Next year, with elections coming, we will again start our spending spree with social initiatives (like Nrega/Farmer Loan Waiver before the previous election) and that will mean that government will again spend much more and to boot, populate the marked with cheap money.

Recall what we discussed about prices some time back. When people suddenly get a lot of free money, and/or if the money exchanges hands really fast then prices rise if all that money is not spent immediately buying goods.

So what we are doing?

• Government has initiated scheme for direct cash transfer: This is to contain corruption in subsidy schemes. The idea is good, but it is tackling the issue of corruption rather than solving the issue of subsidies. So net-net, we will have cheaper money available directly in hands

• There is a chance that government will allow more welfare schemes for 2014 elections: This will mean that a speed with which money will exchange hands in economy will increase and the deficit in our finances, which is already high, will keep getting higher.

• Instead of asking people to spend more, government is spending more on behalf of people. This is not only reducing the productivity of our labor, but is also increasing the wages in rural India. That means we are already destroying our ability to profitability produce quality goods and services in the future.

That can lead to nowhere else but I one direction.

BOTTOM-LINE 3: INFLATION IN INDIA IS NOT COMING DOWN ANY TIME SOON!

So is all doom and gloom! No, there are a few Indians who are genuinely gurarding us against total disaster that can come out of our policies.

Hail Subbu – The Governor of RBI

Recall how a few minutes ago we realized that when inflation is high and the government finances are bad then the currency of the country loses its flavor. Well those 2 are happening in India. But there is one superman trying to save us. He is none other than Dr Duvvuri Subbarao, the Reserve Bank of India (RBI) Governor. Subbu has refused to release cheap money into the country’s economy by reduction of something called Repo Rate. It is the rate at which banks borrow from RBI and so if they get money cheaply then they will lend cheaply and so the country will be awash with cheap money.

This has 2 advantages:

• Controlling of exchange rates: If rates were reduced, our Rupee would have fallen further as compared to other currencies and so all our imports (which are more than exports) would have become that much more expensive. Our domestic manufacturers would have been killed more by that loss than saved by gaining in low rate finance.

• Prevent Misuse of Cheap Money: People with money know that won’t invest in India because there’s simply too much hassle. So if they had got money from government at low rates they would have been more interested to invest outside India, thereby making a complete mockery of the government’s intentions.

So where does this lead to?

BOTTOM-LINE 4: THOUGH INDIAN RUPEE HAS LOST A LOT OF VALUE IT WOULD HAVE INVARIABLY LOST MUCH MORE OF ITS VALUE AS COMPARED TO THE WORLD IF NOT FROM THE SOUND POLICY OF OUR RBI AND ABSOLUTELY POOR CONDITIONS OF THE REST OF THE WORLD (DESCRIBED ABOVE IN THE ARTICLE). FOR NOW, WHETHER IT LOSES ANY MORE VALUE WILL DEPEND ON WHETHER OUR RBI GOVERNOR REDUCES ANY RATES AND WHETHER THE SITUATION IN THE REST OF THE WORLD IMPROVES.

So what are the forces we have learnt about?

From the above logic, it is evident that in the coming days we are going to see:

a)      Cheap money in the rest of the world,

b)      The currencies of the rest of the world are sure to lose their value

c)      A period of high inflation in India,

d)      Whether Indian rupee will gain as compared to others will depend on how better we can control our finances (very low chance) and how long can we prevent interest rates from going down (Hail Subbu for this!).

ABOVE FACTORS HAVE OBVIOUS IMPLICATIONS ON HOW THESE POINTS IMPACT THE VALUE OF RUPEE WE HAVE IN OUR WALLET, THE VALUE OF WHAT WE HAVE IN OUR BANKS, HOW WE SHOULD PLAN TO INVEST IN STOCKS, HOW WE SHOULD PLAN TO INVEST IN METALS AND HOW WE SHOULD ENSURE WE DON’T LOST AT ANY COST.

WE WILL COVER THAT IN THE NEXT ARTICLE.

<<An earlier version of the article was published with a lot of typos. Those have been corrected by me to the extent possible>>

New Delhi….. We have a problem! There is only so much household silverware we can sell to earn money. This country needs a better class of governance, and FDI won’t give it to them!

Over the last few days we have had a slew of artbicles supporting/condemning this decision and the reasons for the same.. The folks who support the decision argue, validly in most cases, that the FDI will bring in a lot of global technology/best practices/solutions to our fledgling retail industry and those are the precise things we need. Those who oppose the FDI argue, equally validly in most cases, that these solutions will mean removal of a lot of human involvement in the industry and that will be catastrophic in the long run. These 2 arguments, in my view, form the core of the entire FDI debate.

I, for one, sit squarely in the latter camp. Last year I’d documented my reasons for opposing the FDI and nothing much has changed in my views since then. In the article below, I am trying to chart out an alternate reform policy than what is being practiced by the present government.

First, let’s recall how a country can achieve growth. As mentioned in my earlier article, growth depends on the amount of money that is available for investments and the quality and contribution of those investments towards the overall vision (indicated by return on equity). If one sees, one would agree that these are the precise arguments that are being made in favor of the FDI. Government is saying that a) FDI will bring in more money that will be available for investment and b) because of the fact that these will be private companies investing towards their goals, the quality of investment will automatically be high which will contribute towards the overall goal. The clauses of 51% investment back in back-end infrastructure and specific areas like cold storage are attempts in this direction.

I do agree that growth will come in the immediate future because of this policy. But before committing wholeheartedly to this path, let us ask ourselves these questions: a) Keeping the fundamentals same, is this the ONLY way for us to seek investment and b) Are these clauses the only way to get the maximum return on the investments we are making.

a)     Where do we get money for making investments in our economy?

Last night, our PM told us that Money Does Not Grow on Trees. I recalled that these are the same words my parents told me when I had got my 1^st job and had encouraged me to plan my finances with prudence. However, along with this they also told me one more thing: MORE IMPORTANT THAN PLANNING FOR NEW WAYS TO EARN, IT IS IMPORTANT TO MAKE SURE ONE IS NOT SPENDING INDISCRIMINATELY. From what I know, I do not have a single friend/relative whose parents have told him/her anything different.

 We have a pool of money lying with us. A part of that pool belongs to individual citizens of the country (in the form of savings), a part of that is with business organizations (in the form of savings/liquid investments) and a part of that is with the government. Over and above that there is a huge pool of money lying with the external world (Foreign Investors). For the purpose of investing back in the country’s prospects, we can take contributions from all these sources.

In the below table, I have mentioned how each pool can contribute some money, and whether they WILL do it to begin with:

As seen above, it looks like our government has give up all hope of getting any money from anywhere within India. I can’t help but think why!

To me, there is reasons why none of us in India are willing to invest in India are:

• The past track record of the government in handling investments,
• The relative inefficiencies of the Indian work systems as compared to the rest of the world and 
• Higher taxes/inflation leading to lower savings

CONVERSELY, IF WE MANAGE TO CHANGE THESE 3 SITUATIONS, WE WILL AUTOMATICALLY START INVESTMENTS IN INDIA BY INDIANS!

This also ties pretty nicely with the fact that if there is good confidence that returns can be obtained; there will be no concerns with making investments.

b)     How to get better returns on or investments?

Anyone who has ever had any interest in making any money knows that efficiencies are the key to better returns. Ideally the more efficient one is in executing the plans, the better returns one hopes to get.

Sadly, we don’t practice that in India. Somehow in the last few years, WE HAVE STARTED BELIEVING THAT THE MORE MONEY ONE THROWS INTO THE BUSINESS, THE MORE MONEY ONE GETS OUT OF IT. That is like saying that gaining body weight is the key to good health for a malnourished person, even if one is gaining fat instead of muscles! You and I both know that gaining fat I key to getting diabetes!

So what causes inefficiencies in our country? Below are some of the factors I have seen working in life that reduces financial returns on paper:

No matter how I slice it or dice it, all the above problems are stalling an Indian entrepreneur but the government is bending backwards to resolve all of them for an external investor. This is exemplified in things like – One stop shop for all clearances, multi year tax breaks, cheap land allocations etc..

I can’t help but think why… WHY CAN WE NOT DO THIS FOR INDIAN ORGANIZATIONS? It is absolutely probable that once we help our own players, they will be able to do even better than external companies because of our local knowledge.

SO WHY IS THIS OBVIOUS SITUATION NOT VISIBLE TO OUR LEADERSHIP?

Following are the reasons why I believe we are going ahead in our growth journey the wrong way.

• Complete lack of vision: Our leadership is gung-ho about growth. Growth of any country should be an output of all the good things it is going, and not the sole factor deciding all of it actions. WHAT WE WANT TO ENSURE IS PROSPERITY, GROWTH SHOULD TAKE CARE OF ITSELF.

To me, prosperity comes when the variance in income can only be explained by variance in hard work/innovation/sincerity/integrity. Then those who work earn appropriate returns.

How many times in the last year we have seen our PM or our FM harp about the importance of 8% or 7% growth? I have heard it quite a few times, and each time I heard it louder than the last. And how many times we have actually seen them meet targets on other parameters that will contribute towards ensuring that growth? I have never seen them meet targets on saving/defecits/borrowings/investments in the last couple of years at least. 

So have we not boxed ourselves into a situation where we have no option but to utter the words, “Money does not grow on trees”? Alternatively, is it not possible to concentrate on our actions better than how else we can generate more money to fill in the holes in our finances?

A country where leadership is clueless has no option but to become dependent on others!

• Complete lack of imagination: People say that Indian IT (our biggest source of pride for a few years now) is itself a beneficiary of FDI policy of western nations, and so people like me are being narrow minded in their critiques. The way I see it Indian it professional improved the business processes of western countries WHILE SITTING IN INDIA. We have enough knowledge, experience, resources and foresight to know what is wrong with our industries.

I am not sure why we should borrow the success templates that have worked elsewhere without considering what made them tick. USA grew for decades continuously simply because it concentrated on its strengths rather than taking shortcuts from elsewhere. They had the benefit that they had no option (rest of the world was either war torn or was under colonial rule). IS THAT NOT THE SUCCES TEMPLATE WE SHOULD BORROW?

Competitive economics say that competitive advantage developed internally is more long-lasting than a tried and tested technique. It allows organizations and countries to realize their inner worth and helps them reinvent themselves in times of need. Coca Cola is still able to sell sweetened carbonated water even one century after inventing it.

I don’t think our leadership realizes it.

• Complete lack of self confidence: Our country is blessed with immense entrepreneurial spirit. In Hindi we have degraded it by calling it Jugaad!

I really do not know why our leadership does not bank on our domestic industry to chart the future growth story of India. No one will hesitate in setting up a business to improve the situations in Indian industries IF IT WAS AS EASY TO SET UP BUSINESS AS IT IS IN US/WESTERN EUROPE? When it is becoming increasingly difficult for a small scale Indian enterprise to make its way in the economic environment, then why should it be equally easy for a large organization to set up business? It is no wonder that corporate India is in complete unanimity over the decisions. They know like the rest of us: what is wrong… and they have what the rest of us don’t have: a policy that supports them.

CONCLUSION  

Reform is an action that takes us into a prosperous future. Such a future has to be sustainable in terms of earnings and should provide us with sound competitive advantage over other economies of the world. I do not believe that the policy on FDI in all sectors can be called a reform. Such action is commoditizing the Indian economy and is leading us to a future where we will have short term growth, but will not have enough prosperity among Indians.

Alternatively, we have too many lower hanging fruits that we can pick. With sound vision and intelligent application we can transform our future to a much better one than what the present FDI action guarantees us. We have enough knowledge, experiences, resources and foresight to know what needs to be done. FDI is to be welcome only in cases where we have acute shortage of expertise as compared to the problem at hand for e.g. – financial liquidation industry

END GAME

If this was an event in isolation by our government, then it would have been still ok. The government, while encouraging FDI, is not stopping the indiscriminate social welfare schemes and fiscal profligacy that are causing both the loss of revenue and erosion of the quality of our manpower. This will only spiral into a future with higher dependence on the external world!

If you’ve never told your child/younger sibling/student/follower/someone who trusts you that “you are not good enough to make it on your own and so the only way to live is to tag along with someone with resources…”  PLEASE SAY THAT NOW.

I hope that this way I will be truer to this website, as lately I believe that I have ignored it to address other professional/personal priorities. I have realized that this way I will be more aligned to the mission of this site – which was to follow a disciplined approach in investing while documenting the successes/failures along the way.

My Holdings

None

About Voltas

I thought Voltas makes ACs. It does, but that’s not what it does all the time. In fact, if it were a man, it will make ACs only 1/3^rd of its time. For over half the time, it will execute Mechanical, Electrical and Plumbing projects in various large projects (like F1/Commonwealth Games/Hospitals etc). 10% of the time will be spent in actually making big machines and selling to other business. These include selling Textile Spinning Machinery to Textile Industries, selling Mining and Construction equipments to Mining companies and Material Handling Equipments to warehouse management companies. As mentioned earlier, for the remaining 1/3^rd time, it will  make ACs and Refrigerators. In whatever time that is left, however miniscule it may be, it will involve itself in performing horticulture, water management and purification work in Oman.

The company, thus, is not a company that sells to retail customers. It is a B2B company and has a profile right from small ACs to big Machines and a service profile that involves project management in all aspects. The company does so all across the world and enters into JV or Subsidiary engagement in geographies where such an option is available or needed.

Voltas’ Ecosystem

As mentioned earlier, Voltas makes products ad executes projects. That means its cash flows in any one line of business are very different from any of the others lines of business. When it makes small products, the ecosystem involves it to project demands on a seasonal basis, plan for the production, manage inventory and quality and eventually sell to customers. In that ways, it works like a normal manufacturing company. Cash is obtained when the product is eventually sold. Also an AC produced in one year can be sold the next year.

When Voltas makes big machines, it projects demand on the basis of economic conditions and government policies that impact its customers and then plans for production. The purchase decision for the customers are dependent on their own cash flows and so there are chances that these machines, if not sold on time, may have to be carried as inventory for a larger period of time. The cash is obtained when the machines are sold, but is blocked for a larger amount of time during the production. The inventory can be converted to cash, in worst of the situations.

When it executes projects, the company takes over a project site, brings in its resources and then starts executing work. Its cash flows come in the proportion of the work executed. The project timeline can be delayed for a myriad set of reasons, from incompetence to government interference to economic condition. If there are delays, the costs incur and these costs cannot be diverted to any other location for a different use.

As one can see, the three businesses that the company operates in are as different as chalk and cheese. That the company operates in these simultaneously is only because it chooses to, and not because it sees much natural synergy between these businesse.

Voltas’ position in its ecosystem

This question is tricky. It is tricky because it is not one ecosystem we are talking about.

One needs to look at how big the company is in its respective businesses. In ACs, the company controls 18% of Indian market (as per its own Annual Report). Apart from this, the company made about 3000 Cr. Rs. in the last FY on its Electro-mechanical projects and services division. Punj Lloyd, the 2^nd biggest project construction company, did about 8200 Cr. Rs. last year. Even though this is not a apples to apples comparison, this indicates that in the business of managing projects too Voltas is one of the bigger players. In its machinery division, the company made more than 550 Cr. Rs, which makes it amongst the top 25 engineering companies in the country (a list that includes totally heavy engineering companies, like BHEL). Purely amongst the industrial/general purpose machinery companies, Voltas ranks in Top 5.

So when we look at this way, Voltas looks like a significant player in all its ecosystems.

For the analysis below, I am using Consolidated Financial Statements

Reported Financial Performance:

The in the last FY2010-11, the company’s total revenue increased and PAT decreased on a YoY basis.

Below is a high level view of the company’s finances as reported in its annual report. It can be seen that the profits have fluctuated rapidly in the last 3 years (consolidated).

Since the last annual report was 9 months old, I have indicated the rolling 4 quarters net profit of the company. It can be seen that the company has reported almost the same amount of net profit in its last 4 quarters, as it did in the last FY.

The PAT and Net Worth exclude minority interest.

Reported Free Cash Flows to Equity Owners

 Along with the above finances, one can look at the below measures from the company’s annual financial statements (consolidated).

 One can see that the company had one round of Capital Expenditures 2 years ago but has not done so recently. Looking earlier into its history as well, it looks like the company takes up capital expenditures in phases, and so to even out the impact of such exercise, one has to normalize these numbers.

The company has financed the Capex using Debt as there has been a similar increase in debt in 2 years ago as well. The company paid back the debt the next year, but then again took some more debt in the last year. As per company’s annual report, this additional debt was due to some local issues in some of its international markets.

The company’s Working Capital change has been negative consistently but fluctuates in magnitude on a year to year basis.

When I normalized the above factors and calculated the FCFE, I get the following data (all amounts in Rs. Cr.):

One can see that the company’s last 3 year’s Average Free Cash flows on a normalized basis are less than the latest reported profit or the training 4 quarters profit.

So why has the share price dipped?

Despite reporting the same amount of total net profit in the last 4 rolling quarters as in last FY (indicating stable performance), the share price of the company is hovering around its yearly lows. This is because:

• In Q2 FY 12, the company reported 40 Cr as profit, which was less than ½ of what it made in Q2 FY 11. This indicated to the market that the company is not going to make the same amount of money in the coming days.
• Companies like Voltas command a lot of their share price due to their growth prospects. Since the growth prospects of the company look dim (due to low profit) the company’s share prices took a big hit.

So, share price is where it is now… Will it go up or go down?

If someone is interested in investing in this stock, he/she will want the answer to this question.  However, instead of answering this question, I am trying to make a case on why it makes sense to invest in this stock.

Following are the reasons I am gung-ho about this stock:

1. Prospect of Dividend: Last financial year, the company payd 2Rs per share of Dividend. As mentioned in the above sections, the company is still a consistently-high-free-cash-flow company and that has not changed. Given this, I believe we can be confident that the company will continue a period of good performance in absolute terms. I am reasonably confident that the company should return dividend in the coming year as well. Whether it will still be Rs. 2 or will it be lesser is a matter of speculation. In the last recessionary environment in 2008, the company stil paid Rs. 1.35 Rs per share of dividend and paid 1.6 Rs. per share in 2009. Even if the company pays 1.6 Rs per share, we are getting 2% fixed return on for sure.

For those who say 2% is not enough, I am only saying that this surety is not there with many companies in this FY. Also, this surety of a dividend is not the complete case in favor of the company.

1. Prospects of Capital Appreciation: Since April/May 2011, nothing materially has changed with the financials of the company. Yet, the company’s shares dropped by over 55%. Since Jan 2011, when the prices were about 3 times of their current prices, nothing materially has changed. Except 2 things. One, the recent profits have dipped. That we have covered above. And two, the company took about Rs. 100 Cr. worth debt. Even after this additional debt, the company’s total debt is at a measly  138Cr. 3 years ago, the company had over 180 Cr. debt and the company paid a lot of it back in 2009-10 and the prices were still double of present value. Since then, both absolute revenue and absolute profits have improved.

With the argument above, I believe that the company’s recent negative returns on share price are more attributable to the emotional nature of the market, and less with the actual performance. Remember, the company is still55% project management company and hence heavily dependent on economy and that is weighing more on the mind of the market. In other words, the same reasons that brought the prices down may bring the prices up later on.

1. Better hedged company: This point is again to underline why market may have been too emotional with this stock. The economic situation is not great for the immediate term, but the retail consumption story esp. the consumptions drive by Indian middle class is still intact. If we look, the business segment composition of Voltas has chaged in the last 3 years. In 2007-08, the company’s AC unit was 25% of its size and in FY 2009-10 it was 30% of its size. Clearly, the company is looking at its cooling products unit as its growth driver and this segment is propelled by retail or office consumption. Even if the company does not make 30% of its sales in Cooling products segment in FY 2011-12, it is still better hedged than in 2007-08 and hence its performance has a degree of stability to it.

1. Ratios look attractive: At present share levels, the company is selling at about 8 times its average free cash flows of the last 3 years, 11 times the latest year’s free cash flows and about 2.25 times the book value. For the same performance, when the share price was 135 Rs 6 months ago, then numbers were 15, 21 and 3.7 respectively. From what I have learnt from books and from my own experience, any time the P/E times P/BV exceed 25, the stock has to be really good to justify the multipliers. For me, no matter how I look at the free cash flows (point in time or averaged out), the numbers are attractive. The same numbers were NOT ATTRACTIVE at levels above 100.

The numbers are mentioned in the below section.

As a bottom line, instead of answering whether the share price will go up or down, I am contending that the share price is attractive now. Tomorrow, if the share prices go up you will gain. If the share prices will go down, then it will be even better as you can buy more to gain still more later! The company is extremely fit right now and should not lose the battle with bad economic situation.

Ownership Structure and Fit vs Flab:

30.32% of the company is in the hands of its promoters. The promoters are from Tata group. They are running a manufacturing cum project management organization with minimum debt and the company had an interest coverage of over 30 times in the last year.

I believe the company’s ownership and its fiscal condition are not in any doubt.

Return on Net Worth:

The PBIT/Avg. Net Worth for VOLTAS was 23.3% 6 years ago. It was 40.85% in the last FY. In this time, the lowest it got to was 52% in 2009. No matter how we slice this or dice this, the company is running on supreme operational efficiency. The premium that the market is giving to its share price is justified.

Value Judgment:

Removing the amount of cash the company carries from the share price, I arrive at the following conclusions. These are the same numbers I had referred to above.

In my earlier analysis of other companies, I made a case for a company when the P/FCFE was in single digits and P/BV was around or below 1. Those numbers make sense for companies that have a lot going for them but also a lot going against them. Those companies were small and had a history of good performance in terms of free cash flows and returns on net worth (good things) but were small in their industry or were in industries that were matured and not expected to be star performers like other sectors (bad things). For such companies, it makes sense to buy a company when the share price to a shareholder is worth the same as the owner of the company.

For Voltas, this is not true. Based on the analysis above, I believe that the company has more things going good for it (financials, business mix, history) and very little (namely economic situation) going against it. In such a case, it is a ‘dream comes true’ situation if you and I can get the share at the same cost as it is worth to the owners. The closer we get to that the better it is. With that belief, it makes sense to enter the share at levels that makes sense. If the share drops below those levels, it is actually better for us as we can buy more of them. For Voltas, I believe those levels of good entry point are reached now.

Verdict:

Investing in Voltas is relatively less risky at present levels. For a patient investor who is willing to look longer term, this is a great opportunity. The stock looks just about rightly valued from its reported performance. For a new investor looking for 1-2 yrs timeframe, I would recommend look at this stock as an “accumulator” which means I suggest keeping on accumulating this stock on these levels and below with hope of a very good payback later.

Personally, I am going to buy the Scrip now.

My Holdings

My Present Holdings
Avg. Purchase Price	Holding period	Highest Purchase Price	Lowest Purchase Price	Unrealized Profit/Loss
31.02	9-12 months	33.3	27.35	(40.21%)

About Electrosteel Castings

The products and services provided by Electrosteel include Ductile Iron Pipes, Ductile Iron Fittings, and Special Products called Electrofresh Plus. Besides it undertakes Turnkey Projects. Ductile Iron Pipes have application in water conveyance. These pipes are used for over-ground pipeline installations and are available in various lengths, diameters, thickness and pressure handling capacity. Electrosteel’s Engineering Procurement and Construction division undertakes end to-end solutions for water and sewerage projects.                                                                                                                                                                                        .

Electrosteel Castings’ Ecosystem

Electrosteel Castings sells pipes that transport water. These are used in projects like irrigation, drinking water and sanitation/drainage systems. The company used to buy iron and made pipes out of it. The business is sustainable, bot not overly profitable as the scope for differentiation is little.  The only way to increase profit was to lower costs and go for economies of scale. In order to reduce costs, in the past years the company has bought an iron ore mine to be able to extract cheap iron and has bought a coal mine to get cheap coking coal for the blast furnace used in such extraction. It also developed a power plant to generate electricity for its own use, as such a source will be cost effective.

The customers of Electrosteel Castings execute projects in which they need these pipes from the company. Most of such projects are in the social sector as the main use of Pipes is to transport power. The customers, thus, are mostly government. That means that the risk of a default in payments from the customer’s side is minimal, and that guarantees the profits in the business. On the other hand, most of the sale depends on the project lifecycle and project commencement and that is hampered by the general economic condition of the country.

In order to explore other markets, the company has started a) exporting to other countries and b) bidding for water and sewerage projects on a turnkey projects. For the purpose of export, the company has opened up its subsidiaries in various countries. For the purpose of executing turnkey projects, the company has started a new construction division for the same.

All said and done… Everything revolves around Pipes. The company has been making them and selling them for over 50 years no€w, and knows in and out of the business. It has made some though investments to minimize its costs and that has helped the company its performance in the past. This ecosystem rewards efficiency, and Electrosteel knows that.

Electrosteel Castings’ position in its ecosystem

India currently produces about 500,000 tonnes of DI pipes per year and Electrosteel Castings produced about 270,000 of them last year. Electrosteel, thus, is a giant in its ecosystem in India. However, that stability comes with a price. The company’s fortunes fluctuate with the fortunes of its ecosystem. This is evident from the fact that in 2008 when the world economy was last at its nadir, the company earned only 1 Rs per share. Immediately before that year and since that year, EPS as hovered between 3-4 Rs per year.

Among the metal pipe making companies in India, Electrosteel stands as 6^th largest in terms of average sales in last 3 years. The company also has a sizeable controlling stake in Lanco Industries which is 9^th in the list (more on that later). Together, these 2 companies are 4^th largest in the country. There are over 40 listed companies in India making Metal Pipes and this makes this company a big player in the wider ecosystem as well.

Above nos are from standalone financial statements.

Company’s Investments are of Importance

As mentioned earlier, the company is all about pipes. The company has invested heavily in backward integration and has bought  coal mines, iron ore mines and invested in power plants. Apart from this, the company also knows that price differential comes from economies of scale. In this regard, it has invested in other Steel and Pipe making companies vz: Electrosteel Steels and Lanco Industries. The company considers these 2 companies as associate.

Ideally when we have JVs/Associates, the company adds the line items of the balance sheet and Profit/Loss statements of the JV/Associate with the parent company’s respective statements, in the proportion to which they are owned. Elecrosteel, however, takes a different approach and considers these 2 Associates as investments and mentiones them in its investments section. For the purpose of this analysis, we will consider the same.

As per the last balance sheet, the company’s total investments in these 2 companies were valued as follows:

• Electrosteel Steels is valued at 722 Cr., with a holding of 700000000 shares  (P90 of Annual report)
• Lanco Industries is valued at 151 Cr. with a holding of 19301218 shares (P90 of Annual report)

Thus, together these 2 companies are valued at over 870 Cr. and that translates to a value of 22 Rs per share (on a diluted basis). That indicates that as of right now, the share price of the company is less than the amount of investments it is holding. Or in other words, if I buy 100% of the company at 20Rs per share, I will get 22 Rs. per share as investments on an immediate basis without doing anything else.

However, we will be mistaken. As of today, the share price of Electrosteel Steels is down to about 6.7 Rs per share and that of Lanco is down to about 25.9 Rs per share from a value of over 10Rs and over 40Rs. respectively during March 2011. Also, out of the 70 Cr. shares of Electrosteel Steel that Electrosteel Castings own, about 50Cr. are pledged by the company to the lenders in favor of securing financial assistance to Electrosteel Steels (P93 of annual Report, in the foot notes). This means that these shares will have to be given to the folks carrying debt of the company, and that may be necessary when the going is bad for the company. Given that Electrosteel Steels’ shares are falling, it can be assumed that the times are bad and it may be a necessity to let go of Pledged shares.

Thus when one values these holdings at current market price and for the no. of shares held and not pledged, we see that the updated amount of holdings are equal to about 183 Cr:

• Electrosteel Steels is valued at 134 Cr., with a holding of 200000000 shares  (P90 of Annual report)
• Lanco Industries is valued at 50 Cr. with a holding of 19301218 shares (P90 of Annual report)

Thus, the company’s present Marketable holdings are over 690 Cr. less than what they are reported, at present market rates.

For the analysis below, we are going to understate the Cash and Marketable holdings by this amount o 690Cr.

Also for the analysis below, I am going to use the Consolidated Financial statements.

Reported Financial Performance:

The in the last FY2010-11, the company’s total revenue and PAT increased on a YoY basis.

Below is a high level view of the company’s finances as reported in its annual report. It can be seen that the profits have fluctuated rapidly in the last 3 years (consolidated).

Reported Free Cash Flows to Equity Owners

 Along with the above finances, one can look at the below measures from the company’s annual financial statements (consolidated).

 One can see that the company has invested heavily into Capital Expenditures 2 years ago but has not done so recently. As per the company’s annual report, one can infer that this was for increasing the capacity of is DI Pipe making plant and for buying coal mines. The evidence is shown too when the capacity of the DI Spun Pipe factory increased from 250,000 tons per year, to 280,000 tons per year. That was a good decision as the company itself knows that increasing capacity is the key to cost reduction.

The company has financed the Capex using Debt as there has been a similar increase in debt in 2 years ago as well. The company has continued to borrow more debt in the las t2 years, even though it has not invested in CapEx, and that is perplexing. With increasing interest rates, that is going to put some pressure on its cash flows.

The company’s Working Capital status also fluctuates rapidly on a year to year basis, and that has to be normalized.

When I normalized the above factors and calculated the FCFE, I get the following data (all amounts in Rs. Cr.):

One can see that the company’s last 3 year’s Average Free Cash flows on a normalized basis are more than the latest reported profit. This is primarily because the company has been borrowing more debt and that is considered as a cash flow to equity.

This indicates that the company has been returning a lot more money to its shareholders  in the immediate past.

Why is the share price experiencing a free fall?

When I invested in Electrostel Castings about an year ago, I saw that the share price was about 33-36 Rs per share. Then I saw the cash holdings of about 22 Rs per share and a lot of positive free cash flows and thought, “Wow.. This is a great value investment. I cannot go wrong with this one.”

The price remained stable for a few months but then started falling and went down to as low as 16 Rs per share. That was a loss of over 50%. In the last few days the price has again stabilized on these levels.

Initially I thought that I was right but the market was wrong. But I should’ve known better. Below are the risk factors of the company:

• Nature of Investments getting killed: 60% of the company’s investments were made in other Pipe/Steel companies. When the market turned bad due to economic situation, these companies lost a lot and that meant their bad performance directly reduced the asset quality of Electrosteel Castings. Other 20% of the company’s investments are in Mtual funds and that meant that when the market turned bad, these lost as well. For te purpose of a new analysis now, I have reduced the investments in associates by 690 Cr (calculated above) and have reduced the value of holdings in Mutual funds by 150 Cr (about 50%).

• Screwed on Debt side: The company has taken a lot of debt in the last few years, and these fixed obligations have to be paid now. As per the annual report (P88), most of these have to be paid from this financial year. The company has issued 100Cr. debentures on 11.8% interest, and it has to pay 33Cr each from March 2012. Then the company issues 200Cr debentures at 9.15% and it has to pay the 200Cr back in Feb 2013. So net-net, the company has to pay back 33Cr debt in FY 12 and 233 Cr in FY 13. Apart from this, the company has borrowed 510 cr from foreign institutions and in the last one year alone the Indian currency has depreciated, and hence the debt value appreciated, by about 15%.

The company has to pay all this back. It cannot pay back by borrowing more (as new debt will be more expensive due to present interest rates and foreign currency exchange rates). It cannot raise new equity as existing equity holders have already been hammered. It has to pay all this from its cash and marketable holdings and that means that it cannot invest in capacity. Alternatively, it can pay back from its profits and that will mean that future payments to equity holders will be hampered.

All this would not have been an issue if the company was to make higher sales. But tat won’t happen either, atleast due to increased production. That is because it is not investing in Capacity.

• No Capacity Expansion: In the last year, the installed capacity of DI pipes of the company was 280,000 tons and the company made over 270,000 tons. That means its production is already running at over 95% capacity. Unless it increases the capacity more, the chances that it will increase the turnover (and hence grow) are minimal. Also, since metal prices are to be muted for some time, the chances that turnover will increase due to price are minimal too.

• More Equity Dilution coming up: To boot, the company has issued warrants that can be converted to equity in the coming years. This information is conveniently placed in the Notes to Accounts (Page 107 of Annual report, point 22). This means that we will see that there will be 3.3 Cr more shareholders (about 9.3% more) than what they are and so whatever the company earns, that will be split amongst these many shareholders more.

All said and done,  I know now why more knowledgeable shareholders have been selling off their holdings when I was buying.

I know my investment earlier was bad. The share price was to go down from the levels I was holding. Now I need to answer, is it worthwhile to continue holding at present levels or should I get out of the company immediately. In other words, are there chances that the price will go down further or will they go up a notch from these levels, thereby reducing my damage.

To answer this, I need to understand how the  numbers change from the reported nos.

What happens now?

To analyze the company’s performance in the worst case scenario I am making the following assumptions:

• Company’s operational performance remains the same as the rolling 4 quarters. Thus the profit for FY 12 changes to 140Cr instead of 162 Cr.
• Company’s cash holdings remain the same, but marketable securities are reduced by 840 Cr (690 for 2 associates, and 150Cr for investments in mutual funds). This reduces Net Worth by the same amount.
• Company has to make a net debt payment of 100-300 cr per year in the coming years (33 Cr in FY 12 and 233 Cr in FY 13, foreign currency borrowings). The company makes this complete payment from its cash holdings, as the profits are not good enough to pay for this.
• The total no. of shareholders are inclusive of all present and potential dilutions (i.e. including those 9.3% additional share holders).
• The company is unable to borrow any more debt for the coming months and is a net debt payer.

Based on above, the updated nos become as follows:

Above are just a set of indicative numbers in the most stressful situation. Various scenarios yield different numbers, but in no scenario the numbers are anyways better than the present reported nos. from annual report.

It should be noted that if the company’s performance on sales/profit front had chance of improvement,            the numbers would have been much better. But due to no investments in capacity improvement, the company may not gain much due to improved production and so it has landed itself in a situation where it has to pay much more than it will earn.

Ownership Structure:

48.46% of the company is in the hands of its promoters. This is a high concentration given the fact that the owners are not spending on capacity improvement but are spending on cost reduction and are borrowing along their way. If an external corporate raider has to buy the company, it will be very difficult for it to do so as it has to buy over 50% of the company, and that means it has to buy all the non-promoters.

To that effect, I believe the concentration of ownership of the company is not ideal.

Return on Net Worth:

The PBIT/Avg. Net Worth for Electrosteel Castings was 19.5% 6 years ago. It was 18.04% in the last FY. In this time, the lowest it got to was 6.9% in 2008 but apart from that it did not go below 18% anytime.

Based on this statistic alone, one can say that the company HAS GOT the formula to make good money in general economic conditions and is using that formula wisely. This is consistent with my assumption of same operational performance to continue in the next year.

Value Judgment:

Based on the above altered numbers of cash/profit/FCFE/no. of shares, we can arrive at the following data.

At 33 Rs per share, the company was definitely not worth a buy. But now if I buy a share at 18.5 Rs per share, I am getting risk free cash back of about 13.3 Rs. For the remaining price, I am getting back 1.9 times the prospective free cash flows of the company. For a company that has been and should be operationally profitable, that is a cheap price.

The company had to be beaten down for its prospective bad performance. But given that the company has good working capital condition and has good history of performance, it is likely that the company will live to see another day and will thrive the day after. Moreover when the metal prices turn for the better, the company will reap in more profits and its investments will pick up and so everything will fall back in line.

The way I see it, there is no major downside from the current levels.

Verdict:

Investing in Electrosteel Castings is relatively less risky at present levels. For a patient investor who is willing to look longer term, this is a good opportunity. The stock looks undervalued from its reported performance, but is not undervalued a lot. For a new investor looking for 2 yrs timeframe, I would recommend look at this stock as an “accumulator” which means I suggest to keep on accumulating this stock on these levels with hope of a very good payback then.

Personally, I have unrealized losses in the scrip but I am not going to sell at present levels.

Personal Note on Electrosteel Ccastings

When I first analyzed Electrosteel Castings, I only took a note of its finances and on the basis of free cash flows, I concluded that the company is great to invest in. Due to reasons mentioned above, I was wrong. And How!

Lessons learnt:

• Looking at Notes to Accounts are more important than they seem. Sometimes a lot of potential risks are hidden there.
• For a medium sized company, a good performance in the immediate past may be an indicator of a bad performance in the immediate future.
• A company heavily invested in other units of its own industry is riskier to invest when economic environment is turning bad.

Quick Recap

Basically, the investment and valuation theory has on very important foundation: the better the Free Cash Flows to Equity are, the more valuable the company is. The free cash flow to equity is an indicator of earnings that the owner has from the operations. At its very basic level, it is calculated as:

FCFE = Profit After Tax – Reinvestment Needs – Total Debt Repayments

 In the above statement, we see that profit is a measure of how much the company earned due to the income and expenses of the previous financial year and how much of that earning has gone towards repayment of loans and/or reinvestments which will give benefit in the future years. The equation combines both the profit and loss statement and the balance sheet.

The Thing About ‘Publicly Available Information’

We should remember that just because a piece of information is available publicly, it does not mean that it is not relevant for a lay investor. Conversely, we should also know that any piece is information that is important to an investor like me IS AVAILABLE PUBLICLY. All we need to know is where to look, and in what detail.

FCFE is Necessary, But Not Sufficient

In the article below, I am mentioning how each aspect of free cash flows can be computed from the information that all of us can access, and where to access that information from. The illustration below should form the basic homework for any lay investor, who wishes to know if the company that he/she is considering to investing has the sound fundamentals or not. One should also remember that this step is necessary but not sufficient to gauge the health of the company. There are other factors too, which when brought into consideration change the perception of the numbers we obtain from the calculation below.

Company Under Consideration

I am mentioning the analysis below for Precision Wires. I had done the analysis for this company about a month and a half ago in this article. Then, I had concluded that the company is fundamentally sound, based on its cash flows.

After I’ve illustrated how I calculated the free cash flows for this company below, I will mention what enhancements I do in my calculations, and how that changes the analysis.

 <<All nos. below are in Rs. Cr. >>

Step 1: Take profit

Any company reports profit or loss at the end of the year. This is its statement of how it has fared in the year. As an investor, we have no reason to doubt that this should be our basic starting point.

 For Precision Wires, the link is: http://www.moneycontrol.com/financials/precisionwiresindia/profit-loss/PWI#PWI

When we go here, we see the following values:

Once we have the above value, we need to look at the reinvestment needs and debt repayments.

Step 2.1: Reinvestment Needs – Capital Expenditures

Next we need to find out the true nature of Capital Expenditures the company made in this year. The first step will be to find out how much the assets have changed between the last year and the present. Once that figure is found out, we will find out how much depreciation was for the present year, and remove this amount from the amount of change in assets. This is because depreciation is a non-cash amount for which the company enjoys tax exemption, and it cushions the capital expenditures to some extent.

For Precision Wires, the link is: http://www.moneycontrol.com/financials/precisionwiresindia/balance-sheet/PWI#PWI (for Gross Block/Cumulative Depreciation/Capital Work In Progress) and http://www.moneycontrol.com/financials/precisionwiresindia/profit-loss/PWI#PWI (for depreciation)

When we go here, we see the following values:

Now, once we see the above values, we can calculate the total capital expenditure as:

Capital Expenditure for the present period = { (Gross Block for present year – Cumulative Depreciation for present year) – (Gross Block for previous year – Cumulative Depreciation for previous year) + (Capital WIP for preset year – Capital WIP for previous year) } – Depreciation charged to Profit/loss for present year

In the light of this calculation, we see that the final expenditure of capital nature for the previous 4 years is:

Step 2.2: Reinvestment Needs – Non-Cash Working Capital

Next we need to find out the expenses due to non-cash working capital changes in the year under consideration. This information relates to how the working capital assets (current assets) changed in the year, but this information can be best obtained from the Cash Flow Statement of the company.

So to get this information, we go to the company website and look at the annual report.

For Precision Wires, the link is: http://www.precisionwires.com/Corporate/Finance/A/2010-11/2010-2011.PDF (Page 43 for cash flow of this year and last) and http://www.precisionwires.com/Corporate/Finance/A/2008-09/2008-2009.pdf (Page 41 for cash flow of this 2008and 2009).

The +ve amount in the above table means that cash was generated from the operations (hampering FCFE) and negative amount means that the cash was released (helping FCFE)

 Step 2.3: Total Reinvestment Needs

The Total Reinvestment needs will be equal to what we calculated in 2.1 above (i.e money invested in fixed assets) – 2.2 Above (i.e. money released from current assets)

Step 3: Total Debt Changes

The next step is to look at how much money has come to the company due to additional debt that is borrowed by the company, or has left the company due to debt being repaid by the company.

Before I proceed on this section, I have a confession to make. My original article on free cash flows that I’ve referenced above had a typo. In that article, I had mention a table on how to consider the various variables involved in the calculation. Unfortunately, I realize now that the 4^th row of that table (on debt) was missing and was pasted as free text below the table. This wiped out the total debt calculation from my table altogether.  I have corrected it now.

For Precision Wires, the link is: http://www.moneycontrol.com/financials/precisionwiresindia/balance-sheet/PWI#PWI

Apart from the debt, one can also look at deferred tax liability as another component of debt. Money control does not depict this for all companies, but this information can be obtained in the Annual Report under the balance sheet section, just below the debt amount. The calculation below on debt can be replicated for deferred tax.

Now, once we see the above values, we can calculate the total debt repayment or borrowed as:

Debt Borrowed in the present period = (debt outstanding at the end of present year – debt outstanding at the end of last year)

In the light of this calculation, we see that the final debt raised in the previous 4 years is:

In the above table, a +ve amount means that the companied has borrowed the amount on the whole (which helps FCFE) and the negative amount means that the company has paid debt on the whole (which reduces FCFE).

Step 4: Final Free Cash Flows

The final free cash flow calculation, as a result, is: Results from Step 1 – Results from Step 2.3 + Results from Step 3.

Analysis, Inference and Enhancements

Based on the above basic calculation, we see that in 2011 the free cash flows of the firm were much less than the actual profit that was reported by the company. This was exactly opposite of what happened in Mar09. This means that the actual performance of the company was lesser than what it reported this FY, and 2 years ago the company gave a lot of reasons for Cheer to the investors.

Above is just one basic inference that one can draw from the free cash flow calculation. The analysis, however, has a lot of caveats. One can look at these caveats, decide if they are important, and then enhance these calculations to arrive at updated free cash flow nos. It is precisely because of these caveats and the subsequent enhancements, the numbers I arrived at in my analysis of Precision Wires were slightly different from what we’ve calculated above in this article.

The numbers arrived above are very close to the numbers I reported in “Latest FCFE before Normalization of Debt and Capex” value in my analysis.

What are the caveats, and their corresponding enhancements that need to be incorporated in the calculation?

Caveat	Enhancement
We have used PAT blindly. A lot of times PAT includes extraordinary income, like income obtained after a plot of land is sold.	PAT has to be altered by removing all extraordinary items. Luckily, for Precision Wires there were not many. But we won’t be so lucky all the time.   If such extraordinary items recur frequently over years, it is better to average them out.
The company pays debt in some years and borrows in others.	Changing debt sign has a huge impact on FCFE. So it is better to average the debt changes out over a period of time and then use that for calculations.
Working Capital investments and Capital Expenditure investments change sign on a year on year basis	Like debt, it is better to average the Capital Expenditure items. One can link working capital changes to changes in annual turnover to come up with an average estimate for change in working capital
Deferred Tax liability is not considered	One can assume that deferred tax liability is actually a debt obligation. If one agrees to this assumption, then treatment can be made on exactly the same lines as debt.
Preference capital raised is ignored	If there are preference capital issues, they have to be treated the same way as debt.

Conclusion

Calculating free cash flow is important and easy for an investor, provided one knows how to calculate it and where to get the information from. The simplicity of calculation should not fool the investor into believing that he/she is missing something. The only thing that one needs to be careful about is that one needs to understand what each and every variable means, how it is relevant to the whole business and hence to the whole calculation, and how to control those variations.

Context Of This Article

With an intention to make sense of the world we are living in and how it is shaping our present and immediate future, I am writing this article. It is meant for folks who want to know what is happening around the word but are not keen to look at hardcore business news on the same. This is the third article in the series of 3 articles on:

• Just what is happening in Europe? (It is posted here)

• What are the other major themes in the world economy right now? (It is posted here)

• Given all of the above, what is in store for an Indian investor

 In this article, I am mentioning my point of view on what we should expect in India over the coming months, and how do I plan to play out my investment strategy to make the most of the situation.

A quick Recap… Where we were with world events

A month ago, I had mentioned in my earlier articles that Europe will have a prolonged period of tough times for Europe (which is the wealthiest region of the world), a prolonged period of near zero to very low growth for USA (which is the growth driver in the world from the demand side) and a slowing growth of China (which is the growth driver in the world from the supply side). In the past month, since the articles were written, nothing has happened that has made me change my beliefs. .

• Europe had another Brussels summit where in the leaders met another time and came out with another promise to fix the situation by revisiting the European treaty. Like each previous similar occurrence, this too looked more like a strategy to buy time. Aside from the story of Great Britain shooting itself in the foot by isolating itself,  the only significant thing was that the rating agencies have put the entire Euro zone on downgrade watch. That, irrespective of your point of view on the efficacy of these agencies, is a bad thing to happen.

The situation will continue for months before normalcy is restored.

• USA, on the other hand, has been the flag bearer of good news in the recent times. Its retail sales numbers are better than expected and that means that people have been willing to buy stuff from their income. The number of people filing jobless claims in that country has reduced, indicating that more people may be getting their jobs back. Their currency is surprisingly resilient as the whole world is seeing the US currency and US government backed treasuries as the safest option on the planet.

I believe this happiness will be short lived. I hope I am wrong, but I don’t believe I am. The key driver of their growth has been the real estate industry, and that is not showing any new signs of improvement. That means that the people are saving to buy holiday items but are not confident that they will have long term earning prospects. USA is having presidential elections next year and like any other country on the planet, it means their government will continue to dilly-dally until a new leader is in place. All of this will mean that the economy may dwindle along at snail’s pace for the next year. If it outperforms the rest of the world, than it will be solely because the rest of the world will be going to dumps.

• China already has the rumblings of a real estate bubble that may slow the economy to a large extent. Its biggest export partners, Europe and USA, are nowhere hear sound health and so it has to slow its growth to a large extent.

The coming months will see China slowing down further. This will lead to slashing of commodity prices.

The train wreck that is India

 We were shining once. But then we got blinded by our own luster and have now collided head-on with a perfect storm of incoming disasters. In the last year (many in last one month alone) we have done the following:

• Started on an ill advised policy of FDI in retail (my thoughts here),
• Then back tracked on it and along with it froze on all important policy issues
• Contrived to pass the  Food security bill that will doom our finances
• Confirmed to the world that we had actually exported less than what we had earlier claimed
• We have fooled ourselves into believing that a double digit inflation is worth sustaining for single digit growth
• Contrived to reduce our growth by increasing lending rates many times more than required
• By opposing Lokpal and suggesting Internet pre-censorship made sure that the entire world sees the India story as one of false promises, both on democracy and governance.

Combine the above with the fact that the rest of the world is sharpening the axe on which it is going to jump, we know that we have managed a near perfect storm situation for ourselves. We are going to get beaten on economic, fiscal and governance fronts in the coming few months and there is no hiding from it. As Ravi Shastri puts it… we are under the pump.

In order to make a sound investment decision of what needs to be done next, it is important to understand which factors come into play from an investor’s point of view. Below I am mentioning what matters to the investor (and not to the sociologist) in me.

How to sort through the wreckage

In order to understand what is important, we need to remember what is important in any financial decision. Any company is profitable when:

• It borrows at a cost that is less than the return it gets after investing those borrowings
• It is able to do this over and over again.

The analysis of our investment future has to be done in the light of above two points. We need to know, what is impacting the borrowing and purchase costs of the companies we plan to invest in, how much money is generated from the core business functions of these companies and how much of the eventual profit the company can afford to reinvest in its own business.

If one looks at all the above external and internal headwinds above and tries to relate those to these financial parameters, one can mention the following broad level correlations. Based on this analysis, it is not difficult to understand why we are being pummeled left/right/center across industries.

Headwind Category	Why it is happening	Who does it Favor	Who does it punish
India is spending more than it is earning	Government is spending on a lot of subsidy/social welfare schemes, many of which are ill advised.   On the earnings side, government was hoping to make a lot of money on exports and by selling stakes on state owned firms. None of that happened	None, except bears in the market	Nearly every firm/transaction that is backed by GOI in terms of guarantees. World thinks that Indian companies are operating in an unstable/unreliable market, and so think that their Indian investments are risky. They, thus, demand more bang for their buck and hence borrowing costs for companies in India increase
Food Inflation is high	Our agriculture is still not modernized and our public distribution system is not functioning properly due to inefficiencies and corruption	No one, except agriculture commodity companies and FMCG companies who can pass on the cost to consumer.	Nearly everyone where sales are dependent on customer confidence. This include retail and auto segment.
Non-food or Core inflation high	Oil prices are high in rupee terms that increase the cost of raw materials and more than offsets the reduction in commodity prices worldwide	It should favor companies in commodity business, but it does not if the inflation is high for a long time in continuum.	It punishes all companies relying on debt as RBI increases bank lending rates to counter this inflation, and that means less business activity in the economy
Rupee is weakening	Our inflation is high and profits are low. People think there are better places to invest, and so are selling Indian rupee in favor of other investments	Anyone who is into exporting business	Anyone who has to pay in dollar terms. This payment can be for goods or loans.
Bank interest rates are high	RBI believes that to counter inflation we need to make sure that people buy less stuff and that will reduce the seller’s bargaining power. So it makes the borrowing costs higher so that any business will think twice before making any new acquisition on borrowed money.   To counter inflation in India, RBI has increased the rates and won’t reduce them until inflation eases	Banks! This will happen only if the affairs of the banks are themselves sorted and they have customers who are willing to borrow from them	Infrastructure companies, real estate companies, heavy engineering companies, auto companies and anyone else who either borrows itself or whose customers borrow money to purchase the product
Anti corruption sentiment very strong, but real corruption is not ending	Stakeholders with vested interest are not willing to end the corruption, but have to pay lip service to the citizens	No one. Any company that wants to operate properly will be stopped by corrupt forces. Any corrupt company will be stopped by anti corrupt forces.	Everyone who is not benefited due to the stalemate. This means everyone!

What happens now?

As mentioned above, each and every sector of the economy is facing one type of headwind or other. In order to understand if we have any reason to be hopeful, and by when that hope will come into fruition it is important to consider about what we think of our immediate future. A point of view on this future is going to shape the point of view of any investor.

Below is my point of view on the future of each heading.

So where does that leave us?

As per the above table, I believe that both the domestic and international situation is not going to improve anytime in the next 3-6 months. After 6 months, we will see signs of some improvement in the emotions of the rest of the world and only after 12-18 months will we actually see some improvement on domestic side.

I can be considered a pessimistic in believing that world will come to its senses earlier than we do, but I believe I am not wrong in that assumption. I have again read my list of headwinds to affirm what I am saying here. I will be happy if I am proven wrong, but the present government leaves us with no reason for optimism.

What is my investment strategy?

I believe that equities are not going anywhere for the next 3 months. They are not going up, that is. However, this prolonged period of low levels are going to create tremendous opportunities for investors like me. In the light of this, I am doing the following:

1. Saving my cash for a big bang: I am saving all my money to invest as soon as I get my 1^st cue that the tide is turning. To me, that cue has to come from within India rather than outside India. It could be a major policy decision by the government, or could be a change of fortunes for the government after the election season or could be the something else that will change the fortunes for the domestic consumption story for the better.

1. Investing in fixed income: I am not good in making much sense of fixed income markets. I understand the relations between bonds and equities and how they signal the future of the economy, but I do not profess any expertise here. I know that right now buying bonds of highly rated bond issuers is a safer bet than equities for the coming few months. Since I don’t know what to buy on a short term, I have lent money to a firm I have confidence on with a promise of a fixed rate of interest and payback when I want it.

1. Short listing candidates from the equity market:   In the coming weeks, the exclusive criteria will be to look at companies with good earnings prospects (to guarantee operating profits), with no loans from foreign issues (to limit repayments in rupee terms), with no convertible options (to limit dilution of equity), with capacity improvement investments already made (to make use of business uptrend immediately) and with investments made in similar lines of business (to prevent negative synergy). Such companies are going to be the biggest jumpers when the stocks rebound, thereby helping me with my big bang approach.

Conclusion

This is a time when the headwinds are for all to see and it is very easy to be either very pessimistic or over confident with respect to our investment strategy. I am saving my money to go for a big bang, so as to make the most of my investment thus made. The idea is not to catch the bottom of the market. The idea is to see what is causing the problem and by when the problem will be sorted out. According to me, we have a breathing space of about 3 months until which we can analyze the market and firm up the investment prospects. After that, we will head into a territory that will contain more optimism than pessimism.

If someone wants to follow my strategy, that person has to have the same conviction on how our future is laid out in front of us. If that is not true, the investment thud made will create dissatisfaction.

My Holdings:

About NILKAMAL:

 We know it is a plastics company. However, it is not only that. The company currently operates in three business segments:

• Plastics Moulded Furniture: The plastic moulded furniture segment manufactures and markets plastic moulded furnitures like chairs, tables and cabinets
• Material Handling: The material handling segment manufactures varieties of crates like injection moulded crates, roto moulded crates, customised crates, corrugated PP crates, vaccum formed crates, bins, vertical storage systems, industrial pallets and automated storage & retrieval systems. The company also provides material handling solutions and intra logistics warehouse solutions.
• Lifestyle Furniture, Furnishings and Accessories: Under this segment, the company operates it retail business. It owns a chain of home decor product store across cities in India called @home. These stores sells products like imported furniture, readymade furniture, soft furnishings and home decor accessories.

The company was listed in stock market in 1990.

  NILKAMAL’s Ecosystem:

If one looks at product segment for Nilkamal, one sees that in the last FY, the company made just under 13% of its revenue from its retail venture. To the extent that one gives weight age to these 2 different types of business (manufacturing and retail), one has to look at Nilkamal in terms of 2 different ecosystems.

In one ecosystem, Nilkamal is a manufacturer of molded plastic products. It is a market where one single raw material can be molded into anything you want it to be. On one hand the manufacturer has to keep a control on the cost that goes into the raw materials for the production, on another hand the premium in price can be charged based on the design of the eventual product. This leads us to a situation where a manufacturer of run of the mill materials has to operate on very but at the same time, an additional increment of design is good enough to command disproportionately high margins. It is in this light, one can say that bigger companies with a penchant of well designed products should be able to operate profitably in the markets.

In the other ecosystem, Nilkamal is a retailer. The company sells its own and imported products under @home brand. Obviously the company has a point of view that says products, including those made of plastic, sold as lifestyle accessories have a market for their own and retailing is one of the better ways to preserve margins on the same. With the changing profile of an Indian customer, one can say that there is market for the same. In such a market, it is easily for the company to look at potential advantages, while ignoring the pitfalls. The biggest pitfall in such a business is that the company is exposed to higher fixed expenses in terms of lease rentals. Lease rentals are the regular rent the company pays for the shops it is occupying and like any form of rent, irrespective of whether there are sales or not, the company has to shed out expenses. In this way, the company needs to look at lease expenses as debt with fixed interest expenses. When looked at this way, the balance sheet becomes  more debt heavy and so the overall business projections can go haywire easily.

In this second ecosystem, success depends on how soon the company has entered in its target market segment (early movers have a distinct advantage) and how easily the company is able to market its service line. It is retail business which is growing and is still highly disorganized. The market is still in its nascent state and the penetration is low. Though aspirational, the customer is still a sucker for price advantage and that is a negative thing. The only stores that generally work well in this market are the ones which are in a post market or in the viscinity of a post market. The standalone stores, generally, don’t attract customers consistently. As a consequence, the retailers in this business have to take buildings on higher rent and that means that the cost pressure becomes so much tougher. The cost of carrying inventory due to obsolescence is high and one cannot simply remold an existing product into a new one. J

It is easy to see that the above two ecosystems don’t mix, just like air and water. For a company to do consistently well in both the segments is a very tough ask.

NILKAMAL’s position in its ecosystem:

I had mentioned the relative size of all companies in plastic industry in India and we saw that Nilkamal is the 6^th biggest in the industry. That is true even if one discounts the retail business in the company. Apart from that, we know that Nilkamal does possess a definite brand value in the plastic furniture segment, even though I had argued that it may count for little in run-of-the-mill products like crates etc. Nilkamal did show remarkable vision in carving a brand identity of its own and that has definitely served the company well. Specifically in that term, the company knows how to create a brand and sustain it.

Since sustainability of brand in the plastic industry is inextricable linked to design, one can say that the company hid show, to some extent, its expertise in crafting out well designed products and hence there is a chance of it doing so in the future too.

The company has to sell to the normal retail customer more often than not. This customer is both a sucker for price and design. And durability! Just from personal experience alone I believe that Nilkamal has got an offering that is good in all these parameters. The only aspect that one needs to investigate more is how much penetration the company has in its chosen market, and in that regard too I believe the company does enjoy a pretty good brand recall and penetration.

Above is more from my personal experience, and not from any objective study.

From the above statements, I believe that the in its 1^st ecosystem the company is an important player. It is resilient and has been so for a long time. It is big enough to command respect and influence the fortunes of the industry. All of these are only good.

In the 2^nd ecosystem, however, we have a different story. The company has opened up stores to sell their furniture/home accessories as lifestyle offerings. However, the company is one of quite a few original entrants in the market. Most of its products, although new offerings for the market, are sourced from nearly the same vendors in foreign markets and so do not bear a distinct retailer’s footprint. Nilkamal’s size too is very small. The company did a miniscule 171 Cr. of business in 2011 in this segment, the highest since its inception. That is not big.

Overall, in the 2^nd  ecosystem the company can take brownie points for having vision to enter into this market, but has little going for it otherwise. The products are as different as chalk and cheese and the cost structures are very different. In the larger scheme of things, the company can lay claim to being an important player but not significant. Hence it is not resilient and can easily succumb to market forces.

As mentioned earlier, for Nilkamal to do consistently well in both the segments is a very tough ask. Luckily for us, as of now Nilkamal’s retail arm is relatively small (under 13% in size). Even though the size of this arm is growing consistently since its inception, I am willing to believe that it is still small in size for to affect the performance of the larger company in a big way. I mean both positively and negatively.

For now, I believe that the company would have been even more resilient if it were a purely plastics company. Given that the new business is still small in size, if one can prove that the company has been equally profitable despite its foray into the retail business, then one can be confident that the company will be a better bet into the future.

Consolidated or Standalone:

For Nilkamal, 5% of the sales comes from its subsidiaries. It owns 76% of one subsidiary and so lays claim to 76% of its profits, assets and liabilities.  For the 2^nd subsidiary, it owns 100% of the company and so we should consider this as a part of the parent company in its totality.

When one buys the shares of a company, one is buying into income derived by the core company (standalone) + all its subsidiaries (consolidated) in the proportion in which those subsidiaries are owned. The consolidated balance sheet for the company follows these principles and is able to give a clear picture of how the subsidiaries combine with the overall balance sheet of the company. For this analysis I am using the consolidated sheet as reported by the company.

The figures below mentioned by Nilkamal are on a consolidated basis (parent company + subsidiaries). The numbers mentioned in my “Plastic Industry Analysis” were on standalone basis. That is why there is a slight divergence between the two set of numbers. I will mention the differences and their ramifications wherever they are relevant.

Reported Financial Performance:

The in the last FY2010-11, the company’s total revenue and PAT increased on a YoY basis.

Below is a high level view of the company’s consolidated finances as reported in its annual report. It can be seen that the revenue and profits have improved rapidly in the last 3 years.

Free Cash Flows to Equity Owners:

 Along with the above finances, one can look at the below measures from the company’s annual financial statements.

 One can see that the company has invested heavily into Capital Expenditures in the last year. As per its own annual statement, it is a opening up a plant in Hosur. It is necessary for any growing company to invest in capacity, and so this is not an unsound investment. Apart from this the company has been investing more into its working capital as well and that is reflected in the consistent negative cash flows over the past few years.

 2 years ago the company paid a lot of debt back and so has spent a lot of cash in doing so. The last FY, the company took some debt to finance a part of the CAPEX but there has been a less than proportional increase in debt as compared to CAPEX.

So from where did the company get the money for the CAPEX? For the remaining funds, the company has issued more equity (i.e. distributed ownership tp more people by issuing shares). In the present year, the company increased its shares by over 16% over last year, by going through QIP (Qualified Institutional Placement). That is a bad thing as the earnings will have to be spread over more folks. I will discuss that later.

  The change in non-cash W/C status of the company has been consistently negative, but has not changed pace with the revenue change. The absolute amount of change is also not small in the bigger scheme of things and so one has to normalize this factor too to understand its impact on the company’s financials.

When I normalized the above factors and calculated the FCFE, I get the following data (all amounts in Rs. Cr.):

Clearly for NILKAMAL, one can see that its Free Cash Flows on a 3 year normalized basis is just over 66% of what the profit is. This depression is entirely due to the CapEx project the company took last FY.

It is interesting to see, how the free cash flows stand for the parent company. When one compares the free cash flows of the standalone parent company and the consolidated one, one sees that the consolidated nos. are much worse than the standalone numbers.

This indicates that as of now the company is investing more in its subsidiaries and reaping less than optimal results.

Fit vs Flab:

In the last FY its interest coverage (the parameters that tells us how much money is left after mandatory obligations are paid) was at 3.64.  This indicates that the company has decent enough earnings over and above its mandatory obligations, and that is advantageous. However, we have companies right in the same business which are having a coverage of many times more, ad so there is definite a scope for improvement.

 However, one should know that this relatively low coverage is a result of the fact that the company has forayed into a business that has been completely different in its dynamics and cost structures than the parent business. Also, the Hosur project for which the company took loans will come into business this year and so the interest to be paid on debt will also start coming out of operating income. This means that the chances for the company to improve this performance is slim in the coming future. To boot, the interest rates have peaked in Q3and so the expense will only increase.

Net-net, one can say that the interest coverage for Nilkamal is an indicator of that the company is managing its finances decently as of now. However, it is very near the situation where its interest coverage can become too big for comfort. That means the company will have little space to maneuver when that happens.

To gauge the health of the company in another way, let us compare its current assets to the current and total liabilities. In this regards, there is a sign of relief. One can say that the company’s current assets not only far exceed its current liabilities but also its total liabilities (current liabilities + long term debt). That is only a good thing as if a time comes when the company has to be auctioned, the liabilities can be paid off without touching any of the fixed assets. The promoters are sleeping peacefully.

Based on above, I believe Nilkamal is fit to survive the vagaries of its industry, its situation is similar to a fast bowler risking an injury due to his bowling action. There is a chance that the bowler can improve his action to improve his effectiveness and avert the injury. At the same time, there is a chance that the bowler can be sidelined for the coming season.

Ownership Structure:

61.03% of the company is in the hands of its promoters. This is not ideal under normal conditions; as if the company performs poorly then it will be difficult for someone else to buy it. Having said that, one advantage that comes with a company that has high promoter holding is that such a company prefers to pay handsome dividends (as dividends are tax free in India).

This is not so with Nilkamal.

In the immediate past 2 years, the company has paid 4-5 Rs. dividend per share (14% of its average free cash flows). This means that the company is retaining 86% of its cash flows for itself. That is generally a high number and generally happens when any company has plans to grow. Given that the company has its forays into retail and has shown increase in revenue and profit in the past few years, it is logical to assume that the company is putting its money where its word lies. We may doubt the company on the choice of its business foray, but cannot doubt its implementation.

Based on this, I can say from a lay investor’s perspective that that the ownership of above 61% is not ideal, but can be tolerated for Nilkamal.

Return on Net Worth:

The PBIT/Avg. Net Worth for NILKAMAL was 12.3% 6 years ago. It was 33.4% in the last FY. In this time, the lowest was 6 years ago but has been between a healthy 33% and a great 65% in the last 4 years.

Based on this statistic alone, one can say that the company HAS GOT the formula to make good money in general economic conditions and is using that formula wisely.

Value Judgment:

To understand how the market is seeing this company, one needs to superimpose the above judgements on finances with the price the market is paying for this. When we do that, we see,

As we can see, if one looks at the recent free cash flows for this year have been negative and so the recent performance is not that good. That is expected as recently the company invested in a lot of CapEx projects/subsidiaries/new business ventures, without much results till now.

However, one can see that if one normalizes the performance over a period of time the numbers look much better.

In the last few months, the performance of the company has taken a hit. Is it only because the company is perceived to be not making good cash flows despite making good profits? The answer could be yes, but only partly so.

Impact of QIP:

As mentioned earlier in the article, in the last FY the company issues 16% more shares to institutional bidders. What it meant is that the company brought in more owners. That was presumably to bring in more equity. But was that money needed?

Above, one sees that the company paid a part of debt in 2009-10 and made great profits. It would not have any issue in taking in more debt? But it still chose to get in more equity, which is nearly always more expensive than debt.

If we were to look at financials without the additional shares, they would have looked like below:

 It could be seen that by bringing in more no. of shareholders, the company’s earnings are spread over a larger population and so on an average a normal shareholder lost by about 17%. This, on the base of this evidence, looks like a bad corporate finance decision by the company. Still the company is trading about 16% more than its book value. I believe that at their worst, a company with good brand and profitable financials can trade at a minimum of just about the book vaue. In that regards, the company may have some more price to pay in case the shareholders do get more jittery with economic prospects.

Verdict:

In its heyday, Nilkamal commanded a lot of premium for its superior brand value and its vision in marketing the plastic products. Lately, however, the company has given a set of not so great news for the investors. One, the company went into a business segment that had little synergies with its existing product line. That business has barely broken-even this year after 5 years. Secondly, the company has taken a corporate finance decision to bring in more shareholders on board and this decision can be termed at best – “questionable”.

I personally feel that if nothing changes in our environment, then the company still has a slight downside for it. (may be about 10-15%). However, if the market turns for the better in terms of overall economic condition, the company will be able to bounce easily. Even if the broader market does not do well but the retail FDI comes in eventually (there are concerns in government as I write this) then the company will gain well. That is because its prospects will get a boost for being a direct supplier to retail chains and for being in retail sector itself.

In this light, I believe the company does not have margin of safety if the investor is looking for an immediate future (say 6 months). However, if the investor is willing to pin his/her hope on a longer and brighter future, this company is a very decent bet.

Personal Note on NILKAMAL:.

When I first analyzed Nilkamal, I had not looked at its business mix and its subsidiary data. I had looked at the company purely from a financial standpoint and the numbers made for a compelling reading. However, now I know that there is a larger picture where the company has given some wrong signals to investors and has paid for it.

Lessons learnt:

• In case there is a spike in no. of shares of a company over an year, pls understand the reason for the same. Equity is expensive than debt and so a company should seldom look for it.

Why Plastic Industry:

Last week, the government of India opened up FDI in retail. No matter how opposed I am to it, it does not make much of a difference in the larger scheme of things. As things stand now, it is a question of when and not if. When organized retailing comes big I this country, two types of entrepreneurs will flourish. One will be organized retailers themselves, and the others will be the producers of those millions of small branded items that supply to that “multi-brand retail” model. Based on my experiences of studying the markets of western world, Plastic companies do have an extremely bright future. Their products will be used in packaging nearly everything. Moreover, plastic products will find innovative and cost effective uses in millions of middle income households in the country. Market for plastic products  WILL grow faster as compared to many other markets in this country.

About Listed Companies in Indian Plastic Industry:

The Indian plastic industry is a highly fragmented one, at least in terms of equity markets. When one looks at the listed companies, there are just under 200 companies listed on the stock exchange. These span across industries like: Builders wares; Carboys, bottles & flasks; Flexible packaging materials; Floor coverings of plastics; Moulded luggage; PVC pipes; Plastic Products; Plastic film; Plastic injection moulding items; Packaging goods; Polyester film; Reservoirs, tanks; Sacks & bags; Tubes, pipes & hoses & fittings and Other articles.

However, if one wants to look at those with significant size, then one sees that there are only 54 companies with annual turnover of over 100 Cr. Rupees in last FY and only 17 of those had a turnover of over 500 Cr.

This tells us that the market is highly competitive with a lot of small players catering the market. The chances of differentiation, as a result, are few and so one has to give premium to good financials. In other words we cannot say that we are ok to give a huge premium on brand name if the financials are not in order.

About The Types of Companies Covered Below:

As mentioned above, one can segregate the plastic industry further on the basis of what kind of material is being produced. I believe the economics of the business do not differ a lo depending on what kind of product is being produced, and so I am taking into consideration EACH company that exists in the industry. To group them more logically, I am grouping these companies in the following groups:

• Plastic films & flexible packaging
• Plastic furniture, floorings & misc. items
• Plastic packaging goods
• Plastic tubes, pipes, fittings & sheets

In order to limit the sample size, I am taking into consideration each company that has made over 100Cr. Gross Sales in the latest FY. This gives us about 54 companies that fit the bill.

Point(s) to note

I the report below, the comparison is made across all companies on the basis of same set of parameters and inference is drawn on which of them are better as compared to other. However, I would like to add a disclaimer. Even though I believe branding matters only rarely and in some exceptional cases, it cannot be denied that there are definitely economies of scale in play. This means that the bigger companies tend to keep a check on input costs a better way and so tend to be profitable, and hence resilient.

Indirectly, I am saying that paying a premium on brad may not be justified but paying a premium on prize is justified. Reader should take that into consideration while making investment decision.

What am I looking for

I am planning to compare the companies across plastic industry on the same philosophy I had documented here and here. Basically, I will look for companies that are supplying a lot of free cash flows to equity owners, are profitable and have remained profitable and in the business for a long time.

Key players in the industry

Below is the list of key players in the Indian plastic industry, sorted by the decreasing size of their last 3 years FY gross sales in Rs. Cr. I have selected only those companies that have been I the business for over 10 years.

It can be seen that there are a bit too many companies between 100-500 Cr. turnover range; and so in other words, there are too many small players.

Reported Financial Performance:

Below are the high level reported financials of these companies in their latest financial year. Some companies from the above table are missing below as I was unable to compile data for those in the format below.

All amounts are in Rs. Cr. I have mentioned the revenue the company earned, the profit it made, its total net worth as reported and what are the cash and investment items it had.

Free Cash Flows to Equity Owners:

Along with above numbers, one has to take into account how debt items moved between the last 2 years and how the company invested the fund it got from operating income and debt for its capital expenditures. We cannot assume one year’s investments or one year’s borrowings to be the result of one year’s planning. The effect of these activities has to be normalized over a period of time. To accommodate this, I have normalized the following over the past 6 years:

1)        Debt

2)       Cap Ex

3)       Extra ordinary income and expenses

4)       Change in non-cash Working/Capital

Below are the results after I calculated the free cash flow to equity. I have also mentioned the ownership % and the latest closing price in BSE. Pls note the following abbreviations:

• BSE: Closing price in BSE on 25^th Nov (in Rs.)
• PH: Promoter holding % (In %)
• AS: Avg. Sales for last 3 FY (in Rs. Cr.)
• LFAN: Latest FCFE After Normalization (in Rs. Cr.)
• LFBN: Latest FCFE before Normalization (in Rs. Cr.)
• AFAN: Average FCFE after normalization for the past 3 years (in Rs. Cr.)
• AFBN: Average FCFE before normalization for the past 3 years (in Rs. Cr.)
• ANW: Avg Net Worth (in Rs. Cr.)
• TQP: Trailing 4 Quarter Profit (in Rs. Cr.)

Each company has its own reason when free cash flows don’t follow profits. The point to note is that one should generally avoid companies that have negative cash flows with positive profits, unless one has really studied the balance sheet in detail.It can be seen that the eventual normalized free cash flows are very different for some companies as compared to their profit. For e.g. Bright Brothers Ltd. Showed a small profit this FY but their last 3 FY average free cash fows are over -3000 Cr. For this company, this has basically been due to non-cash working capital which has been complete unpredictable.

Value Judgment

Till now the I have mentioned how the numbers of the companies in plastic industry how up for latest year and how they show up if one considers the statements for a few years. What does that mean?

The idea is to find out the companies that are giving good free cash flows to the equity owners and are still showing up cheap. To find this out, one has to compare the latest price per share of these companies with the cash flows per share.

Before doing so, we need to look at the cases of dilution in number of shares due to issues like conversion, options etc. To do this analysis I have considered number of shares in post-dilution basis, which means that I have taken the total number of shares that will come into picture assuming all conversions due to loans/GDRs etc take place.

This has brought big impact into some companies. For e.g., for Karur KCP Packkagings, the total no. of common shares outstanding = 11250000 but post dilution, this number swells to 17203333. The total no. of shares due to dilution swell by more than 50%!

Anyways…

Below is what we see when we compare the latest price per share (on diluted basis) with the profits and cash flows per share basis. On the basis of the numbers below, I have made some judgments. My judgments are:

• Any company that is selling more than 1.5 times its average net worth for the last FY is on the overvalued side, unless the free cash flows are positive and high in value
• Any company that has negative normalized free cash flows for the last 3 FY is a negative proposition. For such scrips, I prefer to a barge pole and shove them away.
• Any company can be assumed to be highly/lowly/decently priced on the basis of above 2 points and how big it is. The point of being “big” comes from the fact that in this industry the economies of scale matter.
• The precise judgment for each company will be different but I am trying to broadly group them into attractive or not attractive on the basis of above points and on the basis of other variables like interest coverage (indicative of amount of money the company has got with it after it has paid it debts; the higher the better)
• Any company with good positive cash flows, low promoter holding, has Current Assets more than Liabilities and is sufficiently big is a great buy. Anything that is missing from this list makes our company less and less valuable.

Below is what I believe is the value judgment on the above companies. Pls note the following abbreviations:

• BSE: Closing price in BSE on 25^th Nov (in Rs.)
• IC: Interest coverage (In no.)
• PE: P/E Reported
• PLFAN: Price per share by Latest FCFE After Normalization (in Rs. Cr.) per share
• PLFBN: Price per share by Latest FCFE before Normalization (in Rs. Cr.) per share
• PAFAN: Price per share by Average FCFE after normalization for the past 3 years (in Rs. Cr.) per share
• PAFBN: Price per share by Average FCFE before normalization for the past 3 years (in Rs. Cr.) per share
• PBV: Price per share by Avg Net Worth (in Rs. Cr.) per share
• P4Q: Price per share by Trailing 4 Quarter Profit (in Rs. Cr.) per share
• CA/CL: Whether Current assets are more than current liabilities?  – This is indicative of how liquid the company is.
• CA/TL: Whether Current assets are more than total liabilities? – This is an additional indicator of how liquid the company is
• SGT5: Are Average Sales for last 3 FY GT 500 Cr?  – this is an indicator of size
• PH6: Are Promoter Holding Less than 60%?  – How easily it will be for someone to buy out the firm if it is in distress?

Based on my analysis, not more than 12 companies in the industry out of more than 50 under consideration are worth investments. The ones in Red below are, what I believe, best avoided. Rest can be considered.

Based on my analysis, I believe we can zero on about 12 companies that can be considered worth investing. However, there are a few caveats in my analysis. Because of these caveats,  I believe that this set of 12 is a prospective set only and an investment decision should happen only when we look at the balance sheet of these companies in detail.

Caveats in the Analysis:

I will cover specific financials of these companies later in my company scorecard. For now, in can someone is making an investment decision based on my analysis, then I believe below are the caveats that should be kept in mind

• All the analysis is on standalone statements: I have taken only the standalone balance sheets of all organizations and not consolidated ones. This is done to maintain consistency. However, there are organizations which have subsidiaries either fully or partially owned. Any analysis of the stock price cannot happen without considering the contribution of subsidiaries, joint ventures etc.
• All companies battle their own problems: Solution to any problem depends on problem itself. Different companies have taken debt or invested in capital expenditures. These could be both good and bad. It depends on the company in question. In my analysis, I have presented a pretty black and white picture without any scope of any grayness.
• All companies don’t have the same business mix: There are companies which are pure play manufacturers, and there are some that have a mix of business segments. For e.g., Nilkamal is also having a retail segment. To the extent these differences are present, I have just compared apples and oranges above.

Conclusion

It is difficult to find out which specific company will end up being a great ivestment, but it is possible to find out a group of companies in an industry which are definitely more preferable investments than others. For Plastic industries, these companies are about 10-12 in number and their names are: