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Sunday, February 18, 2007

Anagram Equity & Commodity Weekly

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Edelweiss Market Scan (EMS) - 16th February 2007

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Next Stop Iran

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FIIs, economy and the common man

We have been reading about the large investments being pumped into the stock market by foreign institutional investors (FIIs). The current levels are unprecedented. But what is the larger picture? Is the impact of the FIIs limited only to the stock market or do the institutions have a larger role in the economy? To be more specific, how do FII flows affect the common man?

Taking a closer look at the funds flow, FIIs bring dollars to India which get converted into rupees in the inter-bank foreign exchange market. As the supply of dollars increase, the law of demand-supply starts operating and the rupee appreciates vis-à-vis the dollar.

Appreciation of the rupee

So, other things remaining constant, higher FII flows would help the rupee to appreciate. This allows Indian consumers to import goods (which are priced in dollars) at a cheaper price. However, an appreciating currency also makes our exports uncompetitive in the global markets. As India is a developing economy, it would be beneficial to have a weaker currency, improve exports and, thereby, generate higher domestic activity.

Higher forex reserves

Under normal circumstances, the Reserve Bank of India (RBI), would try to stem the the volatility of the rupee by buying dollars and selling rupees. The excess dollars bought by the RBI would accrue to the foreign exchange reserves. For an emerging economy such as India a higher level of forex reserves affords financial and economic stability and reduces the vagaries of global capital flows.

So, higher foreign (dollar) inflows into India usually translate into more rupee liquidity in the system. This increases the money supply and facilitates easy availability of credit (loans) from banks (thus the frequent calls from telemarketers, offering all kinds of loans).

Invest and capture gains

Thus, we can conclude that higher FII flows also aid in lowering the cost of borrowings. On the flip side, as liquidity is high and banks become keen to lend money than accept it, the rates paid on deposits and bonds would decline. An investment strategy in such a situation is to invest in bond mutual funds and capture the capital gains on the bond portfolio arising from lower interest rates.

The easy availability of credit and the lower borrowing costs increase consumption demand for housing, durables, cars and real-estate. This higher demand often leads to greater public and corporate investments, resulting in higher economic growth. This, in turn, raises the prosperity level and the general standard of living. More jobs are created and wages also rise. Taxes are also lower.

However, as the amount of money in the system grows rapidly, the goods and services available may not grow at the same rate, leading to inflationary pressures (higher prices for goods and services) and reducing the purchasing power of consumers. Such inflationary pressures can push the central banks to hike interest rates.

Creating wealth

From a different perspective, if the FII flows are high (relative to the country's stock market capitalisation), the demand-supply equation comes into play once again and the market tends to rise rapidly, creating more wealth for the investor. This positive wealth effect also often leads to higher consumption and greater demand for other asset classes such as gold, real-estate etc., which, in turn, fuels economic growth and inflation. Higher FII flows can, thus, be seen to help create wealth through higher asset prices.

In case there is a sharp reversal of flows — the funds start flowing out — the conditions mentioned earlier would be overturned. Strong outflows would result in higher interest rates, lower demand and consumption, lower forex reserves, a weaker rupee and falling asset prices.

India's success story

Thus, FII flows do have a great impact even on the common man. The large inflows are often cited by politicians and media as proof that India is a success story and that global investors are flocking in their hordes. It should be kept in mind that the so-called `global investor' can be very fickle. He goes where he perceives profits. If the tide turns, he would be the first to flee with the profits.

A sharp reversal of fund flows could result in economic and financial instability. India was relatively immune to the Asian crisis in the mid-1990s as its integration into the global financial market was not so strong. It may not be so lucky the next time around. India also needs to focus on long-term flows in the form of foreign direct investment to sustain the economic reform process.

What Vodafone will collect from the Hutch call

Vodafone Plc, the world's largest mobile operator, has landed a prize catch in Hutchison Essar, marking the British telecom major's full-fledged foray into the Indian mobile market. In a bidding war that lasted over two months, Vodafone clinched the deal (subject to formalities), pipping Reliance Communications and the Hindujas at the post. At an equity value of $11.1 billion for a 67 per cent equity stake (implied enterprise value of $18.8 billion), Vodafone will be paying a steep control premium.

Clearly, for Vodafone, the control premium is linked to entry into the "largest growth market in which we can acquire control" and 67 per cent will give the company a controlling stake in Hutchison Essar. As Mr Arun Sarin, CEO of Vodafone Plc, said at a press conference immediately after the deal: "It is fundamentally at the heart of our emerging market strategy of extracting growth. India is only 13 per cent penetrated, China is 40 per cent penetrated and Europe is 100 per cent."

Strategic intent

For the world's largest mobile service provider, the rationale for this deal springs from:

Emerging market focus: Vodafone has lacked a cohesive emerging market strategy, especially in India, the fastest growing mobile market. Considering that the monthly mobile subscriber addition in India, at over 6 million, overtook China's in September 2006 and is likely to stay that way for the next few years, there was no choice for Vodafone but to place India as the centre-piece of its emerging market strategy.

In outlining Vodafone's strategic priorities in May 2006, Mr Sarin had highlighted that it would pursue "selective opportunities to extend footprint" in the emerging markets. Following up on this strategy, Vodafone has snapped up Hutchison Essar, which opens the gateway into the Indian market. Fourth largest player: The acquisition of Hutchison Essar will make Vodafone the fourth largest operator in the Indian mobile sweepstakes. Since mobile penetration in India, at 13 per cent , is likely to exceed 50 per cent (at 500 million subscribers) by 2012, the sector is probably at the starting block of a serious battle for mobile market share.

Hutchison Essar's subscriber base, at 24 million, is only 1.5-2 million lower than the state-owned Bharat Sanchar Nigam (BSNL) and 7-9 million lower than Bharti Airtel and Reliance Communications. Considering the four-fold rise in market opportunity and 6-7 million subscribers expected to be added every month, the competition, which will ride on scale economies and innovative value-added services, will be keenly watched.

Bharti Airtel, in which Vodafone had acquired a 10 per cent effective equity stake in late 2005, did not meet its objective. SingTel, which is Bharti's existing and dominant foreign partner, with over 30 per cent equity stake, has remained firmly in the saddle, with no intention of selling out. For that matter, it recently stated that it is willing to buy what Vodafone will have to offload in Bharti if it succeeded in buying Hutchison Essar.

Aggressive deal dynamics

Considering that Hutchison Essar was the only asset available for acquisition, the price tag and valuation attached to this deal are stiff, with a sizeable control premium. Taking three commonly employed valuation yardsticks to compare the Vodafone-Hutch Essar deal with its key mobile peers, Bharti and Reliance Communications, reveals the following:

EV/Subscriber: On an enterprise value (market capitalisation plus debt) per subscriber basis, the Hutch-Essar deal is at a 15-20 per cent premium to its peers, Bharti and Reliance. For instance, based on Hutch Essar's implied enterprise value of Rs 85,000 crore, applied on a mobile subscriber base of 23.3 million as of December 31, 2006, the EV/subscriber works out to Rs 36,300 vis-à-vis Rs 31,800 for Bharti's mobile segment. EV/subscriber is a popular metric for valuation in high growth markets as it reflects the potential for cash-flows.

EV/EBITDA: From an EV/EBITDA (earnings before interest, depreciation, tax and amortisation) standpoint too, the deal works out to a premium of 25-35 per cent to Bharti and Reliance. Compared to the EV/EBITDA of Bharti's mobile business, at 21 times, Hutch Essar's works out to 28 times. This metric reflects the operational cash flows that can be reinvested for growth.

EV/ Revenues: Based on this metric too, the Hutch-Essar deal works out to a 20-30 per cent premium over its peers.

Why control premium?

Vodafone's willingness to pay the control premium stems from some key advantages that it perceives from this deal. It is encouraging to note that the deal meets the investment criteria set by Vodafone in the interest of its shareholders.

The two criteria Vodafone provided are ROIC (return on invested capital) to exceed local adjusted cost of capital within three to five years and IRR (internal rate of return) to exceed cost of capital by 200 basis points. This acquisition meets the Vodafone ROIC criteria only in the fifth year and the IRR is expected to be 14 per cent.

The key elements of the deal that are likely to play to its strengths are:

Infrastructure sharing with Bharti: Concurrent with the Hutchison Essar deal, Vodafone has entered into a memorandum of understanding for infrastructure sharing with Bharti Airtel. This will include sharing towers, shelter, civil works and back-haul transmission. And Vodafone expects savings in capital expenditure and operating expenditure (opex) for Hutch Essar to the tune of $1 billion over the next five years; the opex savings are likely to improve the EBITDA margin by 1.5 per cent.

These are the tangible savings this MOU can extract on an ongoing basis. Essars, however, are threatening to play spoilsport, having indicated their unhappiness at not being consulted on this issue. How this relationship with the Essar group plays out will have to be watched closely.

Value-added services: In terms of value-add, Vodafone can plug Hutch Essar into its global procurement chain, especially in the area of ultra-low-cost handsets. Moreover, as the world's largest mobile service provider, with 200 million subscribers, Vodafone can contribute significantly to Hutch Essar's economies of scale in procurement or operations.

As Hutch Essar commences operations in six new licensed circles (through Spacetel) in 2007, efficiencies in network build-outs, low-cost handsets and bundled packages can play a key role in new subscriber additions. In saturated markets such as the metros, it can launch its popular Vodafone Live! services, which give value added access to entertainment, sports and pictures.

3G foray: Since the telecom regulator is likely to announce the policy for 3G (third generation mobile telephony) in India, Vodafone's 3G experience in Europe will come in handy for growth initiatives. This is expected to help Hutch Essar get a competitive advantage in the 3G market place. Though the benefits from these variables cannot be quantified now, they are likely to pay off in a big way in the long run.

After the dust settles...

Reliance: Disappointing outcome but story intact

Reliance Communications losing the bidding war for Hutchison Essar to Vodafone may be a short-term negative for the Reliance stock. Since the stock had not run up significantly in the homestretch to the deal, the downside risks may be limited. However, concerns arise on two fronts. One, from slower-than-expected grant of scarce frequency spectrum for execution of Reliance's GSM technology strategy (as opposed to its existing CDMA strategy), which it had articulated last year. Two, any slowdown in subscriber additions as Reliance changes its technology course may dampen market sentiment.

We recommend that investors consider taking an exposure in the Reliance Communications stock on weakness as the multi-year mobile expansion story remains intact and Reliance will remain a strong participant in it.

Reliance Communications will be disappointed with the Hutchison Essar outcome as, among the bidders, the company stood to gain the most from the acquisition. This would have fulfilled its aspirations of switching to GSM in a single stroke, with hardly any overlapping circles. Second, as an Indian company, Reliance Communications could have enjoyed the flexibility of buying out 100 per cent equity in Hutchison Essar, unlike Vodafone, which has to restrict its exposure to 74 per cent, under the FDI guidelines. Finally, the acquisition could have helped Reliance march past Bharti to garner a dominant market share.

Bharti Airtel: Focussed on ring-fencing its stake

Bharti Airtel's market share leadership remains intact, with Vodafone winning the Hutchison Essar bid. We recommend investors retain their holdings in the Bharti stock and use any price weakness linked to the broad market to build up fresh exposures.

With Reliance Communications involved in the build-out of its GSM strategy, BSNL struggling to resolve its mega GSM tender and Vodafone-Hutch caught in the integration process, Bharti will be well placed to strengthen its subscriber additions and extend its market share lead in the near term, before intense competitive picks up again.

Bharti has also extricated itself smoothly from a slightly sticky shareholding situation. Vodafone, which held a 10 per cent equity stake in Bharti Airtel, has granted a Bharti group company the option to buy 5.6 per cent equity at Rs 686 per share for $1.6 billion. The remaining 4.4 per cent will be retained by Vodafone, as an ongoing relationship with Bharti. The Bharti management's ability to enter into an infrastructure-sharing relationship with Vodafone may be a positive for the stock in the long run, as the telecom regulator is reviewing the need to share active network infrastructure.

Numeric Power Systems: Buy

Investors willing to consider small-cap stocks can think about the stock of Numeric Power Systems, a maker of uninterrupted power systems (UPS).

The steady financials, the improving margins, and the growth potential in the Indian and foreign markets add visibility to the earnings growth of Numeric Power. Further, it is also a unique listed play in the electronic power equipment segemnt.

At the current market price, the stock trades at seven times its likely earnings for FY-07 on a consolidated basis. Being in the small-cap segment, with a market capitalisation of about Rs 165 crore and relatively low trading volumes, the stock may be subject to volatility. This makes it suitable for investors with a high-risk appetite and a long-term perspective.

Numeric makes power protection products such as UPS used for computer or network protection and process automation.

The company has a wide range of products catering to IT and IT-enabled services, medical applications, financial and insurance sectors, small and medium enterprises, and homes.

Steady business

With more and more businesses (including telecom and critical care medical instruments) running on technology solutions, the need for power protection systems for reliability and quality has become vital. Given India's significant power deficits and the ubiquitous outages and voltage fluctuations, Numeric Power's products have significant market potential in the country. The IT and business process outsourcing boom in the country has further propelled the demand for such products.

The company has a dominant position in this segment and has clients such as Intel, Infosys and Veritas. Its ability to offer remote monitoring through customer IT networks and Web-enabled solutions has not only helped capture overseas market but has also facilitated cost-control through efficient servicing.

Further, Numeric Power Systems has about 156 sales and service offices across India to cater to various regions. Income from service, which stood at about 11 per cent of total revenue in FY-2006, can be expected to increase given the geographic reach that the company has. This is also likely to lead to repeat orders.

While Numeric's brand image may help draw clients in the corporate sector, it may not be easy for the company to fully tap the small enterprises and home needs. This space is dominated by the unorganised sector where pricing plays a dominant role.

This revenue segment, although not significant, has been expanding with the company's new range of digital plug-and-play UPS systems with communication possibilities. Further, its aggressive tie-ups with close to 1,000 channel partners may see an expanded market share from this segment.

The company's fully-owned subsidiary in Sri Lanka and an export-processing unit in Chennai cater to the overseas markets. Other subsidiaries in Singapore and Mauritius, which trade in the company's products, have enabled effective tapping of markets in Africa and the US directly and through partners. The Singapore subsidiary also acts as a sourcing point for batteries, which are fully imported for the end product.

Last year, the company implemented an auxiliary power systems project for Power Grid Corporation in the entire north-eastern States, in a turnkey effort involving design, supply and installation of total power conditioning systems.

With this, the company has elevated itself to an integrated player in power protection systems. This may well act as a reference point for more such projects in future.

Strong financials

Over the past five years Numeric Power's topline has grown 22 per cent annually on a compounded basis. Effective cost-rationalisation measures have, however, led to healthy top and bottomline growth for the nine-months ended December 2006.

This has also led to improvement in operating profit margin to 11.5 per cent for the latest quarter as against 9.5 per cent in the corresponding previous period.

The company's healthy reserves and low borrowed capital gives it the option of using internal accruals or further debt for any expansion purposes.


Numeric Power completely imports batteries used in its products and to that extent subjects itself to foreign currency risks. Steep increase in the prices of key raw materials such as lead, copper and steel could dent OPMs and also affect bottomline as it may be difficult to pass on the increases to the end-customer. Technological obsolescence is a key risk in such businesses.

However, the company's in-house R&D appears well-equipped to face the same and has made strides in products with improved efficiency and high-frequency design.

Subros: Buy

Investors who prefer a stock with moderate appreciation potential and minimal downside can consider investing in Subros. At the current market price of Rs 237, the stock discounts the annualised April-December 2006 earnings by 10 times.

Given the hectic growth rate in the passenger car industry and the fact that the company is a major supplier to two of the top three car manufacturers in the country, the revenue and earnings visibility is excellent. Subros' capacity expansion plans and its breaking ground with new major customers such as Mahindra & Mahindra spell confidence.

The only worry, which is also the biggest risk to our recommendation, is the likely pressure on margins that Subros could face following increasing input and interest costs and the inability to pass them on in a competitive market. Automobile companies, which are themselves facing competitive market pressures, demand and get a reduction in component prices from vendors at periodic intervals.

Subros has been taking steps to mitigate this risk by diversifying its raw material sourcing and initiating local sourcing of some of the components that it was hitherto importing. The benefits of this have begun to show in the company's financials.

The operating margin has been rising steadily in the last two quarters — it was at 12.25 per cent in the third quarter — after dipping to around 10 per cent in the first.

Good prospects

Subros makes automotive air-conditioning systems and is the only integrated manufacturer in India producing complete air-conditioning systems, including compressors.

It derives almost all of its business from just two customers — Maruti and Tata Motors — both of which are doing well in the passenger car market. It caters to 70 per cent and 60 per cent respectively of the requirements of the two vehicle manufacturers. Given the booming demand for passenger cars — 21 per cent increase in sales in the April-Jan 2007 period — and the fact that almost all of the cars sold are those with factory-fitted air-conditioners, the business prospects for automotive air-conditioning systems manufacturers such as Subros appear good.

While there are others such as Behr India, Delphi, Visteon and Denso Kirloskar competing with Subros, what augurs well for Subros is that it is an integrated producer with a strong R&D base and access to technology from Denso, Japan, which also holds 13 per cent equity in the company.

Its predominant position (43 per cent market share) is reinforced by recent developments such as its bagging an order to supply air-conditioning kits for the Maruti Swift; these were hitherto being imported. There are also possible deals to supply commercial vehicle (CV) cabin air-conditioning kits to Tata Motors, Ashok Leyland, Eicher Motors and Volvo.

The volumes are not likely to be significant as CVs with air-conditioned cabins are yet to catch on in the country but Subros will get a foothold in a new market with potential for future growth.

Strong financials

Subros has a conservative financial profile with low gearing despite the ongoing Rs 77-crore investment in capacity expansion. In the nine months ended December 31, 2006, the company's earnings (Rs 20.36 crore) and revenues (Rs 490.07 crore) grew by a third and a fourth respectively, compared to the same period year before.

The fourth quarter revenues and earnings will get a boost from the Swift supplies, which began in January. Besides, the January-March quarter is traditionally a peak period when vehicle manufacturers are on an overdrive and this should translate into additional demand for the company.

The rapidly growing passenger car industry, which itself is driven by the booming economy, augurs well for Subros' prospects in the long term.

Conservative investors willing to invest and hold over the medium-term horizon can invest in the Subros stock.

Hexaware Technologies: Hold

Investors with a high-risk appetite can retain their exposure in the Hexaware Technologies (Hexaware) stock with a one-year perspective. At the current market price, the stock trades at a price-earnings multiple of 18 times its calendar 2006 per share earnings. Since our last recommendation on October 15 at Rs 165 (before the July-September earnings announcement), the stock had perked up marginally to Rs 175, yet under-performing the broad market. The returns from the stock are likely to be sedate and accrue over a longer time-frame.

We remain positive on the long-term prospects of Hexaware. The management has reiterated that it can double its revenues and post-tax earnings within the next eight-10 quarters. Second, the FocusFrame acquisition that Hexaware made in the area of automated testing in November in an all-cash deal for $34.3 million is expected to accelerate its testing practice significantly. The management has indicated that the company's overall testing practice revenues can grow nearly three-fold to $100 million within the next three years. Finally, Hexaware started calendar 2007 with an order book of $170 million, with 129 active clients, including 41 Fortune 500/Global 500 corporations.

Hexaware's core business model is its positioning as a niche software services provider of Peoplesoft suite specialising in the Human Resource Services domain. This is apart from addressing airlines/transportation vertical and German geography. The core model has since been broad-based to include SAP and Oracle-related services in package implementation and an expanded focus into other European markets beyond Germany. For calendar 2006, while enterprise packages (including HR) contributed 41 per cent of revenues, Europe accounted for 25.8 per cent.

Our somewhat cautious short-run view, however, stems from Hexaware's muted post-tax earnings guidance (revenues are expected to be strong) for the January-March quarter of 2007 and the integration of its FocusFrame acquisition. In the latest October-December quarter too, the earnings numbers were disappointing primarily on account of the sharp appreciation in the value of the rupee by 3.6 per cent. While the revenues of Hexaware grew by 6.8 per cent on a sequential basis ahead of guidance, the post-tax earnings registered a negative sequential growth.

Examining Hexaware's latest quarter's performance vis-à-vis the periods reflects the following:

In the fourth quarter of 2006, the contribution of offshore revenues slipped to 38.4 per cent from 38.9 per cent in the third quarter. Since the offshore mix has slipped for the second successive quarter, it has impacted the operating profit margin.

Through better control over direct costs, Hexaware has managed to improve its gross margin by 0.5 percentage point on a sequential basis. But a step up in selling, general and administrative expenses to 22.6 per cent (from 21.2 per cent in the previous quarter) contributed to lower operating profit margins.

Among verticals, airlines/transportation turned in a fairly muted growth in the October-December quarter, while in service offerings, growth in application management revenues was somewhat sluggish on a relative basis.

The client addition in the October-December quarter has also been sluggish. This was only to be expected as the company had added nine clients (from 31 in the Jan-March quarter to 40 in July-September quarter) in the first three quarters of 2006 in $1 million bracket.

Godrej Consumer Products: Buy

A couple of quarters of decelerating profit growth have triggered a sharp decline in the Godrej Consumer Products stock, to Rs 146 from the Rs 180 levels in September 2006. Though rising input costs have exerted pressure on Godrej's profit margins in recent times, we see this being offset by an increase in selling prices, as pricing power improves and demand for traditional fast moving consumer goods (FMCG) products gains traction. A broad-basing of Godrej's product portfolio by way of recent overseas acquisitions and product launches also augurs well for margin improvement.

At the current price levels, the stock trades at about 24 times its trailing 12-month earnings and 20 times the expected FY-08 earnings, placing it at a significant discount to frontline FMCG peers, which trade at 25-28 times forward earnings. Investors can consider adding the stock to their portfolio with a long-term perspective.

Traction in topline growth

Godrej Consumer derives the bulk of its revenues from toilet soaps (54 per cent) and hair colour (24 per cent), with toiletries and liquid detergents also chipping in. The two key categories have shown significant acceleration in demand growth in recent times. While growth in the soaps segment has accelerated from 8 per cent in the June quarter of 2006 to 22 per cent in the December quarter, that in the hair colour segment has risen from 28 to 33 per cent. This has been reflected in the company's topline growth rising from 14 per cent in the first quarter of this fiscal to 19 per cent in the recent December quarter. That the company's brands are strongly focussed on the value-for-money plank would also be an advantage, amidst growing offtake for FMCGs from semi-urban and rural centres.

Material concerns

However, over the past two quarters, Godrej Consumer's earnings growth has failed to keep pace with the revenue increase on account of rising input prices. For the nine months ended December 2006, the company's (standalone) profits rose by a mere 1 per cent, despite a 16 per cent growth in sales. Growing demand for biofuels has triggered a sharp uptrend in palm oil prices (a key input for soaps); with prices over the past four months ruling 30 per cent higher year-on-year. Rising material costs (despite forward cover) have trimmed the company's operating profit margin by about a percentage point in the nine months ending December 2006, to 21 per cent. Given that the company's fastest growing soap brand — Godrej No.1 caters mainly to price-sensitive segment, the company has lower leeway to take price increases, when compared to competitors with a larger presence in the premium category.

Palm oil prices appear set to rule firm over the next year or so. However, the pressure on the company's margins from this source may abate in the coming quarters, on three counts. One, the company has taken significant price increases in both the soap and hair colour segment over the December quarter which appear more than adequate to offset the escalation in input costs. Second, the company's volume growth has strengthened both in the soap and hair colour segments in the December quarter, a sign that price increases have not materially impacted offtake. Third, the recently-commissioned facilities for toilet soaps in Katha and the ongoing capex at other locations, may provide tax advantages that will further reduce the cost structure on soaps.

Broader portfolio

While both toilet soaps and hair colour are growing at a healthy clip, Godrej Consumer's overseas forays and its expanding portfolio in the personal care segment (with products such as diapers, talcum powder, shaving cream) also have the potential to add to revenues and margins. Keyline Brands, a UK-based personal care company acquired by Godrej in October 2005 (annualised revenues of Rs 157 crore), and Rapidol Pty, a South African hair care company bought in September 2006 (Rs 57 crore), have the potential to add substantially to revenues and profits in the coming quarters. While both acquisitions are expected to be earnings-accretive, Godrej has made product launches in these companies in recent months and commenced shipment of its domestic brands to these overseas arms.

Godrej plans to use these businesses as a platform to explore new overseas markets for its domestic brands. On account of these overseas forays, the company's consolidated operations have registered stronger revenue growth (at 38 per cent) and net profit growth (at 14 per cent) in the first nine months of FY-07.

While relatively low valuation levels and the possibility of margin improvement in the coming quarters add to the stock's attractiveness, the following risks to earnings bear a watch.

The possibility of a slowdown in the company's hair colour portfolio, if it is unable to make adequate progress in the fashion colour segment;

Inability to take further price increases in the event of a continuing upward spiral in input costs.

Patni Computers: Buy

Investors with a medium term perspective can consider taking an exposure in the Patni Computer Systems stock. At the current market price, the stock is trading at a price earnings multiple of 23 times its calendar 2006 per share earnings (including additional tax provisions).

Given the competitive intensity in software services among multinational and domestic frontline vendors, investors may have to moderate their return expectations from the stock. Any price weakness linked to the broad markets can be used as an opportunity to step up exposures. Patni Computers is set to benefit from factors such as higher contribution from new client acquisitions, improving operating margins arising from cost optimisation and new service offerings such as product engineering and enhanced revenues from the European geography. Since the demand environment is likely to remain strong, it will play to Patni's strengths in telecom and insurance.

Patni's four key verticals: Manufacturing, insurance, telecommunications and financial services have each grown to a size of $ 80-130 million, with strong anchor clients. This trend is likely to help the company consciously diversify its clientele base beyond the top ten clients. For the fourth quarter ended December 31, 2006, Patni has recorded an improvement in operating profit margins to 17.5 per cent, aided by higher utilisation and lower general and administrative expenses. For the full year, Patni has improved its employee utilisation by 4 percentage points to 71.4 per cent. It is also in the process of broadening the base of its employee pyramid by recruiting more employees at the entry level. From an operational standpoint, the biggest area of concern is attrition, which has risen to 27.4 per cent in the fourth quarter, up from 24.5 per cent the preceding quarter. The contribution of General Electric, its biggest client has been coming down steadily. For the fourth quarter of 2006, it stood at 13.5 per cent of revenues, down from 14.1 per cent on a sequential basis.

Any additional kicker to financials may come from acquisitions in Europe. The last acquisition made by Patni was of Cymbal Corporation in 2004 to foray into the telecom vertical. The key risks to our recommendation are intense competition, anti-outsourcing backlash, managing attrition/wage inflation and appreciation in the rupee.

Raj TV: Avoid

Investors can give the initial public offer of Raj Television Network (Raj) a miss. At the upper end of the price band, the offer is valued at about 25 times the annualised FY 07 per-share earnings, on an expanded equity base.

The seemingly reasonable valuation notwithstanding, we believe there are other quality exposures in the media space.

Our recommendation does not factor in any gains upon listing. While there could be scope for some revenue growth from subscriptions, advertising revenues are likely to remain under pressure, unless Raj really spruces its act on the content front. Viewership preferences currently seem to be overwhelmingly in favour of the Southern market leader, Sun TV.

Of course, Raj may still manage to pull off one or two hit shows. This might significantly boost advertising revenues, given the small base. Its track record in terms of content till now, however, does not inspire confidence.

Two, there is the possibility of the company being viewed as an acquisition candidate at a later date by players seeking a regional presence.

But launching a new channel may still prove to be a less expensive alternative for such a player. On balance, the prospects of either of these contingencies appear to be too much of a long shot for conservative investors to favour the present offering.


Raj Television operates a Tamil entertainment channel — Raj TV — and a Tamil movie channel — Raj Digital Plus.

The proceeds of this offer will be used mainly to fund the launch of a channel targeting the youth and strengthening production facilities and content.

The youth channel is likely to be multi-lingual with a national flavour and would entail an investment of about Rs 10 crore.

The revenues from this proposed channel are likely to flow in only from the first quarter of FY-09. The channel will be free-to-air in the initial months of its launch.

The company is also looking at new subscription revenues by distributing its channels in the American market.

A part of the proceeds will go towards setting up a studio, acquiring film rights for exports and setting up a distribution network for overseas broadcasting.

Raj is also venturing into the production of short tele-films that will be screened on its own channels, in theatres, as also distributed as VCD/DVDs and put on the web.

However, we do not see overseas broadcasting or video-on-demand being a substantial contributor to revenues in the near term.

Challenging times

The Raj network is not without visibility, having been on air for more than a decade. Raj TV's objective news coverage at one point attracted a fair amount of viewership.

However, it is no longer in a position to offer live news coverage as permission to uplink its channels from India was revoked a couple of years ago.

As a purely entertainment channel minus the live news coverage, Raj TV appears on a significantly weaker footing.

Revenues over the last three years have displayed an uneven trend. That the two channels have been pay(except in the CAS area of Chennai) has been a positive, as increasing subscription revenues have compensated for the limited advertising income.

In the two preceding years, advertising income has dropped. Losing its live news spot, which was a key driver of ad revenue, could explain perhaps the drop in advertising income. Raj's latest nine-month performance shows an uptick in advertising revenues. However, this may have come at the expense of cash flows with the amount due from advertisers and other debtors showing a significant jump.

Overhauling content

For Raj, it does appear to be a long way to the top. Sun TV continues to dominate the serials/soaps space, while Star Vijay appears to be gaining ground by successfully cloning programmes aired on Star's Hindi entertainment channels.

SS Music may be a strong competitor for Raj's youth channel, as it addresses a similar audience profile.

Raj has begun to produce its content in-house in an attempt to cut costs.

The strategy has worked with profits in the first nine months of the fiscal at Rs 9.8 crore against Rs 3.5 crore in FY-06.

However, this cost advantage may be hard to sustain. Given the pressure to improve content, we believe that the company will have to pump in significant sums of money to attract good anchors for its interactive shows.

Investors may be better off waiting for signs of an improvement in content before considering exposure to the stock.

Offer details: About 35 lakh shares are on offer, which includes an offer for sale of about 13 lakh.

The offer will raise about Rs 60 crore at the upper end of the price band.

The promoter's stake, post offer, will be 72 per cent. The offer closes on February 23.

The lead manager is Vivro Financial Services.

Pricing value v/s valuing price - Chetan Parikh

In a great book Wall Street on Sale, the author, Timothy P. Vick, writes about the Warren Buffett way.

“To individual investors the world over, Warren Buffett has become the patron saint of due diligence, a man who wrested control of the stock market and proved most known and widely taught financial theories to be ineffectual. Armed with the teachings of Benjamin Graham, he took $100 of his own money, pooled it with $105,000 from family and friends, and over the next 40 years, turned it into a personal fortune of more than $30 billion. Buffett created additional billions in profits for hundreds of investors who entrusted him with their savings. Indeed, no capitalist in this century has figured so prominently in American history as a result of merely trading paper stock certificates. Other great capitalists such as Bill Gates, Sam Walton, and Henry Ford created wealth for society building factories and marketing consumer products. Buffett took what was, for him, the logical next step: He turned the act of passive business ownership into a profit­-making endeavor and an end unto itself.

The enigma that surrounds Buffett he in part has brought on himself, for he shuns publicity and rarely reveals what he buys or sells. But it also partly reflects the public's misunderstanding of his methods and motives. Lesser people have craved more and attained a lot less on Wall Street. Buf­fett seemed to attain more for the sake of showing it was possible. Along the way, his unbelievable track record exploded the popular myth that investing was for crapshooters whose odds of winning were fortuitous at best. Buffett's life story, eccentricities, and string of successes serve as one long mockery of the ticker tape. Yet he has brought integrity to stock pick­ing as no one has. Buffett is among the world's richest people, yet he pays himself a modest $100,000 a year in salary and plans to pass his wealth to charitable trusts after his death. He inhabits the same middle-class home in Omaha, Nebraska, has been known to eat at McDonald's or a local steak­house, plays bridge incessantly, drinks gallons of Cherry Coke each month, and won't waste a shred of paper at his Spartan, understaffed office.

Buffett's life story, eccentricities, and string of successes serve as one long mockery of the ticker tape. Yet he has brought integrity to stock picking as no one has.

In more than four decades of managing money, he's never had a losing year and has defeated the market's returns in all but a handful of years. Dur­ing the 1960s, his investing partnership attained perhaps the best 10-year scorecard of any money manager. He not only beat the returns of major stock indices for 10 consecutive years but by a wide margin. From 1960 to 1969, Buffett posted an annualized return of 28.9 percent for his investors, while the Dow Jones industrial average returned a modest 5.2 percent. An investor who deposited $10,000 in Buffett's limited partnership in 1960 walked away with $126,000 in 1969, when Buffett folded his tent because he could find few stocks trading at reasonable values.

Buffett's longevity and tremendous success stems from four guiding principles: (1) a disdain for losses, (2) his keen ability to keep his trading objective (that is, based on mathematics, not emotion), (3) a honed instinct to recognize undervalued securities, and (4) the recognition that internal growth drives long-term returns. Volumes have been written on Buffett's methods, and hundreds of articles have tried to untangle his synaptic power from infre­quent public quotes. He has left behind, however, a large enough body of material, including two decades of annual reports that he himself wrote, that any investor could pick up his trail and profit handsomely in the market. Buf­fett's variation on Graham can be neatly summed up in 10 points.


As his legacy to the game of baseball, the Splendid Splinter, Ted Williams, left the world one of the best books ever written by an athlete, The Science of Hitting. Williams's basic thesis was that the strike zone could be carved into minizones that tested, to various degrees, the abilities of both hitter and pitcher. A high and inside strike, for example, tested the batter's weakness against the pitcher's strength. A low and inside pitch might test the batter's strength and the pitcher's weakness. Williams outlined a plan of patience for hitters. They should understand their strengths and limitations and look to drive only those pitches that crossed their strength zones.

Buffett often applies a similar analogy to investing. Following the stock market, he believes, is like standing at the plate and watching thousands of pitches whiz by. Each pitch represents one stock offered at one price at one moment in time. But unlike the batter in the stadium, you are under no obli­gation to lift the bat off your shoulder and swing, for there is no one to judge your trip to the plate. In a 1995 lecture to business students at the University of North Carolina, Buffett briefly outlined this balls-and-strikes concept:

In investments, there's no such thing as a called strike. You can stand there at the plate and the pitcher can throw the ball right down the middle, and if it's General Motors at $47 and you don't know enough to decide on General Motors at $47, you let it go right on by and no one's going to call a strike. The only way you can have a strike is to swing and miss.

Indeed, one of the obvious advantages that you, the individual investor, have over professional money managers is that you are not forced into errors. You are not obligated to beat the S&P 500 this quarter or flip the next hot initial public offering for a profit. You are not responsible for earn­ing a suitable return for thousands of clients, nor is anyone forcing you to dress up your portfolio in advance of an annual report. You don't have to worry about sector rotation, asset allocation, whether Motorola will meet its quarterly earnings targets, or whether you are lagging the performance of competing money managers. Your sole responsibility is to generate a sat­isfactory, long-term return for yourself. Thus, you have the luxury of study­ing 100-plus stocks a month and choosing only one. You can bask in reject­ing Sun Microsystems at $50 and waiting until the shares fall to a reason­able price level before buying. If Sun's stock stays overvalued, you can smile and walk away and focus on any of 10,000 other publicly traded com­panies. You can hang up on brokers month after month until they finally offer a stock you have studied at a decent price. You have the luxury of putting all of your money into bonds—or cash, gold coins, or real estate-­if you cannot find a stock that is attractively priced. Buffett did just that in 1969; he closed his partnership and stayed away from stocks until the mar­ket bottomed in 1974.

The stock market doesn't force you to buy. It just seduces you, as Buf­fett has said. You can walk away from any stock at any price and take com­fort in the fact that you have not risked any cash. But once you discover a stock to your liking, one the market has offered up at a ridiculously low price, swing for the fence. Such opportunities do not come along often and investors should not assume they do. You might be lucky to find 20 golden opportunities throughout your investing lifetime, quality stocks so under­valued they harbor no business risk at all. But dozens of other, slightly less­-attractive opportunities will present themselves, and you should be ready to swing when they arrive.


If you invested all of your assets in fixed-income securities and held them to maturity, you would never suffer a loss. Losses occur when investors take bigger risks hoping for bigger gains. To reduce the chance of losses, you must minimize mistakes. The fewer errors made over your investing career, the better your long-term returns. The advantages you derive from beating the market by a few percentage points a year. Over time, the effects of your success grow immensely due to the power of com­pounding. The same holds true if you can avoid any yearly loss.

When you lose money, even if for as short a time as a year, you greatly erode the terminal value of your portfolio. You consume precious resources that must be replaced. In addition, you waste precious time trying to make up lost ground. Losses also reduce the positive effects of compounding. Consider two portfolios, A and B, both which gain 10 percent a year for 30 years. Portfolio B, however, suffers a 10 percent loss in the fifth year. A $10,000 investment in Portfolio A would return $174,490 by the 30th year. Portfolio B's would return considerably less—only $142,76~because of one poor year (see Figure 1). If Portfolio B sustained two 10 percent losses, say, in the fifth and 15th years, the investor would be left with just$116,810. Avoiding losses, as Buffett strives to do; is paramount to good investing.

FIGURE – 1 The value of avoiding losses.

Investor A*

Investor B**


Yearly Gain


Yearly Gain























































How can investors avoid losses? Certainly they can stay above water by selling shares every time a stock threatens to fall below its break-even point. In the long run, however, such a strategy wi11lead to inferior returns because of excessive trading and high commissions. Another way is simply to hold onto the stock until it rallies above your original cost. Such strate­gies are recommended only when you possess confidence in the underlying company. The method I espouse is Benjamin Graham's margin of safety principle: Buy inexpensively to minimize your risk of loss.


Collecting stocks for the sake of diversification is foolish to someone like Buffett, who typically owns large stakes in no more than one dozen stocks at anyone time. Investors who keep adding stocks to their portfolios for the sake of protection are in essence practicing a trial-and-error, "Noah's Ark" approach. They may not derive any added benefits beyond having two of everything. Buffett, like many value investors, defines "risk" unlike the textbooks. Academics define risk mathematically, by stock volatility. To them, the sheer act of buying many stocks controls excessive price fluctua­tions. Store up enough stocks from different industries, they argue, and you minimize the possibility that a dreadful decline in one stock will harm your returns. Of course, this method also reduces the effect that a few great stocks have on your returns. The reality is that by holding good, bad, and downright ugly stocks in one nest, what hatches can only be mediocre at best.

Buffett's approach is to concentrate as much money as possible on a handful of undervalued securities and hold them. Figure 2 shows Buf­fett's major holdings since 1977, as revealed by Berkshire Hathaway's annual reports. We can see that over 20 years, Buffett has owned large stakes in several dozen companies, not merely the eight favorite stocks he owned in 1997. On average, he holds each stock for several years, though there have been times when Buffett has sold a large portion, if not all, of his holdings in relatively short order. We can see, too, that Buffett favors cer­tain industries and by inference, shuns others. Consumer products compa­nies have figured prominently in Buffett's portfolio, as have media and publishing companies and ad agencies. From time to time, Buffett has bought large stakes in financial companies-Federal Home Loan Mort­gage, GEICO Insurance, National Student Marketing, PNC Banks, and Wells Fargo-and heavy industries-ALCOA, GATX, Cleveland Cliffs, Exxon, Handy & Harman, Kaiser Aluminum, and R.J. Reynolds. In these instances, Buffett was trying to capitalize on shorter-term industry trends, such as a bottoming of commodities prices or a decline in interest rates.

From Figure 2, we can infer how Buffett diversifies. He focuses Berkshire's portfolio around a small handful of buy-and-hold companies and devotes the rest of the portfolio to companies able to provide shorter-­term (three- to five-year) cyclical gains. To say that Buffett always practices buy-and-hold principles is misleading. While he often may plan to hold a stock forever, circumstances occasionally have prompted Buffett to dump positions, at times more frequently than biographers have portrayed. Take, for example, McDonald's, which Buffett bought in 1996 but sold a year later, or Exxon, purchased in 1984 at around seven times earnings but pre­sumably sold before crude oil prices crashed in early 1986. Buffett pur­chased 772,000 shares of Woolworth in 1979 at a price around six times earnings. He sold the stock before the 1981-1982 recession hit. Later, he publicly swore off retailers. We also can infer that Buffett engages in mar­ket timing. He is most ravenous in poor stock markets, when he loads up on cheap stocks. He listed no fewer than 17 different stock holdings in his1980 annual report. By 1987, when the market reached a state of excessive valuation and subsequently crashed, he listed only three—GEICO, The Washington Post, and Capital Cities/ABC. Rather than plow more money into overvalued stocks, Buffett bought a corporate jet for Berkshire, remarking, "I'd rather buy a good stock than a good jet, but there's nothing that we can see buying even if it went down 10 percent."


Buffett has made wide use of takeover arbitrage to deliver nearly risk-free returns. In uncertain markets, takeover trades have cushioned him against losses and kept his yearly returns positive. In a takeover arbitrage, an investor buys shares of a company after it has agreed to be acquired and profits from the spread between the market price and the tender-offer price. For example, a company may receive a tender offer for $50 per share, but until the deal settles, its shares may trade for only $46, an 8 percent dis­count. If the deal goes through, you lock in a $4, 8 percent gain. While 8 percent may not sound so hot, the annualized return may be two to three times that, depending on how quickly the companies consummate the transaction. An 8 percent discount, for example, turns into a 36 percent annualized gain if the deal closes in one quarter. String a few of these deals back-to-back and you can counter an otherwise poor year in the market. When playing takeovers, Buffett searches for deals that are almost certain to transpire. If both parties call off their merger or the federal government intervenes to block the transaction, the target company's stock may drop sharply, the major risk an arbitrageur assumes. On occasion, Buffett has scored spectacular success when the stock of the target company soared following the announcement.


The Depression era that profoundly influenced Graham was a faint mem­ory to millions of Americans by the time Buffett was investing full swing. So, too, was World War II. Stability had returned to the American economy and the markets, and the era of the super bargain stocks, ones selling for a P/E of two or for a fraction of their balance sheet cash, had dissolved. Not having seen the full effects of Depression-era market prices, Buffett clung less and less to Graham’s rigid balance-sheet appraisal of companies and leaned more on the writings of Philip Fisher, one of the first to explore the merits of investing in growth companies. After several years of practicing Graham's methods, Buffett rejected what he called Graham's "cigar-butt" approach to investing-picking cheap companies that had one good puff left in them. Buffett never accepted growth methodologies outright, how­ever; too much Graham remained in him. He never let his valuations fall prey to forecasts, nor did he ever rely on a drunken market to validate his investing decisions. To Buffett's great credit, he correctly recognized that growth and value styles were interlocked. "Ben Graham wanted everything to be a quantitative bargain. I want it to be a quantitative bargain in terms of future streams of cash," Buffett said in 1993.3 If a company cannot grow or increase its retained earnings at sufficient rates, it is an unworthy investment to Buffett, no matter how cut-rate the price. It is imperative that companies keep growing to increase intrinsic value. It is equally essential that earnings grow at a rate sufficient to compensate Buf­fett for inflation. This marrying of value and growth investing, premised on a desire to beat inflation and bond returns, is perhaps Buffett's greatest con­tribution to the world of finance.

To Buffett's great credit, he correctly recognized that growth and value styles were interlocked.

Buffett's style continues to blend growth with value, as evident by his purchases in recent years of American Express, Gillette, Wells Fargo Bank, and Coca-Cola. These four buys show he is not afraid to pay a higher PIE ratio for a growth company, as long as the company's long-term earnings offer a degree of certainty. An investor can fall asleep for 15 years, Buffett is wont to say, and awake to find Coca-Cola and Gillette operating in the same lines of business they were before, selling syrup and toiletries. That's how Buffett measures certainty.


If you don't know the difference between a router made by Black & Decker and one made by Cisco Systems, sidestep both stocks. When you buy a company whose operations are abstruse, you may as well be sitting in the cockpit of a DC-l 0: You'll land on your feet only if the plane's on autopilot or you're lucky enough to flip the right switches. You may always be tempted to play an exotic, rapidly rising stock in a fast-growing industry, but if you lack even a rudimentary understanding of the company's prod­ucts or services, avoid it, Buffett believes. Your portfolio will not suffer as a result. The sin of regret is never as painful as the sin of investing beyond your ability. Some of the strongest-performing companies in the 1990s were unexciting enterprises in equally ho-hum industries that virtually any­one could have grasped: funeral home operator Service Corp. Interna­tional, drugstore chain Walgreen, discount retailer Home Depot, and motorcycle king Harley-Davidson, to name a few.

I often counsel clients to steer clear of most foreign stocks for this same reason. You should avoid investing overseas unless you understand the eco­nomic, tax, accounting, and political landscapes under which foreign com­panies operate. The less you know about an investment before you buy, the more you are venturing into that perilous territory called gambling. With more than 10,000 publicly traded companies headquartered in the United States, there are few reasons to look past the continental shelf. The United States offers the most diversified roster of companies and industries of any­where, with dozens of niche industries and companies for the picking. Rarely will you find an exceptional foreign stock that offers better appreciation potential than a comparable American stock.

Buffett intentionally shuns many U.S. and foreign companies, namely, those in the technology sector, because of his limited knowledge of the industry. But he has never regretted ignoring the likes of Oracle, Intel, Hewlett-Packard, or Texas Instruments. Asked why he won't buy technol­ogy companies, Buffett told Berkshire Hathaway shareholders in 1998 that he will not try to compete in a field dominated by experts.

The truth is, I don't know [what] Microsoft or Intel will look like in 10 years. And I don't want to play that game where I think the other guy's got an advantage over me. I could spend all my time thinking about technol­ogy for the next year and I'd be the hundredth-of-thousandth-of-the-ten­-thousandth smartest guy in the country looking at these businesses. So that is a seven- or eight-foot bar that I can't clear.


I discussed the importance of return on equity (ROE) to a value investor. Buffett obsesses on this standard of performance. On many occasions over the past 20 years, Buffett has stated his preference for com­panies that can generate a minimum 15 percent annual return on equity. By setting such a high hurdle rate, Buffett intentionally limits himself to com­panies experiencing strong and steady earnings growth (recall the link between ROE and earnings growth). A company that pays no dividend and posts consistent ROEs above 15 percent will attain yearly earnings growth in excess of 15 percent. That should translate into long­-term stock-price growth of at least 15 percent a year as well, a rate that far exceeds inflation and bond yields. In calculating ROE, Buffett makes a simple adjustment: He divides yearly operating income (not net income) by shareholder equity. Let's say a company reported $10 million in net income and $15 million in operating income off an equity base of $30 million. Using net income as the numerator, ROE would be 33.3 percent. Using operating income, ROE would be 50 percent. Taking the operating return on equity results in a truer picture of how well management used the capi­tal stock and bond investors provided. Companies can manipulate net income any number of ways by reporting nonrecurring gains or losses.


A business whose products are proprietary, novel, or difficult to replicate by competitors has an impenetrable shield, a "moat" that can allow it to grow unimpeded for years. FlightSafety International, the maker of cockpit simulators, operated without serious competitors for years before Buffett bought the company in 1996. Dairy Queen International, which Buffett bought in 1997, has no coast-to-coast rivals in the soft-serve ice cream business. Walt Disney has no comparable competitors anywhere on earth.

Buffett looks for stocks with defensible franchises, such as Coca-Cola, whose brand name is among the world's most recognized. Coke holds lead­ing market shares in nearly every country in which it sells soft drinks. That the company can increase sales 10 percent to 12 percent a year after 110 years in business is testament to its incredible franchise. Another moat stock Buffett owns is Gillette, whose razor blades and cartridges also hold domi­nant market shares in most countries. "I sleep well knowing that 2 billion men wake up every morning needing to shave," Buffett is fond of saying.

Moats can exist worldwide, like Coca-Cola's, or locally, like your neigh­borhood savings bank or grocery chain. Some of Buffett's best-performing investments have been private businesses, among them See's Candies and the Nebraska Furniture Mart, which hold virtual monopolies in their com­munities. When a business possesses a moat, it has the ability to raise prices without fear of losing market share, a luxury few American businesses have anymore. By contrast, Buffett avoids companies offering commodity like products or services, such as steel manufacturers, automakers, airlines, and retailers. These companies must spend large amounts of their yearly earn­ings upgrading assets or innovating their product lines just to keep pace with other more nimble competitors.


If you can picture where a company will be in 15 to 20 years, you can safely count on the enterprise to deliver consistent returns. Because these types of companies are relatively rare, it makes sense to hold onto them once you've bought shares at an attractive price. Buffett made some of his biggest mis­takes when he rushed to take profits and lost sight of the company's longer-­term potential. One of Buffett's first investments was City Service Preferred, which he bought at the tender age of 11 for $38. The stock even­tually rose to $200, but Buffett sold his shares at $40, pocketing what to a child must have seemed like a good profit. In the mid-1960s, Buffett bought 6 percent of Walt Disney's stock for the ridiculously low price of $5 million but sold the entire stake a year later for $6 million. Had he held on, his original investment would have been worth close to $2 billion in 1998.

Virtually every stock you sell will likely trade one day for a lot more money. If you think a company has the potential to sell for much greater values in the future, hoard it like the king's gold. If you are not confident the stock will continue rallying, you should have run from the stock to begin with. Don't own a stock for five minutes if you are not willing to hold it for at least five years.

Virtually every stock you sell will likely trade one day for a lot more money. If you think a company has the potential to sell for much greater values in the future, hoard it like the king's gold.


Here's where Buffett's strategy becomes a hard pill to swallow, because he advocates ignoring daily market movements. He doesn't care whether the Dow Industrials are rallying or declining, or what the latest economic data suggests. He ignores short-term "noise" and assumes that a stock price, over time, will track the company's growth rates. It wouldn't bother Buffett one bit if the stock market closed for two years and he was unable to obtain a quote on any of his businesses. With or without Wall Street, these enter­prises would continue to operate as usual and generate profits that increase their intrinsic value and the value of Buffett's stake. Imagine for a moment that the stock market closed tomorrow. What would be the result? The bro­kerage industry would surely crumble, but not companies. Would General Electric cease to function if no one could trade its shares? Would orders for Intel's microprocessors dry up? Would consumers stop buying Procter & Gamble's detergent? Would Ford have to recall all of its new cars? Of course not. These enterprises probably would go about their business as usual. Rather than operate with an eye toward next quarter's earnings, they could run their plants happily, finally relieved of the pressure to satisfy fund man­agers, arbitrageurs, analysts, and day traders. General Electric, Intel, P&G, and Ford, of course, would still have value. But their value would be based, as it should be, on earnings and cash flow revealed in financial statements, not on whims, rumors, chart patterns, or analysts' mutterings.


Writing in 1987, Warren Buffett said that investors would greatly improve their stock picking if they realized one fact about Wall Street: It exists to serve you, not guide you. Never assume that the prevailing price offered on a company represents a fair price. You are free to ignore every stock that isn't priced to your liking. The passage below, taken from Buffett's annual letter to shareholders, is one of the greatest investing primers ever written.

Whenever Charlie [Berkshire Hathaway director Charlie Munger] and I buy common stocks for Berkshire's insurance companies, we approach the transaction as if we were buying into a private business. We look at the economic prospects of the business, the people in charge of running it, and the price we must pay. We do not have any time or price of sale. Indeed, we are willing to hold a stock indefinitely so long as we expect the business to increase in intrinsic value at a satisfactory rate. When invest­ing, we view ourselves as business analysts-not as market analysts, not as macroeconomic analysts, and not even as security analysts.

Our approach makes an active trading market useful, since it period­ically presents us with mouth-watering opportunities. But by no means is it essential: a prolonged suspension of trading in the securities we hold would not bother us any more than does the lack of daily quotations on World Book or Fechheimer [two companies that Berkshire Hathaway owns]. Eventually, our economic fate will be determined by the economic fate of the business we own, whether our ownership is partial or total.

Ben Graham, my friend and teacher, long ago described the mental attitude toward market fluctuations that I believe to be most conducive to investment success. He said that you should imagine market quotations as coming from a remarkably accommodating fellow named Mr. Market who is your partner in a private business. Without fail, Mr. Market appears daily and names a price at which he will either buy your interest or sell you his.

Even though the business that the two of you own may have eco­nomic characteristics that are stable, Mr. Market's quotations will be any­thing but. For, sad to say, the poor fellow has incurable emotional problems. At times he feels euphoric and can see only the favorable fac­tors affecting the business. When in that mood, he names a very high buy­-sell price because he fears that you will snap up his interest and rob him of imminent gains. At other times he is depressed and can see nothing but trouble ahead for both the business and the world. On these occasions he will name a very low price, since he is terrified that you will unload his interest on him.

Mr. Market has another endearing characteristic: He doesn't mind being ignored. If his quotation is uninteresting to you today, he will be back with a new one tomorrow. Transactions are strictly at your option. Under these conditions, the more manic-depressive his behavior, the bet­ter for you.

But, like Cinderella at the ball, you must heed one warning or every­thing will turn into pumpkins and mice: Mr. Market is there to serve you, not to guide you. It is his pocketbook, not his wisdom, that you will find useful. If he shows up some day in a particularly foolish mood, you are tree to either ignore him or to take advantage of him, but it will be disas­trous if you fall under his influence. Indeed, if you aren't certain that you understand and can value your business far better than Mr. Market, you don't belong in the game. As they say in poker, "If you've been in the game 30 minutes and you don't know who the patsy is, you're the patsy."

Ben's Mr. Market allegory may seem out of date in today's investment world, in which most professionals and academicians talk of efficient mar­kets, dynamic hedging and betas. Their interest in such matters is under­standable, since techniques shrouded in mystery clearly have value to the purveyor of investment advice. After all, what witch doctor has ever achieved fame and fortune by simply advising "take two aspirins?"

The value of market esoterica to the consumer of investment advice is a different story. In my opinion, investment success will not be pro­duced by arcane formulae, computer programs or signals flashed by the price behavior of stocks and markets. Rather an investor will succeed by coupling good business judgment with an ability to insulate his thoughts and behavior from the super-contagious emotions that swirl about the marketplace. In my own efforts to stay insulated, I have found it highly useful to keep Ben's Mr. Market concept firmly in mind.

Following Ben's teachings, Charlie and I let our marketable equities tell us by their operating results-not by their daily or even yearly, price quotations-whether our investments are successful. That market may ignore business success for a while, but eventually will confirm it. As Ben said: "In the short run, the market is a voting machine but in the long run it is a weighing machine." The speed at which a business's success is rec­ognized, furthermore, is not that important as long as the company's intrinsic value is increasing at a satisfactory rate. In fact, delayed recog­nition can be an advantage: It may give us the chance to buy more of a good thing at a bargain price.

Sometimes, of course, the market may judge a business to be more valuable than the underlying facts would indicate it is. In such a case, we will sell our holdings. Sometimes, also, we will sell a security that is fairly valued or even undervalued because we require funds for a still more undervalued investment or one we believe we understand better.

We need to emphasize, however, that we do not sell holdings just because they have appreciated or because we have held them for a long time. (Of Wall Street maxims the most foolish may be "You can't go broke taking a profit.") We are quite content to hold any security indefi­nitely, so long as the prospective return on equity capital of the underly­ing business is satisfactory, management is competent and honest, and the market does not over value the business.

In 11 simple paragraphs, Buffett summarized the key elements of success­ful value investing. He boiled down everything that has ever been written about finance and stock-picking-the good, bad, and the downright chi­canery-and condensed it into a few key themes that should lead any investor to success. To briefly restate them:

  1. View yourself as a "business analyst," not as a stock market prog­nosticator. No one has ever foretold the direction of the economy or the stock market with any consistency. Neither will you. If you accept this limitation, you already are well ahead of the game. Hence, any investment decision you make premised on movements in the market or the economy has a higher probability of failure. However, if you narrow your task to that of evaluating businesses, you can't help but score successes in the long run.

  1. Don't be swayed by share-price movements, for they often reflect irrational responses to events. The true measure of success is the rate at which your companies continue to grow. Over the long term, share price follows the growth of the company.

  1. Don't be a price-taker in the stock market. Just because your favorite stock trades for $30 per share doesn't mean the business is worth $30. It may be worth $20; it may be worth $50. You alone must decide whether the offering price is a fair one.

  1. Market participants, on occasion, are patently wrong in assessing the true value of businesses. The prudent investor stands ready to snap up companies thrown out at bargain prices and sell when their value has been grossly overestimated.

  1. Wall Street s mission is to sell you something and to create quantita­tive justifications to induce you to trade. It thrives on maintaining a shroud of secrecy. By positioning investing as a rigorous academic endeavor, the industry tries to hold you hostage to its arcane method­ologies and build a cult of awe around its leading personalities.

  1. No amount of technical or mathematical know-how can substitute for old-fashioned financial-statement analysis. Successful stock investing requires no more than a moderate grounding in mathemat­ics, a working knowledge of basic business principles, a little intu­ition that can be acquired through experience, and the ability to read financial statements-nothing more, nothing less.

  1. Being a value investor sets you apart from, but ahead of the crowd. If everyone subscribed to value investing, few values would exist anymore in the market. The fact that most investors respond irra­tionally to information or fail to value a company before purchasing works to your advantage. From their fickleness, you shall prosper.”