Manufactured Luck

FAIR & FINE ???

2016-12-02T17:52:00.004+05:30

Let us say, your friend and you are partners in a partnership firm. Your friend chances upon a piece of land which may be of use to your partnership firm. Let us say the fair value of that land is Rs 125 but he seems to be getting a good deal at Rs 100. What should he do?

Ideally he should come to you and after due consideration your partnership firm should go acquire the land at Rs 100 or for that matter any price upto Rs 125, since the land is needed for your business.

What does he do instead? He buys the land personally at Rs 100. He then promptly offers to sell the land to your firm at Rs 125 seeking increased stake in the partnership in exchange.

How would you feel about this transaction and more importantly your partner? Would you still consider him your friend?

Now for a true story on similar lines.

Listed Entity X owns a majority stake and not whole of listed Company A.

X now buys unlisted Company B for Rs 100.

On the very same day, in an apparent act of day trading, X sells B to A. So much for not treating business as pieces of paper.

Remember that A is only partly owned by X. X does not seek money for this transaction but additional shares in A which would result in increased shareholding. Interestingly based on CMP of A and the swap ratio, the implied value of this transaction works out to Rs 132. Its of course only a matter of detail that X paid Rs 100 to buy B, that day itself.

One could correctly argue that CMP of A may not be the right benchmark to make this calculation given various unknown influencing factors. Since the net effect of this transaction is increase in shareholding of X in A, maybe we should look at the SEBI defined pricing for preferential issue allotments to promoters. On that basis, the implied value would work out to roughly Rs 122. Again remember that X paid Rs 100 that day itself.

Whether you look at CMP or SEBI discovered price, it seems that X made itself neat gains of 20-30% in one day. When somebody gains somebody loses. So who lost in this transaction? Company A lost the opportunity to buy B at Rs 100 directly and ended up paying a premium of 20-30% through its equity as currency and/or minority shareholders of A ended up ceding increased control to X. All without X seemingly having brought much to the table.

Remember that X is also listed, therefore this favourable transaction should have some bearing on its share price/NAV.

Further, what if the whole of Company B was not sold in this transaction? What if X retained some undisclosed part, probably insignificant but not quantified, and sold the balance to A? How would you think about this transaction now?

Company X in the above story is Fairfax India. Company A is Adi Finechem and B is Privi Organics. However, nobody seems to be asking any questions even after 5 months of the transaction. Maybe because Company X is Fairfax?

The Dry Details

Adi is a listed speciality chemical company controlled by Fairfax. Fairfax India had acquired management control of Adi in February 2016.

On July 12^th, Fairfax acquired a 50.8% stake in an unrelated unlisted speciality chemicals company, Privi Organics Limited (POL). To acquire this stake, Fairfax paid approximately Rs 370 cr valuing POL at roughly Rs 725 cr.

The very same day, an announcement was made to carve out the aroma chemical business of POL and merge it with the listed Adi Finechem. In lieu of this merger, Adi would issue shares as well as CCPS as per the exchange ratio recommended by Grant Thorton to the shareholders of POL, including now Fairfax.

Read the related announcements here and the presentation here

Slide 23 of the presentation discloses that the implied share price for Adi for the transaction works out to Rs 287 per share. This is interesting in the backdrop that Adi shares traded on July 12^th in the region of Rs 380 per share (32% premium) while the pricing of Adi as per the SEBI formulae would work out to roughly Rs 350 per share (22% premium).

Therefore Fairfax bought POL at a valuation of 725 cr and sold it to Adi (interestingly retaining some small unquantified part of POL) at an implied value of roughly 900 cr depending on which price you use to calculate, on the same day.

We reproduce Fairfax statement on this transaction as part of their Q3 Interim Report and YES they seem to say the same thing !!!

Investment in Privi Organics Limited

On July 12, 2016 the company, through its wholly-owned subsidiaries, announced it had entered into a share purchase agreement with existing shareholders of Privi to acquire a 51% equity interest in Privi. On August 26, 2016 the company closed the acquisition of Privi for total consideration of approximately 3.7 billion Indian rupees (approximately $55 million). Additionally, on July 12, 2016 the boards of directors of Adi Finechem Limited ("Adi") and Privi approved a merger arrangement (the "Merger") involving the two companies, which is expected to bring significant diversification and synergies to both. The Merger is expected to occur in the first quarter of 2017 and is subject to regulatory approvals in India and approvals by Adi and Privi shareholders. Upon completion of the Merger, Fairfax India will own approximately 49% of the merged entity. Under the terms of the Merger, the Privi shareholders will receive 27 subordinate voting shares and 27 compulsory convertible preference shares of the merged entity for every 40 Privi shares exchanged ("swap ratio"). At September 30, 2016 the company prepared a valuation model to determine the fair value of its holding of 9,517,042 Privi shares using the quoted bid price of Adi and the swap ratio. The company's internal valuation model indicated a fair value of $82,148* and an unrealized gain of $26,568* which was not recorded in the consolidated statement of earnings as the Merger is still pending regulatory and shareholders approvals. Transaction price was considered to approximate fair value due to the proximity of the transaction closing date to September 30, 2016. At September 30, 2016 the company had appointed two of the eight Privi board members. Privi is a supplier of aroma chemicals to the fragrance industry. Privi's world-class products are the result of its very strong research and development team that has proven expertise in developing new products, customizing odor as per customer requirements, scaling up products from basic research to commercial scale, and designing process improvements to drive quality and cost optimization. With an installed capacity of 22,000 TPA of aroma chemicals, Privi enjoys a dominant position and economies of scale in its product categories.

* in '000

For listed entities Fairfax uses market price to disclose its NAV to its investors. It is not tough to conclude the impact of this transaction on its NAV.

In Conclusion

Many a time we are easily swayed by the opinion of others as well as that of media. In this case it is widely known that Fairfax is the vehicle for Mr. Prem Watsa who is widely known and respected by investors and the media as the “Warren Buffett of Canada”. This episode to us however seems to be in sharp contrast to the perceived ‘fair’ image of Fairfax.

To our mind this has reinforced what we already know but are not always able to practice. It is important not to fall prey to the Bias of Authority and make our own independent judgements. In this case by being able to focus on what is being done rather than what is being said.

Many of our beloved notorious promoters may be wondering. “Tum karo to Ram. Hum Karen to Asaram ??” J

Best of Manufactured Luck!!

Disclosure: We have no position either long or short in either Adi Finechem or any other Fairfax controlled entity in India. This piece does not offer any view on the suitability or otherwise of Adi Finechem as an investment but only focuses on the specified transaction structuring. As such it does not constitute Investment advise and is merely a post towards enhancing learning and knowledge.

Is there a ‘Bubble’ in Quality?

2015-04-24T00:31:00.000+05:30

The entry of ‘quality’ and ‘moat’ into the lexicon of most investors has resulted in valuations of these businesses touching stratospheric levels. Consequently, investors of today are faced with some difficult decisions.

There seem to be two schools of thought emerging.

Camp 1 seems to believe that valuation has nothing to do with the sell decision. As long as a great ‘moat’ company with great management has a visible growth outlook, the best time to sell is quite literally, never.

To us in Camp 2, this seems like a case of forgotten lessons from the past. Investors who overpaid in Infosys and Hindustan Lever had to wait for a decade or more for their investments to start generating some returns in spite of continued growth of the underlying business. We are confident that for many of today’s darlings, this time is not going to be any different!!

Neither does that mean that we throw the baby out with the bathwater and exit ALL seemingly pricey positions. There is undoubtedly still great merit in holding on to some winners and one needs to guard against selling out too early from some huge long term compounders. Since trees will not grow to the sky, this post is an attempt to pen our thoughts towards building some framework identifying which trees to climb in the current frothy environment and which to jump off.

Implied ‘look out’ earnings growth

In two recent posts here & here, Prof Bakshi has provided us some excellent insights into his thinking on the valuation debate, while suggesting that valuation indeed has something to do with the sell decision.

To Quote:

I don’t think in terms of entry multiples. I do think about exit multiples though and never value a business at more than 20 times owner earnings ten years from now.

And Elsewhere

Also when I said 20x multiple ten years from now as maximum I will value the firm at, I mean it. Many of them are valued at 15x and some as low as 10x…

While most would have worked on ‘Implied’ DCF models, let us try to invert what Prof is saying and understand what this ‘implies’ as per our understanding. Few caveats before we start.

First, As Prof has mentioned, not all companies are suitable for this kind of evaluation. Second while he likes to apply a multiple on owner earnings as compared to stated earnings and has also in the past talked about pre tax earnings multiples, for the sake of simplicity we conduct this exercise with post tax stated earnings.

To illustrate numerically, let us say a company has an EPS in year 0 of Re 1. If we are able to visualise a growth of 20% in earnings, then in 10 years, the EPS should compound to Rs 6.19. Now if we apply an exit multiple of 20x to this earning, we arrive at a price of Rs 123.8. As a next step we need to discount this with OUR hurdle rate. Let us say this is 18%. On discounting with this hurdle rate for 10 years we arrive at a PV of 23.7 which translates essentially to a multiple of 23.7 times on Re 1 of current earnings.

What the above implies is the following. If you have a hurdle (expected) rate of 18% and are not prepared to pay an exit multiple of more than 20x on 10 years look out earnings, you should buy/hold this company with an earnings growth outlook of 20% only if it is available at less than 23.7x current earnings.

Now armed with clarity in understanding, let us fool around with some real numbers.

In today’s day and age, a PE of 23.7 is considered cheap for the kind of companies we are talking about J Let us be more realistic and analyse say Hawkins Cookers trading at 45 PE. What is my asking rate for growth in profits with an exit multiple of 20 and a hurdle rate of 18%? The answer is - I should buy into Hawkins only if I expect profits to compound at more than 28% over the next 10 years. [You can arrive at this by doing a simple goal seek function here] This would translate into current profits of 35-40 crs growing to more than 400 crs in 10 years. This helps us put in perspective what we probably know i.e. Higher the entry multiple, higher the growth required to justify the purchase.

Let us look at some other examples to buttress this point, all for an exit multiple of 20 and a hurdle rate of 18%

				Rs Crores
Company	Current PE (TTM)	Implied Asking rate for 10 year PAT growth	PAT (TTM)	Implied PAT 10 years forward
Jubiliant Food	80	36%	117	2444
Symphony	77	35%	127	2561
Page Industries	78	35%	185	3781
Bosch	71	34%	1050	19476
Astral Poly	70	34%	80	1456
Relaxo Footware	52	30%	82	1112
Motherson Sumi	51	30%	825	11067
Cera Sanitaryware	44	28%	65	745
Kitex Garments	36	25%	99	943

Data as of 23^rd April 2015, approximate numbers ignoring exceptionals

It is thus quite evident that under these assumptions of exit multiple and hurdle rate, markets already seem to be pricing in fairly strong future earnings growth.

20% + CAGR of profits – is it possible?

While high profit growth over 10 years is not unheard of, we did a reality check to see how fast quality companies have been able to grow in the past. Out of a universe of roughly 5200 companies that we ran a screen on, 203 (3.9%) had ROCE of over 20% in at least 7 out of the past 9 years. There being no formal definition for judging quality, we used this filter as a proxy for ‘quality’ companies. Next we checked on the CAGR growth in PAT that these companies demonstrated over the nine year period.

PAT CAGR	No of companies	% of Quality	% of all listed stocks
<10%	44	21.7%	0.8%
10-20%	59	29.1%	1.1%
20-30%	44	21.7%	0.8%
30-40%	31	15.3%	0.6%
>40%	25	12.3%	0.5%
Total	203	100%	3.9%

Key observations from the back testing exercise:

Mere 2% of all companies were able to demonstrate both quality and high growth.
Of the quality companies more than 50% grew profits at less than 20% CAGR, which also implies that the balance grew at more than 20%. The narrow point being made here is that while markets are today sanguine that all the companies in the above table (and many others) will be able to compound profits at high rates for the next 10 years, past data suggests only an even probability of success.
The hyper growth companies (more than 30% CAGR) where the big money was made in the past is a mere 1% of the listed universe of the companies, almost akin to find a needle in a haystack.

But is it fair to use 18% hurdle rate?

To complicate matters further, many investors rightly or wrongly, have a hurdle rate well higher than 18%. Quite obviously Higher the hurdle rate, even higher the growth required to justify the purchase. You can play around with the numbers for yourself by choosing a hurdle rate to see how the nos change. If you have a hurdle rate of 30% [Seriously, we have come across investors with hurdle rates even higher] Kitex will deliver for you only if it is able to grow its profits at greater than 37% compounded for 10 years to nearly 2500 cr.

So if you think this to be a tall ask, you have only two choices. The first is to tone down your hurdle rate and continue to hold Kitex, the second to look for greener pastures.

Without opining on what an appropriate hurdle rate should be, it is important in our view for serious investors to have a realistic hurdle rate. Having too high a hurdle rate can force you out of some great businesses available at sensible valuations in favour of moderate businesses at cheap valuations, thereby exposing you to higher risk of permanent losses.

Why an exit multiple of 20x?

Finally if the required implied growth looks too daunting, investors always have the option of remaining invested in the hope that the market will provide an exit multiple higher than 20. To understand if it is a good idea, let us start with what Prof Bakshi writes on this matter.

Finally all expected return models as an exercise in discipline, even though I know that many businesses would be worth a lot more than 20x earnings a decade from now, given their profitability and growth potential even beyond 10 years.

(Emphasis mine)

Conservative principles of valuation suggest that one could be neutral between a ‘0 growth’ company and a high quality bond. Therefore seeking earnings yield of 6-7% or roughly 15x PE may not be irrational. Paying a higher multiple implies a growth expectation. Using the same principle, assuming no significant changes in general level of interest rates 10 years hence, it may not be unfair to give a 15x multiple to a no growth entity. Therefore, a 20x multiple already assumes some growth even beyond 10 years.

Put differently applying a 20x multiple means that in your judgement the business would be able to demonstrate growth not for 10 but maybe 20 years or beyond. Most would agree that the risk that we may end up rationalising the unknown is high. In this light applying 20x in our view is aggressive enough. Going even further may be nothing short of pure adventurism.

To summarize, while not all, valuations of some quality companies seem to have overshot their intrinsic growth potential by a fair margin. While buying today or holding on to these ideas may not result in permanent loss of capital given the inherent growth in many companies, those investing today should be prepared to face sub optimal returns over elongated periods. Investors would do well to be careful in their stock selection in the current environment.

Best of Manufactured Luck!!

Disclosure: Examples used in this post is for educational purpose only and is not intended as a buy or sell decision on any stock. Neither us nor our family members have invested in any of the mentioned examples over the past 1 year

Fool’s Wisdom #4 : An alternate approach to position sizing

2014-04-20T18:12:00.000+05:30

Howard Marks in his classic, The most important thing, divides the investing community into people who think that the future can be foreseen or the ‘I know’ group as against the ‘I don’t know’ group viz those who believe that it is absolutely impossible to tell what tomorrow will bring.

He writes “The question of whether, trying to predict the future, will or will not work isn’t a matter of idle curiosity or academic musing. It has – or should have – significant ramifications for investor behaviour. If you are engaged in an activity that involves decisions with consequences in the future, it seems patently obvious that you’ll act one way if you think the future can be foreseen and a very different way if you think it can’t.

Investors who feel they know what the future holds, will act assertively: making directional bets, concentrating positions, levering holdings and counting on future growth – in other words, doing things that in the absence of foreknowledge would increase risk.

Those who feel they don’t know what the future holds will act quite differently: diversifying, hedging, levering less (or not at all), emphasizing value today over growth tomorrow, staying high in the capital structure and generally girding for a variety of possible outcomes”.

In the above few words, Marks summarizes quite effortlessly, what we have been struggling to communicate in the previous posts (Post 2, Post 3) of Fool’s Wisdom ie we fall in the ‘i don’t know’ group which drives our decision making.

Before discussing the position sizing approach, we think it makes sense to first reiterate the context. Recently in an article we came across a photograph of Rakesh Jhunjhunwala in his office standing next to a poster of what he calls his ‘10 commandments of investing’. Inspired, we decided to ape him!!

Our Ten Commandments

1. Capital Preservation takes precedence over capital maximisation. However, we need to guard against permanent loss and not focus unduly on risk of temporary losses.

2. Investing for us is similar to a amateur marathon runners goals. It is more important to finish the race (reach our goals) as compared to winning (beating the index or others to it). Therefore, building wealth over a period of time through controlled risk taking is more important than identifying the next hot thing.

3. Mr. Market is much more intelligent than he is given credit for and thus deserves respect at most times. It is incredibly difficult to identify truly mispriced opportunities. What appears mispriced is more often than not, cheap for a good reason. A reason which we get to know painfully, mostly in hindsight.

4. There is enough available opportunity within discovered ideas, mispriced or otherwise. While obscure hidden gems and micro caps find favour with many, we are happy to pass up most ideas as we don’t trust our own judgement and fall in the ‘i don’t know’ camp.. While multi baggers happen, we don’t set out to identify them. We believe, multi baggers are known only in hindsight while at the beginning they are at best good investment ideas.

5. You can know only so much, beyond that however intensive the level of research it’s all illusion of control

6. Being lucky is the only 100% sure shot strategy. Improve your process since outcomes will always be influenced by the presence of good luck or the absence of bad luck. While making correct decisions obviously helps, it is harder than it seems. A relatively easier goal is to reduce errors.

7. Conviction is for fools. Scepticism followed by constant questioning of your thesis is a good friend to have. There is absolutely nothing wrong with having to change your opinion even if it means that you fall from a pedestal of respect. Also a change of mind need not necessarily be preceded by a change of facts. Improved insight is enough reason.

8. Diversification is the only insurance against ego as well as misfortune

9. Position Sizing is a larger driver of overall portfolio returns and wealth creation as compared to stock selection. By focusing only on stock selection we tend to ‘miss the woods for the trees’

10. We only have 9. There are no fixed rules. Expect the unexpected. Rules of this game are liable to change without notice!! Constantly question your beliefs and learn from your mistakes!!

The 4 quadrant approach

The above commandments define our ability to assume risk in our allocation decisions. Rather than be guided by our convictions, we like to continuously slot our investments, current & potential, on a simple business quality v/s valuation matrix.

It is said, beauty lies in the eyes of the beholder. Likewise assessment of both business quality and valuation are also subjective and differ from one beholder to another. Also, experience and time generally tends to improve the quality of this judgment.

So which are the businesses which look ugly or ‘bad’ to us?? While there are no fixed measures, some obvious ones are low ROCE, poor pricing power, commodity stocks, manufacturing cyclicals, highly regulated entities, any businesses lacking moats, poor balance sheet plays etc. Sometimes inherent business characteristics might be good but unscrupulous and/or incompetent managers (example some PSU stocks) make us qualify a good business as bad.

While the above is mostly obvious, in line with Commandment 6 (try and reduce errors over trying to hit home runs) we also have a habit of slotting ideas outside our circle of competence as well as complex business, as bad business by default.

We think businesses with these characteristics represent a dominant part of the market. A good 80-90% of the ideas that we look at tend to get slotted into the bad business quadrant. Always better to be safe than sorry!!

Conversely what are ‘good’ businesses?? Companies having characteristics which are the opposite of the above qualify as good businesses. Healthy long term ROCE, unregulated mostly consumer facing businesses having pricing power in relatively low cyclical industries, industries with low rate of change, clean balance sheets. Businesses with moats also run by managements with a trustworthy track record.

So what are we trying to achieve through this demarcation? In line with our 1^st commandment, we need to guard against permanent losses of capital. And in our experience, it is our investments in bad businesses which, have been and are most likely to be in the future, the source of losses which are permanent in nature. While we are yet not wired to fully eliminate our investments in bad businesses (we will explain why in a short while), we surely want to KNOWINGLY monitor our exposure so as to closely guard against the risk of permanent losses. Demarcating the bad businesses from the good ones is the first step in this regard.

Conversely, we believe that for genuinely great businesses risk of permanent losses are quite low (while not nil) for the very long term investor, even if he were to have overpaid to some extent to start with. For eg. if you bought Infosys at a PE of 200 at the height of the dotcom boom in 2000, you would still have broken even after 10 odd years, without getting into a debate on time value of money. However we are not sanguine if long term buyers of Suzlon or Kingfisher will EVER break even.

The judge of valuation can be equally subjective and has been the subject matter for many an author. Investors would however recognize that it is at best a probabilistic exercise and concepts like intrinsic value and margin of safety take many expensive lessons from Mr Market to understand in the real world.

This judge of quality and valuation cannot be a one time but needs to be a continuous process. Not only does valuation change with the price, businesses can also lose their mojo due to industry upheavels, management decisions and black swans. Good businesses can slide to the Bad business quadrant or vice versa, thereby calling for an allocation review.

While on the face of it, this slotting looks easy, it can get complex even for highly experienced investors largely due to their personal biases. When we have already jumped to a conclusion based on let us say valuation, our mind will figure out a way of convincing us that the business quality is also good by only selectively paying attention to the positive arguments. Quite often we tend to wrongly confuse ‘growth’ for ‘moat’ and most of the times we simply lie to ourselves because a ‘screaming buy’ is nothing but another word for ‘instant gratification’.

Therefore, when analysing a prospective idea, we have learnt to first conclude on the business quality judgement and then move to the valuation, in that order. The reverse somehow just doesn’t seem to work!!

Good Business, Good Valuation (GG) quadrant – Quality at a discount

This one is easy. There is no logic, not to invest confidently into ideas that fall into this quadrant. We therefore wish to have the highest possible overall exposure as well as concentration into individual ideas that fall in this quadrant.

However, given that we are wary of very high concentration, we tend to limit most individual bets to between 5-7% of the portfolio, but this is strictly a matter of personal choice.

That said, it is ONLY an idea in the GG quadrant which can potentially be worthy of an initial 10% allocation, our maximum comfort level. So what will make us go there? First, the business will need to be great. Simply good will not suffice!! Second, the valuations will need to be doubly attractive. Borderline cheap is not good enough!! But most importantly, the steward of the ship ie the management will need to be of impeccable quality both on competence and ethics.

So for example, VIP Industries, which we have written about in a previous post, fell in the GG quadrant, in our view, at the time of writing. We allocated roughly 5-6% weight. Why did we not go to 10%? Because, we classified the business good not great (discretionary spend based industry prone to some cyclicality) and had no issues with the management (quite different from being in love). Should we have changed our mind and gone to 10% if hypothetically the price fell further by say 30-40%? We don’t think so. We bet big (defined as 10% J for us) only if superb management is an insurance against our possible mistakes of omission and commission and the curved ball that the future is certain to often throw at us.

GG ideas once found need to be exploited to their potential. We try to guard against the mistake of underweighting. A 2-3% weight simply does not do them justice!!

So why not simply put all your eggs in the GG quadrant? Wish we could!! However, truly good businesses don’t always come cheap. Even if you are able to identify a few such ideas, it might be difficult for diversified investors to build an entire portfolio of such names. Though it might be possible if you are willing to concentrate heavily, which brings its own set of risks.

Assuming that you have allocated the maximum possible into GG ideas, while at the same time successfully able to sidestep all BB ideas, the challenge now is to choose between quadrant BG and quadrant GB, for the residual capital. This is where one has to contend with a divide of opinions even amongst the investing greats. While Graham/Schloss/Seth Klarman feel that valuation provides the margin of safety and tend to favour the BG quadrant over GB, Buffet/Munger/Fischer advise the reverse and seek margin of safety in quality and not in price.

Bad Business, Good Valuation (BG) quadrant – Smokers corner

Why invest in a bad business knowingly in the first place? First, because it is cheap and appears to come with a large margin of safety. And second, because it is better than Unknowingly investing in a bad business, which in any case is incredibly tough to avoid.

We think that if slotted without bias, this quadrant is where the bulk of ‘value investors’ portfolios rest. Value investors find it tough to avoid a bargain when they see one since they have are constantly on the lookout for ‘mispriced’ securities. Also since we tend to overestimate ourselves and underestimate Mr Market, we think that there are a large number of dollars available for 50 cents out there.

Reality however could be a bit different. While mispricing is most easily found in businesses without moats, history teaches us that value traps are real and what is cheap is quite likely, because it deserves to be!! What’s more, poor quality businesses are most likely to result in a permanent loss of capital, something we wish to avoid in line with Commandment 1.

So why not avoid the quadrant altogether and put all residual capital after investing in the GG quadrant into the GB quadrant?? This is difficult since we are not wired to pay what is a seemingly high price. Like a smoker who is unable to quit despite prior knowledge of the ill effects of his actions, we are also yet unable to resist the temptation of a mispriced bad businesses altogether, especially when the alternative is to ‘pay up’.

There are two reasons for the same. One practical and the other emotional. The emotional reason is that like most ‘value’ investors we still feel that we are smarter than Mr. Market and while others might get hurt investing here, we wouldn’t due to our superior skills :). Maybe we will learn in time, but it is not yet time!!

The practical reason is that it helps us turn more stones. And as we keep turning more and more stones, we keep learning. If we close our mind and restrict ourselves to delving into only high quality businesses, then the risk is that we stop turning stones and therefore stop learning.

Since we are going to smoke anyways the trick then lies in controlling our extent of smoking!!

In this case, since we are assuming higher risk knowingly, we need to monitor and control our overall exposure as well as reduce risk by practising wide diversification.

For investible ideas with a high margin of safety that we categorize to be in the BG quadrant, our rule is to have no more than 2-3% of the portfolio weight. Why? Because when we fall, as we frequently will, it should hurt but not kill us. And when we sometimes get it right, it moves the needle, otherwise what’s the point?

So when we spoke about Triveni Engineering in an earlier post on sugar, we harboured no illusions. This idea fell squarely in the BG quadrant. Allocations thus capped at 2-3% to protect against risk of permanent loss. Likewise with Polaris.

Over and above a stock level weight, we think it is extremely important to closely monitor the overall BG quadrant level weight. We like to be slightly tactical here.

In greedy times like today, we wish to be careful by reducing our weight to a minimum in the BG quadrant. When players start compromising on quality in search for ideas that haven’t ‘run up’ and look ‘relatively’ cheap, we prefer reducing risk in favour of quality, moving to investible ideas in the GB quadrant or cash in their absence. As we speak we have less than 15% in BG names with no single name above 3%.

Conversely, when fear grips the street and markets seek refuge in high quality, we hope to draw courage to get out of our holes. At these times GB ideas need to give way first to newly opened opportunities in the GG quadrant and then to increased opportunities in the BG space, now available on even more favourable terms. The underlying principle of high diversification remains at all times, to ensure a basket approach to assuming higher risk. In the worst of times for the market and the best of times for this quadrant, we would not prefer keeping more than say 40% in the BG quadrant, always capped at 3% and floored at 2% for an individual position.

New ideas in the BG quadrant therefore need to make space for themselves within these dynamic quadrant limits.

Bad Business, Bad Valuation (BB) quadrant – Deceptively Easy

If i ask you to pay up for a Bad business, what should you do? Obviously walk away.

While this does not require a lengthy discussion, we think investors are quite commonly guilty of remaining unknowingly invested in this quadrant.

The first reason could be an error of judgement. So for example if you are buying PSU banks thinking that they make good BG investments, it is quite likely that you find out in time that they were infact BB investments, because their book value on which your valuation is premised, simply vanishes. Judgement errors are ofcourse impossible to avoid and can at best be reduced over time.

A more critical error is made when investors fail to sell after a price gain, an originally BG idea but now a BB idea. Sometimes paralyzed with indecision and at other times smug with a feeling of success, investors fail to spot this situation in the absence of a framework for the selling decision.

Good Business, Bad Valuation (GB) quadrant – Pay up for quality, but don’t forget growth

This quadrant is the most difficult to buy into for the price conscious investor. Since you will find enough thoughts on this quadrant including Prof Bakshi’s post and this great talk, we do not wish to add a whole lot of our two bits here.

The market is full of examples of high quality businesses with strong durable moats turning out to be multi year compounders. This has happened even though prima facie they have been far from cheap, in some cases quite expensive at first glance.

So what do we look for before investing in this quadrant?? Quite simply, we look for sufficient headroom for multi year growth and management ability to capture it. Stock prices can move in only two basic ways. First, earnings growth keeps rolling in without compromising the balance sheet and second market rerates a great business from what was earlier average to now premium valuations. Since expensive is the assumption to start with for the GG quadrant, it is unfair to bet on further rerating, and its growth that counts. Should you invest in Cera or Relaxo without counting on future growth? Probably not.

We like to cap ideas in the GG segment at 5% with a floor of 2%. We tend not to go higher because 1) psychologically it is difficult for us to pay up and 2) being in the ‘i don’t know’ camp, we remain wary of looking far out for future growth. We however don’t feel the need to apply a lower cap since we judge low risk of permanent losses.

Applying the framework to the selling/averaging decision

The 4 quadrant approach also guides us when weight changes occur due to price movement. While we have spoken on the initial allocation based on quadrants, an equally important decision investors need to make is whether to keep adjusting the portfolio weight by selling (profit booking) or buying (averaging) when prices rise or fall.

We present our thinking about the scenarios in a tabular format.

Existing Quad	Price	New Quad	Comment	Action
Good Bus, Good Val	Up	Good Bus, Good Val	Price higher, valuations still attractive	Let it run. Why cut flowers?
Good Bus, Good Val	Up	Good Bus, Bad Val	Price higher valuations expensive	Let it run. Why cut flowers?
Good Bus, Good Val	Down	Good Bus, Good Val	Price lower, valuations even more attractive	Buy and average. Quality gets cheaper.

Good Bus, Bad Val	Up	Good Bus, Bad Val	Expensive gets more expensive	Let it run. Why cut flowers unless its gets extraordinarily expensive.
Good Bus, Bad Val	Down	Good Bus, Good Val	Quality get cheap	Buy and average. Possible increase in allocation

Bad Bus, Good Val	Up	Bad Bus, Good Val	Price Higher, valuations still attractive	Restore initial weight. Control Risk
Bad Bus, Good Val	Up	Bad Bus, Bad Val	Price higher valuations expensive	Sell entirely. Book Profits
Bad Bus, Good Val	Down	Bad Bus, Good Val	Price lower, valuations even more attractive	Recheck for value traps. Average only selectively.

We sincerely hope we have set you thinking about your portfolio!!

Best of Manufactured Luck!!

Wheels India Rights Issue – A Free Lunch for minority investors??

2014-02-04T16:56:00.000+05:30

Wheels India has announced a rights issue only for minority investors, which seems to present an interesting opportunity.

However, before we get into the discussion, let us quickly talk about the opportunity in rights issues in general. Those who know about rights issues can jump forward to the next section on the specific opportunity in Wheels India.

How rights issues work

Let us say Company X has 1 cr shares outstanding with a CMP of Rs. 200. Since the company wants to raise additional funds from the market it announces a rights issue whereby the shareholders have the right to subscribe to, say 2 additional shares for each share held at a price of Rs 100 per share.

How can you participate in this opportunity? While many others have also explained this in the past, the following is the way in which we evaluate this.

Step 1: Buy 1 share before the record date at a cum rights price of Rs 200

Step 2: On the day the stock goes ex rights, you have the choice of selling this share in the open market. You should do this only on the ex date or thereafter and thus retain the right to participate in the rights issue. At what price will you be able to sell this 1 share?? The theoretical price on ex date will be determined as per the formulae by the exchange

[(Pre dilution no of shares x cum rights price)+(New shares issued x Price at which issued)]

Fully diluted no of shares

In the above example this should be [(1 x 200) + (2 x 100)]/3 = 400/3 = Rs 133.33. While this is the theoretical ex rights price, the price at which you will actually be able to sell your share will of course be decided by the market. In cases that we have followed in the past, the market has generally allowed an exit at or about this theoretical ex rights price. Let us assume that we are able to sell at this price ie Rs 133.33. Therefore, we have booked a loss upfront on this 1 share of Rs 66.67 (Rs 200-Rs 133.33). What have we got in exchange?? We have bought the right to buy 2 shares at Rs 100 each. You can also think about this as similar to having bought a call option with a right to buy 2 shares at an exercise price of Rs 100 and a premium paid upfront of Rs 66.67.

Step 3: The company will announce a period during which you can make your application. Let us assume that there is no change in the market price which if you now remember is at Rs 133.33. You go ahead and make your application to buy 2 shares. You can also bid for additional shares which you should at this stage. Some investors may not choose to bid for their entitled shares. These shares get allotted to those who bid additionally on a pro rata basis.

Step 4: Receive your 2 entitled shares and let us say 1 additional share (assumed). Sell these shares at CMP which if there is no price movement in this case is Rs 133.33. So how does the final math work? On your original entitlement of 2 shares you make [(133.33 – 100)*2] = Rs 66.67. However, if you remember you had already booked a loss originally in Step 2 of the same amount. Thus on the original entitlement there is no arbitrage returns on a theoretical basis. The returns on this trade would come entirely from the profit generated on the sale of the additional 1 share on which you make [(133.33 – 100)*1] = Rs 33.33.

Thus if all goes as per above assumptions you make a return of 16.67% on your original investment (33.33/200). What can go wrong?? Firstly, there is no science to confirm what will be the additional shares allotted and thus there is no way to compute the expected return outcome. If too few people let go of their rights or too many people think like you and bid additionally, overallotment might be quite low. Secondly, the outcome would also depend on the prices at which you are able to exit your various positions at multiple stages. In the above example, the ex price has been assumed to remain constant. However, as we all know markets are anything but stationary.

The Wheels India Opportunity and why it is different..

First a quick background. In the various alternatives that SEBI had provided promoters to bring their shareholding within the regulatory limit of 75%, one was allotting rights only to minority shareholders. Thus, in these issues, the promoters forego their rights entitlement and only the residual shareholders participate in such a way that post issue promoter shareholding is brought down to less than 75%. In the case of Wheels India, promoter (TVS group + Titan International) is at 91.44%. The promoters have thus chosen to use the rights to minority holders as the route to bring down their shareholding also presumably raising much needed funds for the company (to pay down existing debt) in the bargain. They have now spelled out the terms of this issue in this announcement.

So what are the facts?

CMP 825 (A)

Current o/s Equity : 9869444 shares (B)

Fresh Issue : 2162835 shares (C)

Diluted Equity = B+C = 12032279 shares (D)

Issue Price 400 (E)
Record Date for entitlement : February 14th 2014

If you were to work the above explained math for Wheels, how will it look? So let us say you buy 20 shares at CMP which will give you a right to subscribe to 51 shares subsequently at issue price. Total cost of purchase will be (825 x 20) = Rs 16500/- Since we will look to sell these 20 shares on the ex date, what should be the theoretical ex price. As per the formulae it should be [(B x A) + (C x E)]/D = 749. While all other things are constant, the CMP would of course keep changing going into the last cum day and thus this ex price would change accordingly.

Now if you are able to sell your 20 shares at this ex price viz 749, you would book an upfront loss of Rs 1528 [(825-749)*20] on your investment of Rs 16500/-. This as discussed is akin to paying a premium for buying a call option for the right to buy 51 shares subsequently at an exercise price of Rs 400 per share.

Subsequent to the issue, if you are able to sell these 51 shares at the same ex right price viz 749, you would make a profit of Rs 17799/- explained as [(749-400)*51]. Net of your loss of Rs 1528 booked earlier, you would still be left with a profit of Rs 16271/- leading to a theoretical return of roughly 98% on your investment of Rs 16500/-!!!

WTF...Had we not mentioned earlier that there is no theoretical arbitrage on the original entitlement?? The reason why this is there in this case is because this issue is only for minority investors and the promoters are foregoing their entitlement, which is what is different in the Wheels India rights issue. Of course the returns will look even more ballistic if we were to start using some estimates of overallotment and further profit on those shares!!

The basic point is as under. If you were to divide potential profits from rights issues into entitlement shares and additional shares, in normal issues almost no returns can be made on your entitlement. The only returns are on additional shares if you get allotted any. Here, the entitlement shares itself seem to be suggesting supernormal returns. Any additional shares will only add to the math.

So what are the risks and where can things go wrong?? The key to these returns would of course be the price at which you are able to exit the trade at various stages. While the current math looks like as we have explained, what do the fundamentals say?? Can we get some sense as to what could be a fundamental fair value??

While we would urge you to read more about the company from public sources, Wheels India is an auto ancillary in the production of steel and aluminium wheel rims. It derives its revenues primarily from selling to OEMs in the various vehicle segments of CV, Buses, cars, 2 wheelers and tractors. Exports form roughly 20% of sales. Given the recent weakness in the auto sector, near term nos are nothing to write home about. However, the company is still trending towards making some 140 – 150 cr of EBIDTA on nearly 2000 cr of sales at some 70% capacity utilisations. Being largely a fixed cost business change in utilisation can obviously lead to both positive or negative operating leverage. While it is obvious that it is no generic me-too business neither is it a great business. Historical ROCE/ROEs are in the early teens suggesting high capital intensity. Debt is at roughly 475 cr on a market cap of roughly 800 cr providing an EV of ~ 1275 cr translating to an EBIDTA multiple of ~ 8.5x.

The way we would like to look at this is question what happens in a worst case scenario. The worst case would be if we subscribe to our rights shares and subsequently the price falls leaving insufficient profits or for that matter losses, leaving us holding those shares. Would the loss in that situation likely be ‘permanent’ or temporary?

We have earlier written that when you sell your original 20 shares at 749 (assumed ex price) you book a loss of Rs. 1528/- (para marked in red). Since this translates to a right to buy 51 shares, the per share cost is [1528/51] ~ Rs 30/-. The total cost per right share for you is Rs 430/- (explained as Rs 400+ Rs 30). You will start making a loss in this trade only if the price falls below Rs 430/- under the above assumptions. This translates to a fall of more than 40% from the theoretical ex rights price of Rs 749/- within a span of 1 month (rights allotment after issue generally takes 15 days while new shares might take 1-2 more weeks to get listed) for you to start making losses. Can it happen?? Of course it can..However, we are comforted by the fact that at a price of Rs 430/- Wheels India would be available at roughly 6 times EV/EBIDTA which may start interesting value investors.

Opinions from the investor community would as always help us analyse this situation better!!

Best of Manufactured Luck!!

Disclosure: Long

Fool’s Wisdom # 3: Tennis v/s Roulette

2013-11-21T12:24:00.001+05:30

Students of behavioral finance and game theory would have probably read about the group mind exercise which involves choosing a number between 0 and 100 such that the winning number is 2/3^rd the average of the guesses of the group.
(Spend some time here before reading ahead if you are not familiar with the game).

We find the interpretation of this game truly fascinating and instructive when applied to markets. But, before we explain the reasoning behind our fascination, we need to first critically examine whether this game can be used as a proxy for market behavior.

To start with, just as beautifully explained by Keynes, this game mimics the need for participants in markets to attempt to always stay that one step ahead, in the process demonstrating how difficult the attempt is!!

Another similarity with markets that we see is that the same information is available to all. However, each participant in the game, just like in markets, interprets and processes the information as per his own understanding. While some think that they understand the problem particularly well, others play along without having the slightest clue of what is going on. Quite similar to markets we feel :-)

The most interesting takeaway however for us is the outcome for the insider. Insiders here are defined as those who have already played this game before and thus know that the correct answer is 0. Think for a minute that you are an insider. If you were playing to win, should you guess 0??

As beautifully put in the Wikipedia write up on this topic

“This game illustrates the difference between perfect rationality of an actor and the common knowledge of rationality of all players. Even perfectly rational players playing in such a game should not guess 0 unless they know that the other players are rational as well and that all players' rationality is common knowledge. If a rational player reasonably believes that other players will not follow the chain of elimination described above, it would be rational for him/her to guess a number above 0.

Interestingly, we can suppose that all the players are rational, but they do not have common knowledge of each other's rationality. Even in this case, it is not required that every player guess 0, since they may expect each other to behave irrationally.”

Thus if you were playing to win, you should not guess 0 and your guess should be a number depending on your judgement of how rational the other players are!! How insanely complex can that be?? When this game was conducted in real life instances, the winning number was found to be somewhere in between 13 and 21. However, think about it for a moment. Is there any argument, which can help somebody reach a logical conclusion for the winning number?? Obviously not. Thus even if you had been right in deducing 0 as the correct answer, you would be a winner only if you luckily stumbled on to the average answer. It thus follows that it would be ‘luck’ and not ‘skill’ that would determine the winner.

Let us take an example of Jubiliant Foodworks Ltd, a company we have tracked for a while and are fascinated with. To apply the game in here we would classify the market participants in the following categories:

Fan followers: People who have seen/ tracked the stock since its IPO and seen the phenomenal wealth it has created for the shareholders. They are truly sold on the concept of “Buy and Hold” despite the fact that they may not be holding the stock. They have no regard for short term over-valuations but the 10 years story for Pizzas look great in India.
Technical Analysts: Looking at the past trends and using weird sounding terms like morning stars, doji, candle, resistance, supports, RSI, MACD etc come up with forward looking price trends / targets. Price is up for a few day in a row they have a Buy and vice versa.
Lay people: Have no clue of the valuations / business model but have seen/ eaten a Dominos pizza and hence think they know of the company. These people typically act on the basis of some tips or are shooting in the dark with logic of their own.
Fundamental Analysts: Valuations for the business are too high, the incremental ROCEs are likely to fall as expansion in Tier 2/3 cities increases, same stores sales growth is coming off, margins are under pressure but the size of the opportunity is huge, management is competent and demonstrated the scalability of the business etc. They are readjusting their numbers every quarter based on the results declared and commentary of the management.
Insiders/Management: We know the business the best, recently the going has been a bit tough with consumer spending slowing down, our commentaries have been cautious, we have withdrawn the guidance for FY 2013-14 but still price is at life time highs – Lets SELL a bit!! (They have sold 0.5m shares recently in the market).
Operators/ HNIs: 90% of the shares are either with management OR FIIs (largely long only) with hardly 10% in the markets, given that F&O open interest is equal to total shares in the market (non institution) we are in control of the game. We can drive the price when we want to. If you want to increase the price spread rumours of Burger King franchise agreement and Voila!! stock is up 15% in a couple of days despite bad quarterly numbers.

Given the various sets of thinkers for Jubiliant present in the markets, let us assume the winner is the one who guesses the return for next one month / 6 months / one year / 5 years. Who do think would be the winner? Our answer – NO IDEA!!

So this is why we are fascinated with this game. Let us say, that we have a fair value assessment for a certain stock idea and for a minute assume that we are perfectly right in our judgement. Just like the insider in the above 2/3^rd game, we would still be completely exposed to the consolidated irrationality of the various market players as a whole during the price discovery process. Even if our assessment of a stock's fair value is correct, we would win only in case we luckily stumbled on to the average right answer. Making money would thus almost always involve a huge slice of luck and we would be foolish if we were to mistakenly attribute our success only to our skills.

Luck or Skill?

Some critics of our previous post on diversification pointed out that concentration is not for everyone. So if you reread Buffett’s quote in the earlier post, he recommends betting heavily ONLY if ‘you know what you are doing’. Michael Mauboussin brings in a fresh perspective to this debate. He says that for probabilistic activities like investing, luck plays an extremely large role, much larger than we would like to believe. Thus even the ‘expert’ is not really in control of the outcome.

Taking examples from various fields, Mauboussin in his book ‘The Success Equation’ talks about the ‘Skill – Luck continuum’. Thus games like tennis, chess or running a marathon fall on one end of the continuum. Here your skill is the primary determinant and thus the ‘expert’ is largely in control of the final outcome. On the other end of the continuum lie games like playing roulette, tossing a coin or snakes and ladders. Here there is no skill involved and thus the outcome is entirely random and uncontrollable. According to him a large number of games like poker, bridge, cricket etc. fall somewhere in the middle. While degrees vary, the outcome here is dependent on a mix of luck and skill.

So where does INVESTING rest on this continuum?? Without doubt it is a mix of skill & luck!!

But isn’t it more skill and less luck than the other way round?? In a fascinating thought experiment, Mauboussin takes a leaf out of Munger’s book and suggests that we ‘invert’ the problem to get a better judgment. He argues that if we were truly in control of outcomes, we should be able to influence both ‘positive’ and ‘negative’ outcomes. It can thus safely be said that a tennis game and a game of chess can be ‘thrown away’ if the player so wished. Likewise, a marathon runner can lose a race on purpose quite easily. It can therefore be said that these games are about skill and very little luck. Be it winning or losing, a skillful player is largely in control.

Now, try going to the other end of the continuum and attempt losing a game of roulette, snakes and ladders or a coin toss competition!! You are neither in control of winning nor losing and thus it is entirely about luck.

We tried to apply the same inversion principle to investing and therefore started identifying future losers. Immediately, the obvious names sprang to our mind. Kingfisher Airlines, Alok Industries, Financial Technologies, PSU Banks, Suzlon, HCC, Anil Ambani group of companies etc..etc... The names kept popping up. But hang on…Were we really sure?? After some introspection we came to the conclusion. NOT REALLY..

Were we certain that Vijay Mallya, Jignesh Shah and Tulsi Tanti would not be able to do a ‘Houdini’ and get out of their current mess?? Low probability in our judgment, but what the Heck!! Who knows for sure!! Similarly for the other names while we felt negatively about their future outlook, we were unwilling to put money where our mouths were. Kal kya hoga kisko pata!! We realized that in effect we were trying to identify candidates for shorting and were reminded of the wise man who once said that it is much more difficult to go short than long!!

We already knew that our attempts at seeking positive outcomes (making money on our portfolios) had been largely futile :-) We now knew that we were neither in control of losing money on purpose. So were we in charge of our destiny?? Put differently, did we satisfy Buffett’s ‘fit and proper’ test of ‘knowing what we were doing’?? Probably not!!

While in most professions one gets more confident with time, investing has taught us to be less sure of ourselves as we have gone along!!

Best of Manufactured Luck !!

Fool’s Wisdom # 2: One, Few, Many or All??

2013-10-23T15:42:00.001+05:30

No framework on portfolio construction can be developed without first choosing between the camps of concentration and diversification. In this second, of a four part series, we discuss the subject as we see it.

In the debate whether one should take large percentage positions on a single/group of stocks or always spread out one’s bets, the oracle of Omaha puts his weight firmly behind concentration. Early in his investing career, he is famously known to have wagered some 40% of his partnership capital in a single position viz. American Express. While we have no way to verify this, we read somewhere that a study of his portfolio revealed an average of 73% held in the top 5 positions over the years. He has also been quoted as saying “Diversification is protection against ignorance. It makes little sense if you know what you are doing.” Meanwhile, Buffett is not alone in his belief. Giving him company are the widely respected minds of Keynes, Soros and our very own Rakesh Jhunjhunwala.

No wonder then, that a large number of investors unquestioningly embrace concentration as the right way of life. We have come across investors who are quite comfortable holding only 2-5 stocks in their portfolios. Infact, a few investors we have high regard for, have at times had 50-70% exposure to a single idea.

We however remain confused as we sense outsized bets in portfolios as an outcome of various biases.

It is not that serious investors build these positions without doing a fair bit of primary and secondary research. However, it is possible that this process of ‘deep dive’ gives them a false ‘illusion of control’. They think that they are in a better position to control the future since either the management is a friend or they know the business like the back of their hand. In reality however, while solid research and an intelligent mind map can improve your understanding of a business and associated investment risks, the only way you can tell the future with certainty is if you are a good astrologer. And unfortunately we do not believe in the science of astrologyJ. What is true for Berkshire Hathway coming from a position of management control may not be true for a minority shareholder unable to influence management decision making.

Secondly belief in high concentration could also be a result of the bias of survivorship. Everybody sees the riches produced by a few using this approach while choosing to ignore the countless millions who undoubtedly perished following this undeniably riskier path. While bucket loads of books have been written about star managers, we do not remember reading about wannabe star investors who did not make it due to their concentrated portfolios since the story was probably not worth telling.

Further, it can be argued that extreme concentration is an outcome of our need for instant gratification. Who wants to toil the difficult road to riches through diversified holdings, when it can all be possibly attained in a short while?? It possibly also has something to do with the basic construct of the brain which is the laziest human organ. Why track so many companies, results, annual reports, regulations etc., when you know that you are sitting on a goldmine?

Critics of diversification on the other hand argue that more the number of decisions, more the chances of error. It is said that even the ‘best’ investors get no more than 7-8 out of 10 decisions ‘right’. Wealth creation through a diversified portfolio thus automatically demands that the investor needs to get more number of calls right.

The other risk diversified investors grapple with is the risk of ‘over diversification’. Very often in their search for ‘safety first’, they end up with a huge number of stocks (sometimes more than 100!!) rendering their portfolios both unmanageable and immobile J at the same time.

Equally eminent minds of Benjamin Graham & Peter Lynch have been votaries of sticking to spread out diversified portfolios. To quote Nassim Taleb from the Black Swan “The inability to predict outliers implies the inability to predict the course of history”. The simple thought being that NOBODY fully knows what lies tomorrow. So stop trying to imitate astrologers and stop taking undue risks. Maybe highly concentrated investors in ‘quality’ businesses like MCX, Yes Bank and to some extent Titan would currently be appreciative of Taleb’s intellect.

A Matter of Choice

While we realize that concentration or diversification will always be a matter of personal choice and risk appetite, we think concentration is a luxury of the rich man rather than just about average individuals like us.

Answering the following question might help one develop a framework towards judging the risk / rewards from concentration.

Q: What best describes your goal for equity investing (choose one)

Equities are an important part of my overall investment basket which I hope will help me meet my goals over my lifetime. (Absolute returns matter)
I invest in equities with an aim to beat the market (Focus is on relative returns)
Equities are part of my overall wealth. I have sufficient alternate investments that help me meet my goals. (Equity gives me a high!!!)

If you have answered (2) to the above question, you are most likely to have an orientation of an institutional investor and therefore this debate is largely irrelevant. You have no choice but to start with the benchmark and add/subtract a few basis points of weight here or there. In our view, investors managing their own wealth would be ill advised to attempt to walk down this path. There is no point in coming first in a race if you don’t finish it!!

Like for us, we suspect that for most readers (1) would be the most appropriate choice. In our view those dependant on their investments for meeting their long term goals have no choice but to build diversified portfolios. While diversification can surely be accused of leading to sub optimal returns at times and reducing one’s odds of getting rich quickly, it is still the only way to go if you cannot afford ‘financial death’. Chances are that bad decisions will mostly succeed at injuring, as compared to killing you!!

That leaves concentration as a relevant option only for those making choice (3). If you are in it primarily for the ‘high’ then honestly anything goes as long as you can ‘sleep’ with it.

While, we have set for ourselves a maximum single position size limit of 10% (don’t ask us where we got that number, honestly we don’t knowJ. Its probably just a well rounded market anchor), we must confess that we have never dared to go beyond 6-7% (probably suggesting that we risk losing our sleep if we go higher). Likewise to protect against over diversification, we think that if we are not confident enough to build at least 2% in a given idea, it is not worth the effort.

We are happy to drive slowly if it means improved chances of reaching our chosen destination. We think to survive in markets, it is important to avoid the big mistakes than chase multi-baggers, as also pray for good luck (more about that in the next continuation post in this series). Sorry WB, even at the risk of being called ignorant, we would rather go with Taleb on this one!!

Best of manufactured Luck !!

Fool's Wisdom # 1 -Its how much that matters !!!

2013-10-14T18:40:00.001+05:30

Whenever a novice investor suffers financial losses in markets pat comes the advice from relatively seasoned players “Consider it as tution fees for your learning”. After having paid (and continuing to pay) enormous amounts of such tution fees on numerous occasions we are beginning an attempt at collating some learnings through posts thus appropriately labeled “Fool’s Wisdom”.

Over time we hope to share our philosophy and general thoughts on investing through this series.

We hasten to add that this mere act of posting should not mean that we have discovered some holy grail of investing and are now any less novice in our actions. Also, these are and should be merely construed as OUR colour blind view of the ‘right’ way. Like clothes, you are the best judge of whether our brand of investing may be the right fit for your temperament. Infact, as time passes, our own bodies may change shape and thus clothes that used to fit perfectly well earlier, might not fit anymore and need to be discarded. Our thoughts are similarly liable to be discarded to make way for fresh (or old) approaches which we ourselves find more suitable.High conviction is not amongst our strengths and we think we are better off without it (as of now J).

To quote Parcher, the imaginary boss of Dr. Nash from the movie ‘A Beautiful Mind’-

“Conviction, it turns out, is the luxury of those on the sidelines”.

It’s not only ‘WHAT’ but also ‘How Much’

Let us start with a story...

Without fail four friends, let us call them Niren, Abhinav, X & Y, make it a point to meet annually every new year day for a ‘stock idea forum’. The goal of this meeting is unambiguous. Hoping to learn from ‘the wisdom of the crowd’, they aim to discuss threadbare and identify 2-3 ideas which they could each add to their individual portfolios with a 3-5 years investment horizon.

In January 2010, for reasons best known to them, this group narrowed down on two ideas viz ITC and Suzlon. They all decided to add these stocks to their respective portfolios. Three years later when they met again in January 2013, other than the customary discussion on fresh ideas, they also got down to reflecting on the performance of their individual portfolios. Soon, it became evident that each had a different perspective. X was thrilled with the positive contribution these meetings had made to his overall wealth. On the contrary, Y seemed distraught. He seemed to think that the picks made by the group had been nothing short of disastrous and he was seriously reconsidering if he wanted to come back next year. Niren and Abhinav were largely indifferent.

This was a big surprise!! Had not these friends had the same stocks in their portfolios ?? How come then each had a different view on the returns of the stock picks??

The answer thankfully was not too difficult to find. We share below the secret they unraveled J

Friend	Portfolio allocation to idea	Portfolio Impact
X	10% ITC, 1% Suzlon	+ 11.5%
Y	1% ITC, 10% Suzlon	-6.8%
Abhinav	1% ITC, 1% Suzlon	+ 0.4%
Niren	5% ITC, 5% Suzlon	+ 2.1%

ITC went up 122% in the 3 years while Suzlon fell 80%

It now dawned upon them!! All these years while they had been vigorously debating stock ideas, they had conveniently forgotten to close the discussion with the most important follow up question. What should be the allocation!! While they were mature enough to acknowledge that both, positive outcomes like ITC and accidents like Suzlon are inevitable in the life and times of any investor, they realized that the position sizing decision can make a good decision look bad and vice versa.

In fact sizing of the position probably has a larger role in overall wealth creation as compared to the idea itself.

The discussions inevitably led to the sharing of past experiences (The I had told you so syndrome). Niren remembered how he had identified Zydus Wellness early but allocated only 1% to it thereby barely moving the needle, while Abhinav had been none the wiser after his large allocation experience in SKS Micro. While Y was understandably silent J, X pointed out the fact that while there is a plethora of advice coming daily on how to go about the what to buy or avoid decision, there seemed insufficient debate on how to go about the all important position sizing decision.

They solemnly promised never to break up without debating ‘HOW MUCH’. Without this it was all really a colossal waste of time!!

We will follow up soon with OUR thoughts on "How Much".

Till then ..Best of Manufactured Luck !!

VIP Industries – Packed off by the Rupee

2013-07-19T15:21:00.000+05:30

While domestic consumption oriented stocks have generally been having a party of their own in the past 2-3 years, one tribe member they clearly forgot to invite is VIP Industries, the largest seller of branded luggage in the country.
To illustrate, as of the 18^th of July, while the CNX Consumption Index has given a return of 33.7% over the last 1 year as against Nifty returns of 13%, the stock of VIP Industries (CMP 49, Mcap ~ 700 cr, EV ~ 750 cr) has lost nearly 40% over the same period.

When it rains it pours!!

In the 6 years till FY12 VIP’s topline grew at a CAGR of nearly 18% to a level of about Rs 850 cr on the back of rising consumerism and increasing travel by Indians. On a year on year basis, revenue grew at between 15% and 30% barring 2009, the year of the global financial crisis, in which it contracted 5%.

FY13 topline (broadly split as: 10% - exports, 25% - CSD , 65% - domestic retail) growth however slowed to less than 2%. Infact even this anaemic growth was a result of pricing while volumes shrunk YoY.

VIPs management explained this as a result of slowdown on all the three segments. Exports slowed due to weak demand in developed markets, while domestic sales were sluggish due to a cut back in discretionary spends on the back of rising inflation also evidenced by the slowdown in air traffic growth. Also, due to some political/ministerial issues, canteen stores were seen destocking during most of the year. A cut back in CSD sales was not specific to VIP but across all product categories but given that it is a meaningful segment for VIP, sales took a larger knock as compared to other consumer names.

Profit margins on the other hand were severely dented largely on account of the free fall in the rupee. The fast growing segment of VIP’s sales is the soft luggage segment (65-70% of revenues) which is almost entirely imported from China. This is not unique to VIP since China is supposedly the sourcing hub for much of the world’s soft luggage requirements. So, Gross profit margins (Gross profit as measured by Net Sales – Raw Material costs) in FY13 fell nearly 300 bps from the previous year to 49% (ranged between 52% and 56% in the previous 4-5 years). While the company took price hikes to offset this margin pressure, they were insufficient due to the extent of the fall in the rupee in FY13 (Average of 13.5% for the year).Inflation in freight, rentals and rebates led to a further fall at the EBIDTA level with margins coming in at 8% a contraction of nearly 600 bps over FY12 (EBIDTA margins between 11-15% in the past 4-5 years other than FY09 wherein it was at 7.5%)

Consequently, PAT for VIP in FY13 was down more than 50% at 31 cr.

All in all FY13 was a deadly concoction of all the things that shouldn’t happen to any business.

A bit more about the business

VIP claims near 60% share in the branded luggage market (through multiple brands at every price point) where it enjoys a near duopoly with Samsonite. The unbranded market is estimated to be roughly the same size as the branded, pegging the total luggage industry size at 3000-3500 cr. This of course does not include segments like ladies hand bags etc. into which VIP is a recent entrant.

When you look at the demand drivers, the industry enjoys the same tailwinds of the India consumption story as other consumer plays viz. Low penetration, rising per capita incomes, favourable demographics etc... However, since per unit costs are high at between Rs 2000-4000 and spends discretionary, the industry is prone to some cyclicality. While that undeniably weakens the case for VIP as against some consumer staple names, for us it still does not take away from the moats that consumer facing businesses selling brands enjoy. Barring a blip once in a while, we would not be surprised to see sustainable periods of double digit industry growth driven by increasing travel by Indians and additionally helped by replacement demand and the shift to branded luggage as people become more quality and fashion conscious.

Another factor of appeal to us is the simplicity of the business. Unlike many other consumer facing businesses, the luggage industry is not meaningfully exposed to the threat of substitutes (remember the challenge faced by scooters from motorcycles) or any technology led product change (mobiles handsets, Televisions etc.). Shifts in consumer preferences, for eg. from hard to soft luggage, are more likely to be gradual than abrupt. All of which add up as natural moats for incumbents, leaving challengers with little scope for disruptive innovation. With manufacturing increasingly outsourced, pricing, brand building and distribution remain as the primary strategy levers.

Unlike some consumer businesses however, the business does not enjoy a float provided by negative working capital. VIP has been able to maintain its net working capital needs at between 2.5-3 months. With the fast growing soft luggage segment almost entirely sourced from China, there has however been relatively small allocation of capital to new capacity expansion. Consequently, dividends have been at between 30-50% of profits for the year (It remains to be seen if this will improve as the company is likely to become debt free by the end of this year). Due to poor profits, while ROEs have been around 12-13% in the last financial FY13, the average 3 year prior ROEs have been 30%. With the business not thirsty for capital, ROEs can thus show consistent improvement if growth and margins were to return to levels as seen in previous years.

Coming to management, whilst being a promoter led concern (part of Dilip Piramal group of cos) we have not seen any glaring instances of capital misallocation. While some may point fingers towards management judgement, on integrity there seem to be no major red flags to our notice. We also draw comfort in the simplicity of the business since the halo effect invariably has a large role in influencing our judgements of management’s decision making abilities.

To sum up while not a VVIP, VIP does look to us as good as its name.

A cyclical low or the new normal??

Given that the rupee has depreciated by nearly 10% already this financial year, FY14 has also started on a challenging note for the company. While Q1 results are not out yet, it is quite likely that the numbers will be muted in spite of a beginning of the year price hike of 5% or so. Infact, given that the first quarter contributes to roughly a third of annual sales, it would probably make it all the more difficult for full year numbers to improve meaningfully, even if things on the rupee front were to stabilise/get better hereon. So is this the new normal or only a cyclical low??

On a near term P/E (FY13/14e) the stock still trades at between 20-25 times, not extraordinarily cheap. But when you start considering the 50-70 cr of PAT that the company managed to achieve between FY10-FY12 the P/E drops to between 10-15 times. The verdict is thus clear. Markets do not seem to be pricing in a return to earnings in the near future. For Mr. Market this is probably the new normal.

While we believe that return to revenue growth is but a matter of time, expectation of margin reversion is not so easily justified. Given VIPs import dependence, any discussion on margins without a discussion on the rupee is fruitless. For starters, we are not about to make a case for Rupee appreciation, what with the continuous challenge the economy faces to fund the unmanageable CAD. The only point of view we have on this subject is that the rupee is unlikely to be allowed to depreciate annually at the same frantic pace as we have seen in the past couple of years. The belief is that the rupee’s behaviour in the last couple of years would likely seem more of an aberration when seen over the longer term. If however, this thesis not be true, then of course we have a lot more to worry about in our portfolios than only VIP Industries J. A more benign 5-6% kind of annual rupee depreciation should not be difficult to pass through to consumers in our view.

The other thing going for reversion in margins is that apparently the entire luggage industry imports from China and thus is equally exposed to the fickleness of the rupee. While we are not certain if the whole industry will have the stomach for a one time price hike given the near term demand challenges, we think VIP should be able to claw back margins in future years. In any case, if the rupee does not fall further, a ~5% price hike should be able to take back VIP to the gross margin levels seen in the past 4-5 years.

The primary risk with mean reversion themes however remains in the judgement of where the mean lies and the time taken for such reversion.

Net, Net we think the market is giving us an opportunity to buy a quality business temporarily displaced due to external factors, at interesting valuations. Maybe not in FY14, but we are willing to bet on VIP returning to its earlier levels of profitability in a year of two and growing thereon with healthy ROEs.

Best of Manufactured Luck!!

Polaris – A good value punt?

2013-06-07T11:36:00.000+05:30

We think Polaris Financial Technology Limited is a good punt in the (oft misused) context of value investing.

Rather than presenting our thoughts in a structured paragraph format we have tried to present this one as an excerpt of a conversation between us (Niren:N and Abhinav:A)

N: I think it’s worth punting in Polaris, the risk – reward is clearly in our favour.

A: Why do you say so? Simply because there is buzz in the papers, news channels about the services division being sold? What are the broad numbers like, I have no clue?

N: There is talk of services division of Polaris being put up for sale. The division with FY13 Rs 1780 crs of revenues (77%), gross margins of 33.44%, EBITDA margins of 20.4% or Rs364 crs. Now compare that with the market cap of Polaris of Rs 1125 crs and cash equivalents of Rs 490 crs.

A: Will there be any takers for this one? What is your guesstimate of the deal value?

N: If you look at general deals in the midcap IT space in services business the buyer is interested in the access to clients and ready to use facilities of the sellers. This is a pure Application development and maintenance work which tends to be sticky. In this particular case, it seems that Citibank (also 19% shareholder of the company) is almost 50% of the services piece. Citi is the largest outsourcer in the BFSI space and clearly a great account to have for any large IT vendor to make in-roads / grow the BFSI practice. I don’t know but maybe a Wipro – telecom heavy, Cognizant – Healthcare focused, LT Infotech looking to ramp up in BFSI space.

Coming to deal value, given that it’s a reasonably profitable business, it can get an average of 0.9 – 1.3 x Revenues OR 6-8x EBITDA. The possible range of values using these matrices is Rs 1600 to Rs 2900 crs. With almost 9.95 crs shares, the per share value can range from Rs165 to Rs300.

A: Why is the market valuing the same business at such a sharp discount to even midcap IT plays?

N: Sir, clearly has to do with the perception of the management, the general discount and non-interest for Midcap IT, The large hoarding of cash and hence the risk of possible mis-allocation etc. At the same time it’s perplexing since Institutional holding is high at 28% . Dividend payout is in the range of 20-25%.

A: Assuming the deal will go through, do you think the stock will become another of those huge cash bargains?

N: Citibank, through its subsidiary – Orbitech Ltd. (previously known as Citicorp Overseas Software ltd) owns a 19.7% stake in Polaris while the current promoters own 29.2%. Also the Employee Welfare trust of both orbitech and Polaris own 2.7% of the company. It is my hope that with Citi on board, being a large shareholder and the largest customer as well they would have significant influence in ensuring that the proceeds will be distributed in an appropriate manner. In any case, we may not want to wait for the distribution of the said proceeds, the market price will reflect the deal if it goes through.

A: What about the balance products business?

N: It seems that Mr. Arun Jain is very gung-ho about his products business from the multiple interview and concall transcripts. Products have revenues of Rs530crs, gross margins of 50% and EBITDA margins of 11.5%. Post amortizations and finance cost this is actually a loss making business. (FY13 operating loss at Rs 42crs). While gross margins look fine, most of the EBITDA is invested in the high Sales and marketing cost, given the hope of the management that they will able to scale this business significantly. Licence revenues are 14%, maintenance at 38% and implementation is 48%. They have won 39 large deals in FY13, with a deal pipeline of more than $800m.

A: What if the deal doesn’t go through? What’s the downside protection?

N: The stock has moved from Rs 100 to Rs 115 on the back of this buzz in the press. At CMP of Rs115, there is a Rs5 dividend. Valuations on a trailing basis are as follows: PE – 5.7 , PB – 0.85 , ROE – 15% , EV / EBTIDA – 1.2. It may trace back to its earlier levels of Rs100-105 but given the dividend of Rs5 , my hope is that’s the bottom for the stock – a downside of 10%.

A: What’s the possible upside?

N : I am valuing the services business at Rs185 a 10% premium to the lowest range of valuations explained earlier. The premium is a function of the profitable nature of the business and attractiveness of Citi as its largest customer. To add to this the Rs50 of cash per share on the books and the products business. One can assume that the loss making products business negates the existing cash on the books in the worst case. Hence a possible target price of Rs185 – an upside of 60%.

A: But isn’t it one of those EVER PREGNANT NEVER DELIVERED (EPND) stories, what’s the difference this time around?

N: While there is no surety given the track record of the promoters having been in the same situation for a couple of times earlier and then things not going through at the last moment. There are a few management actions which suggest that this time it could indeed be different (to use the oft abused phrase).

The separation of the services and products division done recently by a task force formed by the Board of Directors for enhancing shareholder value.

The clarification given to the exchange expressly not denying the said rumours but rather alluding to the fact that there are no material events as yet for them to intimate to the exchanges.

Having said all of this, I still have only a 40% probability of the deal going through. What’s the logic – I don’t know – I have none but can mail you a complex model to justify the assumption of my probabilistic estimates.

A: Net-net what are we looking for?

N: So net- net we are looking at punting here in a stock which fits in all the (holy grail) VALUE criteria of statistical cheapness but with trigger of value likely to be unlocked basis the management actions and the news flow (there is no smoke without fire syndrome). On a Fermat Pascal framework, conservatively the payoff looks like 40% prob of a 60% upside vs a 60% prob of a 10% downside. Net – Net 18-20% return in a six months time frame plus 4-5 % dividend yield.

A: Makes sense maybe, but what allocation do you think we should put in here?

N: Well, this is a tricky one. I was thinking of this one more from a substitution angle given the plethora of value traps / junks / duds in our portfolio. How about converting from the existing basket the least preferred and building up a 5% weight.

Given our fancy for trying to manufacture our luck, we think Polaris suits the bill well.

We hope to seek your comments, suggestions and feedback as always

Best of Manufactured Luck!!!!

Post Delisting Options

2013-05-06T12:56:00.000+05:30

Some time back we had made a case link for avoiding the delisting theme since we thought the current regulations are 1) flawed and 2) significantly favourable to promoters.
We note that now the delisting bubble has largely burst with serious investors generally more appreciative of the risks in the space. We continue to regularly consider though some interesting strategies that the regulations provide POST the success of the delisting offer and announcement of the discovered price by the acquirer.

The first strategy is that of cigarbutt investing which we have already written about in our post. Taking the example of Chettinad Cements where the stock is temporarily trading post success of delisting offer. While the accepted delisting price is at Rs 720/, you can still buy the stock at ~ Rs. 695/- and tender to the acquirers giving you an absolute return of ~ 3.25% (assuming one side transaction cost of 0.35%).

Also as per the regulations, the acquirers need to give residual shareholders an exit window of 1 year at the same delisting price. Operationally, those who tender by a certain cut off date every month (to be announced after all approvals are in place and stock stops trading), are paid off by a certain date next month and so on. Based on time taken for previous delistings, we expect the entire process to get completed by 15^th June (at the earliest) or by 15^th July (most likely). Thus, by tendering at the first available opportunity, one can generate between 15% to 25% per annum. Since the risks are extremely low, we compare this strategy to returns from a 3 month Fixed Deposit yielding 7-8% at best. Looks interesting for those seeking to spice up their fixed income returns!!

The second opportunity is to think like a PE investor and buy shares and remain a continuing shareholder in an unlisted enterprise. Suitable only for those with a very high appetite for risk, this strategy if at all should be considered only in specific circumstances like

The business has been delisted at a large discount to intrinsic value and you expect this to get unlocked in some manner. Examples could be expectations of a future sale of the company or a large dividend payment from existing cash reserves. So for example, while bordering on speculation, one could argue that in cases like Amrit Banaspati, Carol Info or India Securities where the delisting happened at a discount to net cash on books this is a possibility, since promoters might want to strip the excess cash off the company books at some point of time.

You expect the business to do very well in the future and throw up large amounts of Free Cash Flow. You might thus want to remain a shareholder in anticipation of healthy future dividends combined with some form of unlocking.

The most important consideration for both the above is the management. Management should be of impeccable quality and unquestionable ethics. While most of us might not be disciplined enough to only buy into listed companies which as Buffett says “You’d be perfectly happy to hold if the market shuts down for 10 years”, when it comes to evaluating unlisted investments, we have no choice. And hence we think that this strategy can be employed only in the ‘rarest of rare cases’. It is difficult if not near impossible for us to envisage the existence of management in which minority investors can repose such blind faith. For an interesting discussion on this subject have a look at this.

A combination of the both the aforesaid alternatives and our love for preserving optionality led us to a third strategy while thinking about Chettinad Cements. This approach involves buying shares and not tendering at the first available opportunity but waiting it out for upto one year to tender (Since regulations allows an exit to all shareholders upto a year from the date of delisting).

If during the course of the year, some dividend comes along or some form of value unlocking happens, then investors can hit a jackpot. This low risk strategy is akin to buying an American Put Option since the exercise price is fixed at the delisting price, the period is fixed for one year after which the option lapses, you have the option to tender anytime during the year (American option) and lastly the premium you pay is fixed at the opportunity cost of letting your money do nothing for 1 year less the returns made on the cigarbutt. So for instance if a company with large net cash delists and your opinion is that promoters have stretched their pockets/borrowed to pay for the delisting, you may choose to employ this strategy in hope of a good dividend in the first year. Of course naysayers would legitimately argue that chances of a positive outcome are low. However we think that this could be an interesting strategy especially if the residual shareholding % is very low leading to small leakage for the promoter. In any case the approach appeals to us given the low cost lottery ticket nature of the trade.

Chettinad Cements – To do or no to do?

So where does Chettinad Cements stack up on strategy 2 & 3?? To start with, we were surprised that the promoters chose to delist a significantly capital intensive business. This in our view could be because 1) The promoters intend to sell off the business at a premium in the near future or 2) Capex is over for the company and the business is expected to throw up larger free cash flow in the future which is not yet reflecting in the price.

Our basic research on the company leads us to believe that it is the latter ie Chettinad is likely done with its capex for the time being and FCF is likely to improve over a period of time on the back of rising capacity utilisations.

So does this make for a case for creating a put option like in strategy 3? We think not. This is because as per the annual report, the promoters are keen to pump money from the cement business into their power business leaving little hope for any large dividend inspite of improving FCF. Certainly not in the first year given that there is still some leverage on the books.

Is there a chance for holding on for a longer period of time as in strategy 2, we are not sure given the capital intensive nature of both the cement and the power business. Also cement in general has had a good run for the last couple of years and we aren’t that good at predicting cycles.

To conclude, to us in the case of Chettinad Cements the cigarbutt strategy is the only one of appeal as an alternate to fixed income investing.

Best of Manufactured Luck!!

A swan or an Ugly Duckling ??

2013-04-17T12:04:00.001+05:30

In Feb 2012, the promoters of Numeric Power (now Swelect Energy Systems) chose to sell its core UPS business (roughly 90% of revenues and profits) to Legrand for ~ 825 cr through a slump sale.

After paying tax on the transaction and repaying all debt, it was expected that the company would still be left over with roughly 550 – 600 cr. Available at a market cap of 250-300 cr, wasn’t Numeric a screaming buy?? Well not really!! Mr. Market probably did not like two things 1) The slump sale as against the sale of the company itself side stepped the takeover code regulations thereby leaving the minority shareholders at the mercy of the promoters and 2) While a special dividend was declared and absorbed roughly 135 cr, the balance sale consideration was retained in the company for seemingly unrelated diversification (solar energy in this case). Those seeking a value trap might still find the stock interesting at an odd 50% discount to cash on books.

Ofcourse Numeric was not the first and nor the last that this theme has been played out in markets. Names which come immediately to mind are Kanoria Chemicals, Amrit Banaspati, Borosil Glass, Carol Info, Piramal Healthcare and more recently Strides Arcolab. While Amrit and Carol have since been delisted, some others are still available at near/large discount to cash.

Is this case any different??

While Mr. Market may be understandably worried on the above counts, to us it would seem that the same yardstick has not been applied in the matter of Clariant Chemicals (CMP 470, Mcap 1250 cr), a case similar in some areas and even more brazen in others.

After nearly 3 long months of silence accompanied by roughly 25% destruction in market capitalization, details while insufficient are finally beginning to emerge on the divestment of certain businesses of Clariant Chemicals to SK Capital. Ever since we raised some apprehensions on the deal in this post, we have been following the developments.

First, in a meeting in end March, the BOD of the company approved the slump sale of the textile chemicals, paper specialities and emulsion businesses together with their dedicated assets for a princely sum of 209 cr. While minority investors hungry for information should be grateful that the board chose to share how much the company will get from the sale, if they also expected to be informed simultaneously what was getting sold (revenue, profit, capital employed), they had reasons to be disappointed. The media release had little for them other than some strategic rhetoric.

The CY12 annual report however had some important pieces of information to offer. It disclosed that the divested businesses account for roughly 35% of the net sales of the company which should thus be in the region of 375 cr. Ideally, the annual report could have come clean with the profit and capital employed data as well but shall we say they again ‘missed’ the fat pitch.

In a surprising decision to say the least, the company has now chosen to send the postal ballot notice without this important data. While it is stated that all material information has been provided, we beg to differ. In effect, the company expects shareholders to assent/reject a sale of business telling them what they will get (209 cr) as compensation but not what they are selling/giving away (profits, capital employed). How only the revenue number is considered to be material and sufficient data for decision making leaves us baffled. However, we must move on with some assumptions since markets will not necessarily wait for all information to emerge.

In the annual report, while the directors expectedly in their judgement have assured shareholders that the sale is in their best interests, other interesting takeaways from the Management Discussion are reproduced for the benefit of readers.

The industry is increasingly shifting to Asia in consonance with the shift of its key consumer industries. This has led to share of Asia in the global chemical industry increasing from 31% to 45% between 1999 and 2009. With Asia’s increasing contribution to the global chemical industry, India emerges as one of the focus destinations for chemical companies worldwide.

Compared to the developed countries, the current penetration of specialty chemicals within India’s end markets is low. However, the huge potential of domestic demand and low per capita consumption in each of its industry segments compared to world average provide a strong potential for overall performance for Indian chemical industry. With an increased focus on improving products, usage intensity of specialty chemicals within these end markets will rise in India over the next decade.

Majority of global dyes and pigment manufacturers are shifting their operations to India and China, as REACH regulation is increasing their cost of production in majority of the European countries.

The dyes segment is highly fragmented in India due to excise concession provided for the market participants. This segment has an inherent element of value addition to a wide variety of products like textiles, leather, paper etc. The Indian textile industry which accounts for about 4% of Gross Domestic Product (GDP), accounted for 14 percent in Index of Industrial Production in 2010 and acts as one of the main drivers of the economy. The industry consumes about 80 percent of the total dyes consumed in India. The growth of the dyes sector thus depends considerably on the performance of this industry. Clariant is a major player in the filed of dyes and chemicals and plays a key role in providing innovative and sustainable solutions throughout the entire supply chain and all segments from fiber to finishing of textiles and retanning to finishing of leather. Clariant provides knowledge and expertise in the management of whiteness, coloration, special coatings and strength and offer products to improve optical and functional properties of all kinds of paper and board.

On reading the commentary, the following thoughts come to our mind (Our views in italics)

While cautious on certain counts, it seems to us that the management is generally positive on the future of the divested businesses in India. This is backed by the common knowledge that India along with China & other South Asian economies is fast emerging as the global hub for textiles. Even in paper while developed economies are witnessing volume contraction, India is expected to show reasonable growth. While the divestment could be good for Clariant at the global level, is it right for the India business?? Maybe not...
Had the Indian business been kept out of the deal, could there have been a risk to the deal itself?? Probably Yes..
If that be true can the sum of 209 cr considered to be fair consideration?? We think not..
And lastly the tricky one!! Does a 2/3^rd business owner have the right to sell a material part of the business at a huge discount without sharing complete information and showing total disrespect to the value attributed by the market?? While in letter yes but good governance is all about the spirit isn’t it??

On what counts can this case be compared to Numeric Power & others?? In the case of the others, while revenue contribution of divested businesses was higher, we think 35% contribution is material nonetheless. Also, in those instances, businesses divested were generally at a large premium as compared to market perception of value and thus the sale was justified in some sense. In the case of Clariant no such comfort can be derived since the divestment has happened at a huge discount. And last but not the least, while at the mercy of promoters, the residual cash in the earlier mentioned cases is atleast still in the listed entity. The same cannot be said in the case of Clariant where it can be argued that the India business was one of the jewels the acquirers were courting and willing to pay a premium for, while the promoters have already been merciless by providing inappropriate consideration. While the parents strategic and financial goals may have been met through the deal, minority shareholders in India are probably wondering who ate my cheese!!

In our eyes, what we thought to be a swan all along turned out to be an ugly duckling!! Infact the ugly ducklings in comparison are beginning to look like swans.

Was it an ugly duckling all along??

Did we miss calling a spade a spade?? What lead to the perception that the quality of governance at Clariant Chemicals is the best in class to start with??

We think the reasons are primarily two

The fantastic track record of the company in the payment of dividends as a % of distributable surplus and
The fact that it is an MNC

Out of the two, while many might believe that the primary is the first ie dividend record, we think it is the latter ie the foreign parentage. If healthy dividends were to be a measure of good governance alone, PSU enterprises would automatically top most of the charts which they probably don’t. However, most companies with foreign parentage are blindly considered to be high on governance. While Indian governance is considered guilty until proven innocent, MNC governance is considered innocent until proven guilty.

This in our view is a classic case of Representative Bias. The same unfounded reason why blondes are considered less than smart and some communities are considered stingy while some others are considered enterprising. For the record one of us is a Marwari while the other is a Gujarati... : )

It would be interesting to see the reaction of markets to MNCs if for example Nestle chooses to sell Maggi globally at global valuations or likewise Unilever were to sell its oral care business. We have generally been wary of paying a premium on account of MNC parentage.

Cut the chatter!! I am a Clariant shareholder..

Existing shareholders of Clariant might be tiring of our ranting and theorizing by now and more interested in a discussion on the future course of action. Actually this post was more from a perspective of raising an issue we thought to be of relevance as compared to a stock view. Nevertheless, emboldened with the success of our previous guess, here is how we would have looked at the stock had we been shareholders.

The company in CY12 made an EBIDTA of ~135 cr with a margin of 12.6%. Using similar margin % for the divested business on a revenue of 375 cr gives us an EBIDTA of ~ 50 cr which the company will now forgo, thus leaving us with an EBIDTA of ~ 85 cr. Given that 1) The halo for the company has worn off in our eyes 2) The company is reported to be looking to sell its leather chemicals business at a global level for which minority shareholders should expect similar treatment and 3) Better available opportunities in the current market environment, we would not be keen to value the company at a premium to its parent valuations ie. ~ 7x EV/EBIDTA translating to an EV of ~ 600 cr. Clariant India (CMP 465) is available at an EV of 800 cr (post inflow from the divested business). Broadly speaking, we would not be surprised if the stock were to lose a further 25-30% from current levels. As always investors are requested to make their own judgement before buying or selling.

Those choosing to hold, may wish to consider rejecting the slump sale in the postal ballot.

Best of Manufactured Luck!!

Is this a fat Pitch?

2013-01-31T18:37:00.000+05:30

Buffet has been frequently quoted on his strategy of swinging hard at a fat pitch (a juicy full toss for us Indian cricket lovers) when the right opportunity presents itself. Likewise, we have been swinging hard at two recent open offers where we believe the odds to be quite favorable. Needless to say that this post needs to be seen in light of our vested interests.

The basics of open offer arbitrages have been covered in an excellent manner in Prof’s, Kiran’s and Neeraj’s blog. Over the past two weeks, the promoters of Orient Refractories (link) and Liberty Phosphates (Link) have cashed out of their businesses triggering an open offer for minority shareholders.

The broad specs of the opportunity are as follows:

	Orient Refractories	Liberty Phosphate
CMP - (A) - 30th Jan 2013	37.50	210.00

Offer Price - (B)	43.00	241.00
Gross Arb (%) - ( B/A-1 )	14.67	14.76

Acceptance Ratio (AR) %
Promotor holding - (C )	48.61	61.42
Public shareholding - (100 - C= D)	51.39	38.58
Offer for - (E)	26.00	26.00
Theoretical AR (E/D)	50.59	67.39
Manufactured luck AR %	70.00	80.00


Quantity returned out of 100 tendered shares	30.00	20.00
Effective cost price of returned shares (Rs.)	24.67	86.00

All above calculations are ignoring transaction costs and taxes

In other words, in the case of Orient, if one buys today at CMP and tenders 100 shares, we expect 70 to get accepted at a price of 43. Adjusted for the profit made on these 70 shares, the cost price for the residual 30 shares drops to Rs 24.67. Thus the trade will be in profit till one is able to sell the residual 30 shares at a price higher than Rs. 24.67. In other words, one can create shares in these companies at a substantial discount to current price.But is that good enough ? Lets see,

Orient Refractories at a adjusted cost of Rs 24.67, will be the Indian subsidiary of the world's largest refractories player ( RHI AG) available at a trailing 12 months PE of 7.8, PB of 3.1, Div.Yield of 4% and ROE of 40%.

Liberty Phosphate at an adjusted cost of Rs86, will be part of the Murugappa Group (largest market share in phosphor fertilizers) available at a trailing 12 months PE of 2.7, PB of 0.7, Div. Yield of 2.1% and ROE of 55%.

Juicy enough ? We think so !!!!

Quite obviously, these nos will vary depending upon the actual acceptance ratio which is the only variable. The Acceptance Ratio we have assumed is higher than the theoretical ratio explained above since we have observed that a large no. of retail/other shareholders do not tender shares in open offers, thereby improving the acceptance ratio for those who tender.

For the numerically oriented and scenario analysis lovers, here is how the deals stack up.

Return Profiles of the deal:

ORIENT REFRACTORIES
Exit Price for residual shares Rs	27	29	31	33	35	37
Absolute % Returns	1.9	3.5	5.1	6.7	8.3	9.9
Annualised % Returns
2 months	11.2	20.8	30.4	40.0	49.6	59.2
4 months	5.6	10.4	15.2	20.0	24.8	29.6
6 months	3.7	6.9	10.1	13.3	16.5	19.7

LIBERTY PHOSPHATE
Exit Price for residual shares Rs	100	120	140	160	180	200
Absolute % Returns	1.3	3.2	5.1	7.0	9.0	10.9
Annualised % Returns
2 months	8.0	19.4	30.9	42.3	53.7	65.1
4 months	4.0	9.7	15.4	21.1	26.9	32.6
6 months	2.7	6.5	10.3	14.1	17.9	21.7

Fields in the red is the range of our expected return

Invisible Fielders

For us, it’s been a while since we are dabbling in special situations and both opportunities look quite attractive. In most cases generally the gross spreads hover in the range of 8-10%. We have tried to use the “Invert, Invert, Invert – Always invert “ framework to try and figure out what’s on the minds of Mr. Market. Beware again that we could be biased since we have already sized up our positions!!

Deal Risk: Maybe people are speculating that the deal won’t go through and hence the spread reflects that. Our understanding based on annual reports/ cash flows and existing valuations don’t seem to suggest that they are sham (Khoka) companies. The profile of the acquirers (RHI AG – world leader in refractories and Murugappa Group – one of the largest South India based conglomerates) also gives us comfort as to the pre-deal due diligence and sufficient financial muscle to fund the acquisitions. Regulatory approvals could in our view, at best delay the offer rather than lead to the deal failure.
Time Risk: SEBI recently has a track record of clearing clean deals normally in the time frame of roughly two months. Clean deals here should be construed as one where acquiring promoters have a clean track record of public market activities and where there are no controversial embedded clauses. Other regulators (RBI, CCI, FIPB etc.) may take their own time but in the current context they don’t seem to be a road block apart from the usual RBI approval for repatriation of open offer proceeds to NRI investors.

In cricketing analogy, we think that even if the fielders get a hand to the ball they might not be able to stop it from crossing the ropes. Unless, we have missed noticing a fielder (risk) or two. Do let us know if you spot something not visible to us!!

Why is somebody selling it cheap??

The question still needs to be answered as to why sufficient volume is available at what we believe to be distorted prices. Here is our hypothesis.

Insiders/speculators generally buy into such counters at a rumor stage itself leading to a Pre deal run up in stock prices. Most of the liquidity after the announcement is provided by these people and we hear that most of the speculator community is on margin funding hence the need to liquidate ASAP, rather than wait for the 3 months of the open offer completion.

Our guesswork in both cases suggests that there is a large proportion of shares disclosed as public shareholding which seem to be either related to promoters or preferential issue to corporate bodies (loosely we prefer to call them as friends of promoters shareholders). The details of the shareholding are available in more than 1% categories on the exchanges. The shares have been acquired prior to one year at a fraction of the current cost and hence for these shareholders the gains would be significant. The taxability of the same can be very different for them depending on how they choose to sell their shares. They would be liable for a zero long term capital gains tax (after paying STT) if sold in the market OR if they choose to tender the shares in the open offer their incomes would be taxed at the normal marginal rates of taxation. Hence it makes tremendous sense for them in our view to sell the shares in the open market even if it means at a discount to the offer price. (In the case of Liberty Phosphate the bulk deals disclosures show Blue Deebaj Chemicals LLC holding roughly 14% of equity having sold nearly a third of their holding at Rs214 while the offer is at Rs241)

We have always had great difficulty in looking into the future, with or without the help of glasses. This explains why we normally do not try to emulate Sehwag and rarely swing hard at the ball, but when we do we also pray hard J. Given our weight exposure to both the stocks, we can only pray for luck and seek any disconfirming evidence if any, from your feedback.

This time, we seek the best of manufactured luck!!!

Please mind the Gap

2013-01-05T11:44:00.002+05:30

First up a disclosure – This post is about a company whose business falls way outside our circle of competence (its more like a dot of competence J in our case). However, we are still inclined to stick our neck out because Mr. Market’s behavior (or rather the lack of it) has surprised us. Your views are sought to lend greater clarity to our thoughts.

Commanding Respect

Clariant Chemicals (CMP 635) is one of India’s leading specialty chemical companies and is the No.1 player in Pigments, Textile Chemicals, Leather Chemicals and Biocides for paints. Majority held (63.4%) by the global giant Clariant AG, the company in India employs more than 900 people across various facilities and generates roughly 1000 cr of topline. Clariant is widely respected in the Indian investor community for its transparent governance and a clean capital allocation record. The company has been extremely liberal in its dividend payout policy having distributed between 60-80% of its annual profits to shareholders in recent years. More details on Clariant can be found on their website

Let us first look at some broad financial metrics of the global listed entity and its Indian subsidiary. Global figures have been converted at 1 CHF = Rs. 60/-. Figures have been approximated for easier reading.

All figures Rs cr	Clariant AG	Clariant India
Sales CY 11	44000	1000
EBIDTA CY 11	4700	175
EBIDTA Margin	10.6%	17.5%
Net Debt	10000	(200)
MCap	22000	1700
EV	32000	1500
ROCE%	8-10%	25-30%
Mcap/Sales	0.5	1.7
EV/Sales	0.7	1.5
EV/EBIDTA	6.8	8.5

As is evident, the India business enjoys substantial premium valuations as compared to its parent. Reasons are not difficult to attribute. Higher growth outlook, better margins, absence of leverage and clean balance sheet, healthier ROCE and probably many more. So far, so good..

Interesting Developments

The reason for this post is the recent divestment at a global level of Clariant’s textile chemicals, paper specialties and emulsion business to a PE investor SK Capital (link). The details of the deal encompassing the whole R&D, applications, sales & marketing organization along with production plants and sites is as under.

All figures in Rs cr	Clariant Global
Divested Business Revenue CY12E	7200 cr (~15% of overall)
Divested Business EBIDTA CY12E	480 cr (~ 9% of averall)
EBIDTA Margin	6.7%
Sales Consideration	2750
Debt to be transferred	250
EV	3000
EV/Sales	0.4
EV/EBIDTA	6.3

At the outset, it is evident that the deal has been struck at valuations which are closer to the global parent valuations and are at a substantial discount to valuations of the Indian operations.

Also, these valuations are not out of line with transactions which have happened in the similar space in recent years.

Is the deal good for Clariant India’s minority shareholders??

Being part of a global divestment, the respective business, as well as the facilities of the India subsidiary are part of this deal. This is ofcourse subject to legal requirements like shareholder consent (which given the majority promoter holding is unlikely to be a major hurdle).

Firstly, what does Mr. Indian Market think about this deal?? While not rejoicing, markets seem to be largely unconcerned. The stock went up 4-5% in the intervening last week but is now back to levels similar to the those on the date of the announcement.

Infact, given that the deal has happened at substantial discount to India valuations, the fact that markets are not worried is surprising and could only mean one of the following in our view.

The divested businesses are an insignificant part of the India business, thus the market thinks that the transaction is irrelevant or
Divested businesses are a significant part, but the Mr. Market expects Clariant AG to pay top dollars to Clariant India in line with Indian valuations (at a substantial premium to deal valuations) and Clariant India in turn to reward shareholders handsomely as in the past

So, firstly are the divested businesses a significant part of the India business?? Unfortunately, we don’t know for sure. Clariant India has so far chosen not to put out basic information like revenue, profitability, capital characteristics of the divested business in the public domain. They must be having their reasons, but all we can say is that such lack of transparency in data which is critical and should normally be shared is not befitting the high standards of governance displayed by the company in the past.

What we do know however, is that the sold businesses are a subset of the Dyes and Speciality Chemicals segment with CY11 revenues of 577 cr (60% of India revenue) with an EBIT of 86 cr (57-58% of EBIT) and are produced at their plant in Roha.

Given the large size of the textile & paper industry in India, the companies leadership position in the textile & paper chemical industry and anecdotal evidence like the emphasis given in the AR to these businesses, we think that it is safe to believe that the divested businesses are a significant part of the overall business.

Our educated GUESS at this stage (if you have other views, pls do share) is that they should be contributing in the region of 300-400 cr (30-40% of overall) sales. Assuming 10% EBIT margin on a conservative side, this still gives us 30-40 cr of EBIT (20-25% of overall). If the above be conservatively true, then the attributable value should be roughly 350-400 cr for this business (average of 1.7x sales and 8x EBIT, assuming uniform capital characteristics for the business) as per current valuations.

Is Clariant AG likely to cough up this sum?? We remain unsure..Why??

The India piece is likely only about 5% of the global divested business. A sum of 350 cr is 12-13% of sales consideration. Would the global company be willing to value India at a substantial premium. Put differently, are they under any compulsion to keep in good humor the Indian market’s valuation judgement? If India business eats some extra food, who goes hungry??
The parent has high debt and one of the goals of the divestiture is to delever and improve profitability. Sending money to India to distribute amongst minority shareholders does not serve the purpose. One can argue that a hefty dividend in India will go back to the parent. But this will involve forex risk, time, process as well as dividend distribution tax. We consider this improbable.

Conversely, if India valuation be done in line with global valuations, then only 150-175 cr should be forthcoming, which could finally surprise markets negatively and lead to a base case collapse of 200-300 cr (higher/lower if revenue/profit contribution of divested business is higher/lower that assumed) in market capitalization. This does not take into consideration any accompanied pass through effects of the wearing off the good governance halo.

Ofcourse, all this assumes that markets efficiently priced Clariant India pre event correctly to begin with. Which by itself may be asking too much from Mr. Market J

On a broader note, the events have taught us about a risk which till date atleast we never considered while investing in MNC stocks ie possible implications of M&A activity on stocks with a large difference in parent and Indian subsidiary valuations…We are sure one can discover quite a few examples of wide gaps in valuation.

We are keenly watching the space, if only from an academic interest.

Best of manufactured Luck !!

A brush with (Brain) death

2012-12-31T12:55:00.001+05:30

This post talks about the role of “shit happens” in special situations

A bit late to write the post but none the less the learning for us has been mammoth. Fundoo Prof. talks about the concept of “Brain Dead” investors and their important role and contribution in enhancing our returns in special situations. An example for the uninitiated – people who do not tender their shares in open offers making the acceptance ratio favourable for those who tender.(more about it from here )

The Murugappa group had launched an open offer after the acquisition of Shanthi Gears. We had been accumulating the stock with a view to eventually tender them in the open offer.

As a conservative shareholder, I double-checked the details filled up in the Demat Account instruction slip. Like a good boy submitted the same one day prior to the last day for closure of the offer, got the acknowledgement from the bankers on a photocopy of the DP slip.

Life’s Unexpected Turns !!

Around 2.00 pm on the last day of the offer, I get a call from my depositary participant (DP) stating that there is a problem and most probably my request for tendering the shares will be rejected. Half way through with my lunch, I gather all the relevant documents and run to the office of the DP (4kms from my place) trying to decipher what has gone wrong. The tendering process is officially closing at 4.00 pm. The DP tells me that the request for the “off-market transfer”, for the transfer of shares from my account to the escrow account opened by the Registrar of the company, has not been executed by NSDL (the clearing house). Generally off-market transfers happen online, at a click of a button, so logically my request should have been cleared early morning itself. After discussing the problem with my DP I get to know that typically off-market transfers have to be either accepted or rejected by NSDL. The rejection was important since then I could have re-submitted my request.

They were kind enough to give me printouts of the said transactions, which stated that the reason for rejection on the NSDL clearing platform as-“Awaiting confirmation from counterparty”. A brief chat with my DP indicates that they can’t help me sort this problem, the only solution was to check with the Registrar to the Issue who was the receiving party for this share transfer.

I now rush to the office of the Registrar – Karvy (around 5kms from my DP’s office) around 2.45 pm with all the documents to figure out as to why the request was not accepted. At Karvy’s office the staff tells me there is no problem at their end and this being the last day for accepting forms I should not disturb them. After patiently trying to explain to them the issue I had, I was told that they had robust systems, being the largest Registrar in the country handling such offers and I shouldn't doubt their competencies. I had no luck explaining to the local staff but was fortunate to get the number of the concerned person at their head office in Hyderabad.

Now the problem gets a bit more interesting, atleast there is somebody willing to take the blame. At Karvy Hyderabad, the officer in charge of Shanthi Gears offer tells me that there was a technical glitch in the server early morning for a couple of minutes and being the last day, there have been a few hundred odd entries which were not accepted by the said escrow account of Karvy (Shanthi Gears had ~ 19000 investors as of September 2012!!). With some clarity of the exact problem, I seek their input in resolving the said issue. Karvy tells me to check with my DP and instruct them to re-fresh / resend the instructions. It is already 4.00 pm by then and I rush back to my DP’s office.

Ab isko dawa nahi, dua ki zaroorat hai..(Prayer is the only hope)

All my efforts to convince my DP for putting in a fresh transfer instruction are in vain, given that the system is already showing a zero balance in my account against Shanthi Gears. So the sum and substance of the story so far –

· My shares are out from account and hence zero balance

· DP can’t do anything about it since its out from his server as well but stuck at NSDL end

· NSDL says they can’t do anything since system is showing awaiting third party confirmation and the system protocol is to reject such “stuck trades” only at end of day around 8:00 pm

· Karvy, the Registrar, obviously have not got the shares stuck at NSDL server.

After a round of discussions with the head office of my DP, Karvy and NSDL the only solution that finally emerges around 5:30 pm is to go to the temple on the way home and pray for the best !!! I am well on my way to being declared “Brain Dead” by using Prof’s definition.

Like a typical Hindi movie, the ending is however happy after all the drama. I get an SMS from NSDL saying that my requests have been cleared around 07:30 pm and I breathe a sigh of relief!

Murphy and Taleb

Remember Murphy’s law? It says something like “Anything that can go wrong, will go wrong”. On careful reading it seems to restrict judgement only to risks which are largely known. Nassem Taleb’s theory of Black Swans however talks about risks which are largely unpredictable.

Earlier, while evaluating open offers/special situations our standard thought process stopped at the routine. Calculate the acceptance ratio, gross and net spread , time risk to the offer, opportunity cost of the trade, expected price of the share after the offer etc. etc… Honing these skills over a period may help reduce the risks as pointed out by Murphy. But what about Taleb. Issues like signature mismatches, wrongly filled application forms etc come to mind. Similarly, those executing trades on online platforms need to be aware of differing settlement cycles if they want to buy/sell on the cum/ex record date. But what about technical glitches like the one discussed above and other risks that we are simply not aware of??

We now we realize that even if we gain confidence over a period in judging some of the controllable factors, there could always be surprises, some of which will be totally and definitely out of our control. As and when you fall into one of these pits, the end result would be the same. Being branded a Brain Dead investor. And there would be no point in saying “It was not my fault”.

So where does one go from here?

Murphy is probably right but Naseem Taleb is surely right - It is extremely important to incorporate some probability for remote SHIT happening events in all investment operations.
An eye for operational detail is as important as an eye for analytical detail
One possible solution could be checklists. In case of open offers/similar tenders, play safe and submit all the documents atleast 3-4 days before the closure of the offer. If things go wrong there would be time to correct it.
Even if things look to be a sure shot deal position sizing should be done incorporating the risks of the unknown. For us, leverage is strictly avoidable

Best of manufactured luck!!!

Extraordinary Popular Delusions

2012-12-13T09:55:00.000+05:30

Last year the Atlas Copco delisting made us great returns!!

After receiving the postal ballot approval from shareholders, the company voluntarily increased the delisting offer to Rs 2250/- (approx 58% higher than the SEBI discovered floor price!!). Even after this announcement, the stock was available below Rs 2100 for a few days, probably reflecting the market’s fear of sufficient shares not being tendered during the reverse book building (RBB) process (For an understanding of the delisting process click here). Our thesis (read Representative Bias) was that the amount required to delist was ‘chicken feed’ for the globally mighty and rich promoters, hungry to capture the ‘India story’ all for themselves. We had also been reading and listening from analysts how the delisting regulations presented an opportunity to squeeze out a tough bargain from these promoters apparently stuck between a rock and a hard place (read bias created by recency/vividity). Also, our ‘khabar’ J was that the requisite quantity would come in. Excited (read endowment bias) with the ‘edge’ we had on the market, we concluded that it made sense to buy and tender.

The RBB itself was like a classis cricket match going down to the wire. On the last day the stock made an intra-day move of ~30% giving us a quick graduation in the concept of Return per unit of stress. As we had predicted, the requisite quantity came in, but at a substantially higher cut off price of Rs 2750/- Also, as expected the promoters accepted the price and delisted.

Uncork the bubbly!! We had made a neat pack. What’s more important, we had been right!! RIGHT ??

Well, heck NO!! As our thoughts took shape on the subject we realized that nothing could be further from the truth..

Do you Smoke??

The journey to our current line of thinking began soon after. To start with, we were intrigued that in spite of the promoters of Atlas Copco having accepted the discovered price of Rs. 2750/-, healthy volumes were being traded on the exchanges at a small discount.

Why did the market price not ramp up to 2750/-? What was in it for the buyers and the sellers? What was the risk in the trade?

We got our answer in Clause 21 (1) of the regulations, reproduced as under:

“Where, pursuant to acceptance of equity shares tendered in terms of these regulations, the equity shares are delisted, any remaining public shareholder holding such equity shares may tender his shares to the promoter upto a period of at least one year from the date of delisting and, in such a case, the promoter shall accept the shares tendered at the same final price at which the earlier acceptance of shares was made”

So essentially, the sellers were those who had not tendered any shares in the RBB. Unlike regular open offers, residual shareholders had the option of tendering their shares for one year at the same price ie 2750/- The discount was thus on account of the time risk to completion of delisting formalities and launch of continuing offer. A near bond in the form of equity!!

A check on time taken in previous delistings revealed that money should be in your account mostly within 2-3 months from that point on. The discount still provided approx 15% annualized returns based on conservative time taken estimates. (In subsequent delistings, we have sometimes seen 20-25% annualized returns on the table) We had discovered a Cigarbutt!!! We were ready to smoke J

To do or not to do?

Our experience of the entire process in Atlas Copco led us to introspect the next time a delisting opportunity came along. The question we asked ourselves is:

What advantage do I get by tendering in the Reverse Book Building process? Or put simply…Do I tender??

So lets look at the possible outcomes and judge our response accordingly

If the company accepts the delisting price, it is bound by law to offer exit at the same price to all investors, including those who have not tendered for 1 year after delisting. So there is no advantage in tendering.

If the company rejects the delisting or sufficient shares are not tendered, tendered shares would be returned in 10-15 days by which time it is likely that the price would have corrected substantially. Those who retained optionality by not tendering can choose to sell in the market without delay and thus are favorably placed against those who tender...Not tendering wins hands down

So essentially it is heads I lose, tails I don’t win. No prizes for guessing the correct answer to our question..DO NOT tender in any circumstance!!

Having come this far, we now ask ourselves the next obvious question.

In a world of rational investors why should anybody tender and thus expose oneself to only downside risk, with no compensating advantage in exchange? And therefore, how is any company expected to succeed at getting the minimum shares for a successful delisting under the current regulations??

Well, given that quite some delistings have happened in the past, obviously Homo Economicus or the rational man, does not exist. Traditional economists please take note. Choosing to tender is a good example of man accepting risk for no visible reward. And be under no misconception, by investors we do not mean only ‘retail’. Institutional investors are widely known to participate (we refrain from using the word ‘punt’ for the so called smart institutional investor J ) and TENDER in the RBB process. The behavioural scientists were right after all in disbelieving the existence of the rational man!!

However, what is most intriguing is that the premise of the delisting regulations thus seems to rest on the irrationality of the human race. Seems like behavioural science has a fan in SEBI !!

Sleeping with the enemy

While there is a large body of advise on strategies investors should adopt in playing this game (MNCs, low capital intensity, high on innovation, high moats, large global parentage with deep pockets etc.) we thought it opportune to first ‘sleep’ with the lonely enemy for a change i.e. chip in with some free unwanted advise for promoters considering delisting.

Why act with a gun on your head

June 2013 is a mirage. It is the deadline to regularize minimum shareholding and not the final opportunity to delist. Companies desirous of delisting would be better off initially bringing down their stake and subsequently launching an offer after the required regulatory cool off period at more favorable prices. No harm in remaining listed for 2-3 more years after being listed for 2-3 decades. Play on your own terms.

Why overspend just because you have deep pockets

An oft repeated argument is that large MNCs will be willing to pay an obnoxious premium since they have deep pockets. However, it is not necessary for a rich man to splurge irrationally. If the price is right, one should be prepared to buy. Similarly, if the price is right, one should be prepared to sell. Since delusional investors are giving an opportunity, why not unlock some gains for the time being. Who knows, the same gains might be sufficient for a subsequent delisting offer.

Go ahead and try if you still want to, you have nothing to lose!!

When it is heads I lose, tails I don’t win for the investor, it means it is heads I win, tails I don’t lose for you since you are on the other side of the trade. In spite of flawed regulations, if you still want to attempt delisting, go ahead and try. There is little to lose!! Its loaded in your favor. You can call it off if you want to at any stage and nobody will force you to accept the delisting price if you don’t want to.

Investors think that they have a gun on your head, but sadly they seem not to have loaded it…The bullets are with you!!

We feel no compulsion to dance just because the music is playing!! Luck is manufactured not only by fishing in a pond full of fish but also by choosing not to open your tiffin box under a tree full of crows. The delisting theme to us is nothing but a bubble waiting to be pricked. We are happier waiting for a last drag on cigarbutts thrown away by the dancers…

Best of manufactured luck!!

Licensed to Speculate!!

2012-10-30T17:59:00.001+05:30

This post talks about an untouchable sector, the institutional imperative and the art of speculation in long term investing (ironical isn't it!)

Notorious Cyclicality

Take a few moments to study and firm up your thoughts on the graph below.

Are there any noticeable patterns?? What do the extent of the swings tell you etc??

Done thinking?? Then read on…

The above graph [Data source: Directorate of Economics & Statistics, Department of Agriculture and Cooperation,link 4.23(a)] depicts the annual % change in area sown under sugarcane nationally for the period 1950-51 onwards. In a nutshell, it shows how fickle cropping behavior over the last many decades has led to the perception of the sugar sector being “notoriously” cyclical.

We culled out the following data from our thinking time on the graph

SY = Sugar Year ending 30^th September

Thus in the period SY51 to SY12 (62 years), there have been 22 instances/times (35% of 62) in which land under cane cropping has swung within a band of + or - 5% from the previous year and so on. Likewise data is provided for the last couple of decades to see if there is any perceptible change in trends in the near term v/s the longer term.

The first noticeable point is that, not much seems to have changed in last couple of decades as compared to longer period data. Cropping swings remain similarly fickle!!

The second point is that this is no bell curve!! Cropping swings of more than 10% are visible in around 3 out of 10 instances during both periods. Much too often and large for a staple food commodity.

If you count the number of up and down years, you would notice that the ratio of years showing positive change v/s negative change remains roughly the same in both the long period as well as the last 2 decades at ~ 3:2. Clearly, the cycle of boom and busts continues with pervasive repetitiveness.

Of course, change in land under cultivation is just the first variable for sugar production. Other factors which effect production cyclicality are

1) Yield per hectare: Can change based on climatic conditions, monsoons, cropping practices, quality seed usage etc. Yields have however largely been stable in the last couple of decades as can be seen from the same data link above, mostly fluctuating between +- 5% on a year to year.

2) Cane diversion to other sectors like gud & khandsari as well as fodder usage and

3) Recovery rates ie sugar content in cane, again largely climatic dependant

Other than production however, sugar prices also depend on government policies (probably the most regulated sector in the country), change in consumption (estimated at 22-23 MTPA in India, growing faster than global rate at ~ 3%), Global prices (domestic impact limited to prevelant export/import restrictions), Size of residual inventory etc. To understand the reasons behind sugar cyclicality and the extant regulations in detail you can access this.

Profitability of sugar millers in turn depends on govt policy including levy obligation, cane and sugar prices, byproduct regulation and prices and of course interest costs etc. Of course we are yet to discuss arcane issues like the impact of depreciation of the brazilian Real on sugar v/s ethanol profitability. All in all a sector with so many moving parts that it is easier to say “Why bother”!! No wonder then that “investors” have historically rarely bothered and left this sector for the “speculators”.

The wolf and the shepherd Boy

In the wolf and the shepherd boy, assume that you, a villager, regularly place a wager on the shepherd boy lying, in spite of the evidence to the contrary. It is likely that you would be a rich man by now. While it is true that you would finally lose your last wager, when the shepherd boy actually tells the truth and the wolf arrives, the net gains would still be high assuming that you bet the same amount each time without getting swayed due to your past winning streak.

Who is the shepherd boy in our story? On repeated cycle upturns (sugar tightness and thus healthy prices) industry captains have gone overboard heralding an end to the cyclicality, due to a “structural” inflection point (see page 11 of this). During downturns (high production and weak prices) like being seen currently, we see ministers talking about visible policy success at breaking the cyclicality (here). Since it is a matter of judgment/view, one cannot say the “shepherd boys” are lying, but simple plain wrong. The “notorious” cyclicality continues to prevail with uncanny regularity. Like in the above story, one can thus make a wager on the wolf not turning up, read continued cyclicality, and simply wait patiently to get lucky.

While in the absence of long dated derivatives, it might not be possible to “short” the sector during cycle upturns, it is surely possible to buy at times of relative pain and wait patiently for the “mean reversion” to happen. The strategy is thus to buy sugar stocks when the industry is bleeding due to oversupply expecting the cycle to reverse and provide reasonable return.

Isn’t this true for all commodities in general?? Of course it is, but the catch is the length and the relative predictability of the cycle. Cycles in metals, oil etc. can be sometimes spread over extremely long periods, even decades, largely linked to global/local economic cycles and hence difficult to wager on. Due to the shorter cropping cycle (generally every 2 years, the farmer can decide whether to plant cane or move to a more remunerative crop) and stable consumption being a food commodity, the “black swans” are more likely to be spotted in the sugar sector.

So if you bought at periods of cyclical pain, without trying to judge if the worst is behind (not so difficult to judge) and sold at times of greed, as against successfully catching the frenzy (again not impossible to judge), it could be a rewarding strategy based on past trends of cycle completion over a 3-5 year holding period. Rather than getting swayed by the daily noise of the markets and confused by the various moving parts of the sector, the one single view that needs to go right, is that of mean reversion. Since Mr. Market generally ends up placing a wager on the shepherd boy, returns could be handsome even with a favorable risk reward.

Sweet Pudding

While the above is instinctively appealing, lets find out if the pudding has been sweet in the available stock price history of the past decade or so.

Sugar production at ~ 20 MT peaked in SY03 in the first of the cycles under consideration. Thereafter, production bottomed out at ~ 12.7 MT in SY05 (Note the extent of the production swing!!). If you had done a daily SIP in Balrampur Chini in the period 1^st Oct 01 to 30^th Sep 03 (period of high production) and spread your sale daily in equal proportion in the period 1^st Oct 03 to 30^th Sep 05 (period of production drop), you would have returned roughly 4.5 times your initial investment. Surely in these two phases, it did not take a rocket scientist to judge if the sector was going through pain or gain. For the record, a similar strategy in the sensex would also have returned 1.8 times your investment in the same period. If you had been a bit more opportunistic, the results could obviously have been even more spectacular.

The next cycle peak was in SY07 while SY08 while lower, was also healthy. Production however fell nearly 50% to ~ 14 MT in SY09. Buying Balrampur at most times in SY07 (period of maximum pessimism towards the sector) would have allowed you to sell at most times in SY09 returning between 2-3 times your investment inspite of the financial crisis in the intervening period.

Since there is significant hindsight bias here, we urge you not to use this data as any meaningful indication of return expectation. What you can do however, is simply ask yourself the question “Based on last 6 decades data, what in my view is the probability that

India

will see a sugar scare anytime within the next 5 years”. If the answer that your mind throws up is north of 60-70%, then maybe you should have a look at the sector. Because remember that even if money doubles at the end of 5 years, it translates into a CAGR of 15%, a return that most genuine ‘investors’ should be happy with. What with current production (25-26 MTPA) only about 10% higher than consumption (22-23 MTPA) and with 3 out of every 10 years throwing up cropping swings higher than 10%, you probably would not have to wait that long. The attractive risk reward inherent in the trade means that we may have the opportunity to manufacture our luck relatively safely here!! No wonder it is sometimes said that the best place to hide evidence is in plain sight.

Whoa!! But aren't we missing something ?? Look at Mutual Fund portfolios. You hardly see any exposure to sugar stocks. Aren't the institutional chaps amongst the smartest in the street. If it was truly so, why don't we see a fairer representation in their portfolios?? In our view, its thanks to the institutional imperative...

If your are a fund manager and even if you are aware that once in 3-5 years there is more than an even chance of making multi-bagger returns over a complete sugar cycle, would you be able to allocate a part of your portfolio to such ideas?? Immediately the spectre of looking like a buffoon while the stock doesn't move for months/years together and leads to huge diversion as against the benchmark starts haunting you.. So when will you look at allocating to the sugar sector ? Taking the liberty of putting on paper some experiences of the institutional investing world, in our view they will participate only when:

There is certainty of improvement in sector fundamentals in next 1-2 quarters accompanied by rising commodity prices
If in their view, there is minimal chance of making losses, even if they are temporary in nature
There is some news / buzz about the sector or reforms etc.
Peers in other fund houses start buying the stock
There are rumours about an acquisition in the sector and you expect a rub-off valuation effect

A three legged stool

Where do we stand in the cycle today?? As mentioned earlier, we do not need the services of a rocket scientist to answer that question with some confidence. While we do not know for certain if the worst is behind us, we do not see any reason to disbelieve that we are in a downcycle (high production, low prices). Sugar mills are raking up losses and shepherd boys are optimistic about breaking the notorious cycle on the back of 4 successive years (including SY13 forecast) of healthy production and potential sector deregulation. We are willing to bet that the wolves won’t turn up.

Are there any interesting opportunities??

A UP based miller, Triveni Engineering is the 4^th largest sugar manufacturer in the country. Other than sugar the company derives revenues from the sale of power and alcohol which are sugar by products. The company also has a healthy engineering business in the areas of gear manufacturing and water. Last year, the company demerged its turbine business, Triveni Turbine from itself and continues to hold ~22% in the listed entity. More details can be found on their website .

Market participants usually value sugar stocks on the basis of a combination of P/B and P/E or EV/EBIDTA ratios. The larger companies like Balrampur have normally traded in the band of 1-1.5 times book, 8-10 times PE and roughly 6-8 times EV/EBIDTA. In the case of diversified entities like Triveni, SOTP valuations are also frequently used.

At the current mcap of ~ 550 cr and long term debt of ~ 500 cr Triveni is available at a standalone SY12E P/B of ~ 0.6 and EV/EBIDTA of ~ 6.(P/E not measurable since company is loss making). Operational cash flows are to the tune of ~ 100 cr inspite of the losses. Based on the current Mcap of Triveni Turbine, the company’s 22% stake (without holding company discount) translates to ~ 300 cr.

In comparison, Balrampur Chini (the sector bluechip) with a Market Cap of 1750 and long term debt of 750 cr trades at an FY13 P/B of ~ 1.2 and EV/EBIDTA of ~ 6. While crushing capacity for Balrampur is only ~15% higher than that of Triveni, it must be said that the company enjoys better cane availability and recoveries and thus produces roughly 40% more sugar. It is also better integrated towards alcohol and power production. However, its stool does not have other legs like Triveni of gears, water and investment in turbine business.

People also like to give a management quality premium to Balrampur. When looking at Triveni, we have not noticed any significant red flags when we considered management ethics. As regards competence, we think that well regulated commodity businesses like sugar leave little room for a fresh creative approach and thus like to discount the same.

Other companies like Shree Renuka & Bajaj Hindustan are less preferred on account of the very high leverage.

Triveni thus looks relatively interestingly cheap on the basis of P/B (more important than earnings based valuations in a down cycle) and market cap in relation to its production capacity. The market also seems to be ignoring its diversity in business as well as investments in Triveni Turbine.

However, in addition we would prefer to look at the company less conventionally. Since we are betting on a sugar scare, is it possible to judge how markets could react towards the stock in a favorable year?

The Engineering business EBIT (roughly 60-70 cr on a normalized basis) and the EBIT of the by products viz power and distillery (again roughly 60-70 cr) are together largely sufficient (with a margin) to cater to the total interest costs of ~ 125 cr. Thus the EBIT profit/loss of the pure sugar business (currently producing ~ 0.5 MT) flows through to the PBT level. In a year of sugar scare, it is not unfair to expect that millers will be able to eke out a profit atleast of Rs. 3-4 Rs per kg at an EBIT level. This could easily result in a PBT of 150-200 cr for the company (0.5MT * 3/4 Rs). With Mr. Markets penchant to repeat its mistakes, it would not surprise us if the company be valued at PE multiples of 8-10 times in these environments or a market cap of 1000-1500 cr. The stake in Triveni Turbine is ofcourse icing on the cake. We think holding the stock can prove to be lucky in the future !!

Investors may consider the sacrilege of speculation!!!

Best of manufactured luck !!

Hic...Hic..Hurray !!!

2012-10-18T15:59:00.000+05:30

This post elaborates a probabilistic thinking framework we used to evaluate an idea. Worked well in the end, but with dollops of luck!

Circa March 2012

The December quarter results of United Spirits (UNSP : Price was Rs 575) were a disaster. Volume growth YoY was less than 1% (historically in the region of 10-15%). What’s more, standalone EBIDTA of ~ 200cr was at a margin of 10.2%, significantly lower than the high teens that the company had normally demonstrated.

Shareholders, already grumpy that they were not getting free tickets in Kingfisher Airlines (another UB group company) inspite of having funded the failing airline indirectly were unimpressed. Debt at nearly 8000 cr meant that operations at these levels were barely sufficient to bear the interest burden, leave alone any meaningful profit for the equity holders. Soon the stock was punished to ~ 500 Rs. translating to a Mcap of ~ 6500 cr and an EV of ~ 14000 cr, a fraction of historical valuations.

The Indian alcoholic beverage market as a whole has grown around 16-17% volumes in the last decade. It is estimated that the rising middle class in India will make it the largest alcoholic beverage market in the world in the coming couple of decades. There are large barriers to entry given that liquor is a state subject and a single business group (Also a Member of Parliament) controls more than 50% market share of this lucrative market.

Positively inclined towards the Indian alcobev story at the margin, we decided to evaluate if the price fall provided an attractive entry opportunity. Our thinking moved along the following lines.

Earnings based valuations: Given the business dynamics, one offs are fairly commonplace for UNSP. We however did not feel that ~ 10% margins could be considered to be the new normal based on last quarters performance alone. We were happy working with a base case of quarterly standalone EBIDTA of 250 cr and consol EBIDTA of 300 cr. Thus the market was valuing the stock at an EV of ~ 10-11x on (our) stressed case EBIDTA [14000/(300*4)]. Reasonably attractive for a past darling (Historical valuations of 15x EV/EBIDTA).

Imagine that you are the CEO of a top 5 global alcoholic beverage company. Given that developed markets are hardly growing, does it makes sense for you to look at this opportunity given by Mr. Market? Does it make you really salivate if also know that the promoter holding is only ~27-28% (chance of a hostile bid)?

We thought there to be a potential for rerating. Surely a plump Aishwarya Rai still has suitors.

Asset Based valuations: As is widely reported in the press, UNSP has multiple levers available for deleveraging its debt of ~ 8000 cr. A) Treasury stock of 7-8%, b) 3.2% stake in United Breweries (market value ~ 500cr) c) IPL team Royal Challengers Bangalore (we put a value of Rs 1000 cr with many ifs and buts..) and d) above all, the reason why the bulk of the debt is there in the first place, Whyte & Mackay, a subsidiary acquired in 2007 for a billion dollars for its scotch inventory (More expensive in theory today as aged alcohol is more precious). When push came to shove, we were hopeful that all this family silver would come in handy.

UNSP to us thus looked interestingly cheap on conventional valuation parameters as compared to its own past. The deafening roar of Kingfisher Airline had of course still not been silenced. Our evaluation of the external factors led to the following decision tree. For the record the UB group & Vijay Mallya own ~ 28% of UNSP, nearly all of which is pledged against the group debt obligations including Kingfisher Airlines.

A brief explanation of the reasons behind some of the probabilistic assumptions are in order.

Option1 is self explanatory. We did not believe that KFA had the ability to attract external capital.

However, what was the reason for us assigning a low probability on option 2 ?? Isnt the media , market and financiers banking primarily on that outcome??

Imagine your house is on fire. It is likely that your first reaction would be not to care for your own safety and try and retrieve your property. However, there comes a point when you overcome the bias of commitment and realize that further efforts will only endanger your life. What is it that you are likely to do?? Cut your losses and probably run for your life !!

The question to ask is at what point Mr. Mallya in his efforts to douse the fire at Kingfisher Airlines and has he managed cross the hump on his bias of commitment. We thought he had and thus in our view it was unlikely that the UB group would inject further capital into a failed venture. Sale of stake in UNSP and other group entities would only result in bankers queuing up for the sale proceeds. The net result would be Mr Mallya losing control of his prized liquor business and be an owner of a bankrupt airline in exchange. We were unable to figure out, why he would wish to do that. What’s in it for him?? Contrary to market opinion, we were happy assigning a low probability to this event.

Option 3 is simply the balancing event/figure. In our view it was the most probable event. As can be seen in the decision tree however, contrary to market opinion, this was not necessarily a bad thing for UNSP. Suitors like Diageo had long been wooing the company. Any sale of stock and change of control was surely going to whet their appetite. Bankers would be stupid to fire sell UNSP pledges in such an environment though you couldn’t rule it out entirely. We thus assigned a low probability to the event. An auction for the highest bidder would have been a very bullish scenario leading to an open offer, probably at a rich price. Interestingly, even though we felt option 2 was unlikely, the result would still be favorable leading to a similar open offer.

Inspite of the nearly heads I win, tails you lose scenario, why was Mr. Market succumbing to its sentiment? Were we missing something??

We thought the following biases largely responsible for this extreme mood swing.

Representativeness: The promoter is also associated with an airline which is likely to go belly up.

Vividness & Recency: The media is flush with news flow about bankruptcy, invocation of pledge shares, sale of personal assets by the bankers. What if the bankers decide to sell the pledged promoter stake in the market? (Think of the multiple small and midcap companies falling more than 50-60% in a matter of 3 days when a single financing company decided to pull the plug)

Recency Again: The last quarter results are showing signing of slowdown and cost pressure along with rising interest burden for this spirited company. For a good long period of 7-8 years, the company had enjoyed higher than market multiple simply valuing it as a growth stock.

We were satisfied on most counts of business, valuations and external factors specific to UNSP. It was time to buy!!!

Circa October 2012 – Cut to the present

UNSP trades at Rs 1200 and beyond. Rumors are rife Mr Mallya is on the verge of ceding control of UNSP to Diageo. Option 2 is a done deal as per the market.

Where do we stand now?? First the valuations.

Two more quarters have gone by. The march quarter saw no improvement in EBIDTA margins as compared to December. However, June saw a sharp reversal with standalone EBIDTA jumping to 350 cr (16.9%). Coupled with the potential M&A news Mr. Market is on a high. At an EV of Rs. 25000 cr UNSP is trading at 15.5 times last quarter annualized EBIDTA and ~ 21 times our stressed case annual EBIDTA of Rs .1200 cr. Not much room for error. As regarding asset based valuations, nothing much has changed. UNSP continues to have the same deleveraging options.

What about KFA dependant decision tree. That also does not change, but obviously there is room to tinker around with the probabilities with the knowledge that the passage of time provides.

Probability of Option 1 reduces further. Inspite of FDI in aviation, we are happy to all but rule out the interest of outsiders in this now “locked out” airline.

But surely, the probability of option 2 increases?? The newspapers are full of the smell of smoke from the supposed fire that is brewing on deal street between UNSP and Diageo. Stake sale and UB exit should lead to an open offer??

But isn’t there something wrong?? Have we found out the answer to our earlier raised question? What’s in it for him?? We don’t think so.

On further thought we introduce Option 4 in our decision tree. Something we had admittedly missed out earlier.

The deal if at all any, would be made purely to delever the UNSP balance sheet and not have any meaningful bearing on KFA. Options available could be sale of treasury stock and/or dilution of equity. Little money could also flow to the UB group through a small sale of equity stake which might be used for a symbolic token recapitalization of the airline, thus paving the way for restructuring of debt and who knows even some more short term debt funding. The PSU banks would thus end up holding not only the can but also putting in some additional money into it.

Lack of support from an open offer, disappointed investors due to no change in management control and extremely ripe valuations make for a richly valued stock indeed. We have sold into the party and will change our view when we figure out..Whats in it for him??

Now where is the skill and how we turned out to be lucky with nearly 100% in less than six months?

In our opinion, the skill was clearly in staying away from newsflow, evaluating the underlying business on a realistic base case and keeping emotions at bay. The post elaborates on the probabilistic framework used to evaluate the idea and arrive at a decision. We were hopeful of around 40-50% return over a 6-9 months framework once the dust settled and people starting focusing back on the alcobev business. The luck part of the trade was Diageo deal newsflow, opening up of FDI aviation and many more reasons (we can now think of with the benefit of hindsight) that led to doubling up of our expected return.

Best of Manufactured Luck!!

An Introduction

2012-10-16T15:02:00.001+05:30

Welcome,

A joint effort of Abhinav Mansinghka and Niren Parekh this blog will focus on thoughts & investment opportunities in the Indian equity market. “Manufactured Luck” as the name suggests is the basis of our investment philosophy.

Asked whether he would prefer courageous generals or brilliant generals in his army, Napolean replied; "I would rather have lucky generals"

God be with those who do not think that luck has a large role to play with investment success. While all of us like to be lucky especially so with investments, we believe that there is a process, which employed diligently can increase the odds of getting lucky over the longer term. A river with lots of fish might be your best chance at fishing success as compared to the pond at which some bloke got lucky yesterday.

Some pointers to our thought process: (we’ll keep exploring details of the same via posts later on)

Rather than trying to be great value investors we aspire to be professional opportunists (as Sam Zell said). We try to go where there is a money making opportunity with minimal downside risk.
We use multiple frameworks including Graham’s statistical cheapness, Buffett’s economic moat oriented businesses, Phil Fischer’s scuttlebutt approach, Munger’s multi-disciplinary approach etc. etc.
We are not obsessed about finding the next super multi-bagger, virgin stocks which no one has tracked till date, micro cap or small cap ideas. Rather we think liquidity serves as a good risk mitigation tool against your mistakes of evaluating ideas.
We strongly believe in “Shit Happens” and hence believe in diversification for building a portfolio.

Why this blog?

Having some experience in both the buy and the sell side, we think the most abused word in the equity markets is “Maine bola tha” (i.e. I told u so). To guard ourselves from this hindsight bias, we think the simplest solution is to documents your thoughts at a particular point in time. This blog is mainly to serve as an aide memoir to us for improving our thinking process over a period of time.
There will be no TIPS here. We have no expertise and can’t guarantee magic in the art of making money and hence the ideas discussed in this blog should not be taken as an investment advice. It is your own hard earned money and hence only you should be responsible for all decisions regarding it. It can be safely assumed that we have a vested interest in the ideas we have discussed on the blog.
Lastly and most importantly, we seek counter arguments, constructive criticisms and different perspectives on our ideas and thoughts. As Daniel Kahnemann , puts it seeking “disconfirming evidence”. We thank you in advance for letting us know your views.

Who are we?

Abhinav has spent more than a decade in various functions in the Indian mutual fund industry. He now works as an independent equity analyst and advisor and is also an avid corporate trainer.

Email: mansinghka.abhinav@gmail.com

Niren is a Chartered Accountant by profession and a PGDBM from MDI, Gurgaon. Had the fortune of studying under Prof. Sanjay Bakshi and working with Mr. Raamdeo Agarwal. The last engagement was with the investments team of an AMC. Currently managing own funds, he aspires to known as one of the greatest common sense investors.

Email: nirenparekh@gmail.com