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Sunday, May 13, 2007
Investing: The 'not to do' list...
When it comes to stocks, everyone from your friend to your colleague to an acquaintance seems to be keen to offer you an advice. Ideally, these ought to be persuasive as well as cautionary. However, the advisors seldom delve on the latter. No matter how appealing the 'quick buck' tips might be the successful investor is one who practices a sufficient degree of vigilance. We point out few ways to ensure this.
Don't buy into companies without sufficient financial history
Financing of start up companies is best left to specialized groups (venture capitalists and the like). For a retail investor, it is prudent to glance over the key historical financials (minimum 3 to 5 years) and make a peer comparison or evaluate the correctness of the direction in which the company is progressing. Even in a long-term investment, one must not forget that the rule of 'ceteris paribus' (other things remaining constant) may not always hold true, and thus it is necessary to periodically evaluate whether the investment still holds the same 'value' as it once did. Historical evaluation also helps in judging the management's integrity and business principles.
Don't invest in the business that you do not understand
The best way to safeguard one's capital is to not invest in a 'stock' but to invest in a 'business'. Nevertheless, it makes better sense to invest in business that you understand. This will not only help the investor in comprehending new business initiatives, but also in diagnosing the 'health' of the business. An understanding of the industry dynamics will also go a long way in cautioning you about the sector prospects.
Don't stress on diversification or ignore competition
While the principle of diversification may apply to portfolios, the same may not hold true for all businesses, especially if the concerned management does not have the bandwidth. For investors who believe that pursuing multiple business interests is in sync with the principle of diversification, we would like to quote Warren Buffet, "Diversification is a protection against ignorance. It makes very little sense for those who know what they are doing."
At the same time, involvement in the current business should not be at the cost of ignoring competition. Philip Fisher in his book 'Common Stocks and Uncommon Profits' says that every investor should judge his investment target by asking one formidable question - "What is it that the company is doing that its competitors aren't doing yet?" The company's awareness of its competitors' strengths and its own weaknesses gives an indication of the management's foresight and resolution to overcome competition.
Don't fail to consider price while buying a growth stock
Investors often make assumptions while selecting their targets. However, the businesses are subject to various internal and external risks, which may affect the earnings growth prospects of a company over the long-term. But if you have a portfolio of stocks selected with adequate margins of safety, you minimise your chances of losses over the long term. In this context, stock selection is of great importance. To quote Benjamin Graham, "Now, while losing some money is an inevitable part of investing, to be an 'intelligent investor,' you must take responsibility for ensuring that you never lose most of all of your money."
And finally, don't follow the herd
The herd mentality is oft associated to investors who wish to make a quick gain in a bull market, without being aware of the downsides. The high valuations of a company must never be directly correlated to better fundamentals and improved prospects, without adequate study. For, quoting Buffet again, "It's only when the tide goes out, that you learn who's been swimming naked."
SEBI discriminating against Retail Investors
In yet another instance, the retail investor is finding himself short-changed. The Securities Exchange Board of India (SEBI) has directed all stock exchanges to change their listing agreements and allow companies to send abridged annual reports to their shareholders unless the investor asks specifically for the complete copy. Rising costs and availability of all the necessary information on the web site of the company and the stock exchanges are cited as the reasons. This step is retrograde and has to be strongly contested. Why should the onus be on the shareholder? Typically an investor would be invested in more than ten company stocks; so he/she would have to write so many letters every year to each company requesting access to information that should be legally given to them.
A simpler solution would be for the Depository to capture whether the Account holder wants the complete or abridged annual reports for the companies in which he has an interest. Every year, as companies prepare to ship the annual reports, they can send either abridged or complete report depending on the choice of the shareholder (as captured by the Depository). Ofcourse, the Depository should capture the choice of the account holder explicitly (prepaid post cards would work well here).
Misguided thrift
The basic function of the annual report is to give the Director’s Report, balance sheet and profit and loss numbers and the details behind them in schedules. If the company has subsidiaries, the number of pages increases commensurately. To print this data in single colour, on the most inexpensive paper would cost a company less than Rs 100 per annual report. In fact Mr Deepak Parekh has mentioned in his Chairman’ speech that they spent Rs 21 to print one HDFC annual report in FY06.
Instead we find many companies utilising annual reports as an extension of their brand building exercise, so the expense on paper goes up. More colourful the plates, more the outlay. But is that for the benefit of the investor or of the company? If the companies do take this April 26, 2007 SEBI directive seriously, and send an abridged version of the report to its individual retail investors, will they not have to incur double the expense when an investor asks for more details and the company has to re-post the full version annual report?
Quantifying costs
To take an example of Infosys, one of the most widely held companies in India. If the company decides to cut costs and print a basic annual report, it would spend about Rs 47.5 m on sending one full annual report to all of its 475,000 individual shareholders. This would be 0.05% of its total expenditure and 0.13% of its net profits in FY07. A mere drop in the ocean.
Besides many investors are not computer and Internet savvy. Owning a computer is still a far off dream for many Indians with computer penetration at 2% of the population. With cyber cafes and access at work, Internet usage is slightly higher and covers about 39m people. But yet to surf the net for information on companies would probably require most old dogs to learn new tricks. So they have to write letters upon letters to different companies to get what is legitimately theirs. This must be the most desperate attempt yet to shore up the postal department’s finances!!
Returns do not outweigh the costs
Very few Indians actually put their hard-earned money in buying up equity. With compulsory dematerialisation, there does exist some handle on the actual number of investors in the country. NSDL has 7.8 m investor accounts registered with it encompassing 6,566 companies. And this is the group that the various companies have to keep informed. Not as daunting a task as it is made out to be. By printing a fewer pages of the annual report for some will definitely not be able to single-handedly shore up their operating margins! However, the pain and confusion for the investors will be more discouraging.
Retail participation is directly proportional to the prosperity of any market. By discriminating against the flow of financial information to investors, the SEBI has taken a step backward.
Motilal Oswal - Andhra Bank, Geometric Software, Colgate, Ashok Leyland, Eicher Motors, Tech Mahindra, J&K Bank
Motilal Oswal - Andhra Bank
Motilal Oswal - Ashok Leyland
Motilal Oswal - Eicher Motors
Motilal Oswal - Tech Mahindra
Motilal Oswal - J&K Bank
Sadbhav Engineering: Buy
Investors looking to diversify their exposure in the infrastructure sector can consider the Sadbhav Engineering stock. The company's ability to diversify its portfolio and forge ties through the joint venture route were key uncertainties when we recommended the IPO (initial public offering) a year ago. The company has made significant progress in both these respects. It has also managed robust financials and renewed bidding strength as a result of a ramp-up in net worth after the IPO. At the current market price, Sadbhav trades at 12 times its expected earnings for FY-08. Investments can be considered with a two-year perspective. Any weakness in the broad market can be used to buy the stock.
Diversification
While Sadbhav continues to remain focussed on road projects, it has managed to increase its order book in mining operations. A 10-year mining operations contract from Gujarat Heavy Chemicals (GHCL) has taken the company's orders-in-hand from mining operations to Rs 265 crore or 11 per cent of the order book. This will see the company deriving an increased contribution from the sector. In FY-06 and FY-07 the segment accounted for barely 2-3 per cent of the total revenue. Further, the payment for mining contracts with GHCL are based on the total excavation work made and not just on the mineral extracted.
The company plans to concentrate only on similar projects. This segment holds potential on the back of plans of Gujarat Mineral Development Corporation (GMDC) to set up new projects to aid power generation. While we do not expect the mining operations to be the key growth driver, this segment can help maintain operating margins, as returns are relatively lucrative compared with the road segment.
Forging ties
Sadbhav ramped up its net worth from Rs 60 crore in FY-05 to about Rs 125 crore, post-IPO. While this has strengthened its qualification to bid for projects, BOT (build-operate-transfer) schemes, which are typically large in size, often require a higher net worth that can be achieved through tie-ups with bigger players. Sadbhav has managed to forge ties with players such as Patel Infrastructure and Gammon India. Such joint ventures lend optimism to the company's prospects in bidding for big projects.
Comfortable order book
Sadbhav's order book as on March 2007 stood at Rs 2393 crore. This is close to five times the FY-07 turnover. The company has stated that about 80 per cent of the orders on hand are likely to be completed in 30 months. This lends considerable visibility to the earnings growth provided the company is able to complete the projects on time. Roads account for 72 per cent of the current works on hand. A majority of these are BOT based with a mix of annuity- and toll-based models. While the latter is considered slightly risky, the company has two of the three toll-based projects with a grant component, which lends more viability to the model.
Sadbhav's turnover grew 68 per cent in FY-07 and net profits more than doubled. The Operating Profit Margin, which is in the 11-12 per cent range, is superior to a number of industry peers. If the company focuses on BOT projects in the road space instead of pure contracts, the OPM is likely to stay at this level.
Any jump in the price of raw materials such as steel and cement is a major risk. The company depends on a few clients for orders in irrigation and mining sector though there is enough scope to broad-base operations in the irrigation space. Any miscalculation in the toll potential in its toll-based projects would leave limited returns on the table from such projects.
Short Takes
Retail margins pressured?
Expansion costs and competitive pressures are beginning to weigh on the financial performance of leading retailers such as Pantaloon Retail, and Shoppers' Stop. In the quarter ended March, both companies reported a strong revenue growth, but profit expansion was subdued. While Pantaloon reported an 89 per cent growth in revenues, net profits rose by 15 per cent. Margins of Shoppers' Stop also dipped by 80 basis points with the departmental store recording a loss in the fourth quarter. Depreciation costs jumped after the company revalued the useful life of its assets. While some of the margin pressure can be explained by aggressive new store openings during the quarter, burgeoning staff costs and increasing interest burden also appear to be straining profit growth. If the trend continues, the stocks' valuations might get tempered.
One-time drag on earnings
Tech Mahindra reported a net loss in the fourth quarter of FY-07 attributable to an exceptional charge. It has, however, recorded a strong growth in revenues and operating profits. In December, Tech Mahindra had signed a $1-billion, five-year outsourcing deal with British Telecom, which encompassed IT services and business process management. Since deals of this size require upfront savings to be shared with the client, Tech Mahindra has made an upfront payment towards `contract concession' amounting to Rs 525 crore ($118 million) to BT. Tech Mahindra claimed that after consultations with its auditors, it has decided to fully expense this amount in its books during the quarter, instead of amortising it over a specified period. Though a sharp escalation in SG &A (selling, general and administrative) expenses impacted the operating profit margin, the company is likely to be less vulnerable to rupee-dollar appreciation, given its focus on the European geography. Revenue from the BT contract are expected to materialise from the second half of FY-08.
Tiles to realty
Nitco Tiles witnessed a 51 per cent revenue growth and a 90 per cent increase in net profits in FY-07. While the company continues to enjoy robust volumes in its ceramic and vitrified tiles business, investors need to track certain developments, which may have significant earnings implications. Nitco recently entered into a joint venture with a Chinese company for sourcing vitrified tiles over the next three years. With increased demand for vitrified tiles (a low-cost substitute for natural granite), higher Chinese sourcing could boost revenues. With exemption from anti-dumping duties on such imports, Nitco may have an edge in the pricing of such products compared to local players. While the core business remains robust, we are cautious about the company's plans to enter real-estate through its 100 per cent subsidiary, Nitco Realties. The company has plans for six projects mostly in Mumbai and Thana, including an IT park at its mosaic tile factory premises. While success in this foray may improve consolidated earnings over the long term, we prefer to now value the company for its tiles business alone. The company lacks experience in the real-estate business and may have to compete with bigger players to establish itself.
HEG: Buy
Investors with a one- to two-year perspective can consider taking an exposure to the stock of HEG, a leading graphite electrodes manufacturer. At current market price, the stock trades at about eight times its likely FY08 per share earnings. A healthy demand outlook, newly commissioned capacities and improving operating margins point to strong earnings growth for HEG.
This apart, a strong order book with about 90 per cent production for FY08 pre-sold and the possibility of higher utilisation of its expanded capacities lend visibility to earnings over the next year.
The graphite segment of the company, which exports more than 60 per cent of its production, is likely to be the key revenue driver. HEG has a strong client base, which includes companies such as POSCO, Arcelor Mittal Group and Thyssen Krupp.
For the year ended March 2007, the graphite segment witnessed a growth in revenues of about 54 per cent in comparison to the corresponding period last year. During the same period, while the segment profit grew by about 68 per cent, contribution from exports increased by about 69 per cent.
The capacity expansion completed in the middle of last year, has just begun to contribute and will make a full contribution to revenues and earnings from FY08. With improving utilisations, margins are likely to get an additional boost from the proposed de-bottlenecking of the graphite electrodes plant with a capex of Rs 35 crore. HEG has also lined up a capex of Rs 80 crore for the setting up of a 30-MW thermal power plant. Since most of its power needs are met by its captive power plants, the setting up of this plant is likely to help it contain cost.
HEG's earnings are vulnerable to any unexpected change in the value of rupee vis-Ã -vis other currencies, given that the company relies significantly on exports. This apart, intensifying competition and any slowdown in the production of steel remain the primary risks.
GAIL (India): Sell
Shareholders of GAIL (India) may consider exiting the stock at current valuation. The company's performance in 2006-07 points to some serious worries over its earnings growth prospects in the medium term. GAIL appears to be hemmed in by growing competition in its core business of gas transmission even as higher gas prices are set to erode margins in its petrochemicals and LPG (liquefied petroleum gas) businesses, something that was already felt in 2006-07.
Primary dependence on the Bombay High field, which is struggling to increase gas production volumes, and the absence of adequate replacement for this is likely to affect the gas marketing business, unless the company hits pay dirt in its upstream exploration activity. There is also the added regulatory uncertainty of a demerger of the gas transmission business and its impact on the company. All these factors point to a significant downside in the stock from current levels.
Pointers from performance
The gas transmission business is the prime earnings driver for GAIL bringing in 57 per cent of the EBITDA (earnings before interest, depreciation, tax and amortisation) and it could be under siege from competition. GAIL has about 85 per cent share of the transmission market in the country but this is likely to drop significantly once Reliance Gas Transportation Infrastructure Ltd. (RGTIL) starts operations, moving gas from the KG Basin fields.
RGTIL will obviously get the first right to transport the KG Basin gas and it is already implementing an east-west pipeline originating at Kakinada (Andhra Pradesh) and terminating in Gujarat; it is also likely to construct the other major trunk pipelines to Mangalore via Chennai and Bangalore and to Howrah from Kakinada.
GAIL has signed an MoU with Reliance for onward transport of the KG Basin gas via its Hazira-Bijaipur-Jagdishpur trunk pipeline to the North but the terms, such as the quantity and the price, are unknown now. It would, therefore, be premature to project an increase in volumes based on this MoU.
Gas transmission volumes were 2 per cent lower at 77.28 million metric standard cubic metres per day (MMSCMD) in 2006-07 compared to the previous year and this was despite an overall increase in gas availability and consumption in the country. Gujarat State Petronet Ltd. (GSPL), a subsidiary of Gujarat State Petroleum Corporation, is growing fast in the mature gas market of Gujarat and has already linked up the southern part of the State with the western end. GSPL has succeeded in taking away some of the volumes from GAIL within the State.
GAIL's gas transmission volumes have been showing a declining growth trend the last three years; they grew 14 per cent in 2004-05; 10 per cent in 2005-06 and fell by 2 per cent in 2006-07. As competition intensifies, from 2007-08 the trend of slowing growth is only likely to intensify especially as GAIL is effectively out of some of the major trunk pipelines being planned to transport gas from the KG Basin to the western and southern parts of the country.
Margin erosion
Higher prices for gas used as feedstock for the petrochemical and LPG divisions caused a dent of Rs 800 crore on the bottomline during 2006-07. GAIL has been forced to pay market prices for captive consumption of gas as the production from the Bombay High declines and is fully consumed by the priority consumers in fertiliser and power sectors. GAIL now pays around $4.75 per million British thermal unit (MMBTU) compared to $2 per MMBTU two years ago.
The polyethylene capacity is set to increase to 4.10 lakh tonnes per annum (3.10 lakh tonnes now) from the second quarter and the incremental capacity will be driven mainly by gas sourced in the spot market at rates that are substantially higher than what GAIL pays now. Buoyant polyethylene prices protected margins last fiscal but they may not be enough to cover up for the higher input costs for the incremental capacity.
Meanwhile, the sword of subsidy-sharing hangs over the LPG business. GAIL's subsidy burden rose more than 45 per cent in 2006-07 and a continuation of the one-third sharing mechanism would mean a similar outgo this year as well.
Problem in gas sourcing
The biggest problem that GAIL will face compared to its competitors, RGTIL and GSPL, is that it has no assured gas supply source in place for the future. While RGTIL and GSPL can source from their parents' reserves in the KG Basin field, GAIL has only the Bombay High gas and regassified LNG from the Dahej plant of Petronet LNG that it markets.
GAIL has rights to market 60 per cent of Petronet LNG's gas sourced on long-term basis and a third of the gas sourced in the spot market. Though gas volumes from Petronet LNG are slated to increase they will be at substantially higher prices likely in the range of $6-8 per MBTU. The company appears to be banking on gas piped in from Iran and from Myanmar, but both these projects appear non-starters for now. While the Iran pipeline is mired in political uncertainty, Myanmar has signalled its intent to convert the gas from its offshore field where GAIL holds a 10 per cent equity stake, into LNG and ship it out.
LNG imports from the Gorgon project of Chevron in Australia and from Algeria through Dabhol and Shell's Hazira LNG import terminal are the other options being explored but the Gorgon project may not ship out its first LNG before 2012.
The picture can change dramatically though if GAIL strikes gas in any of the 27 blocks where it has secured the rights to explore. This is not an unlikely possibility given that five of the blocks are in the same KG Basin area where Reliance has struck gas and three more are in the Mahanadi basin. Such a development will be critical for GAIL to maintain its predominance in the market.
Demerger?
GAIL will have to hive off the transmission business soon as regulations and the regulatory board are in place. This adds to the uncertainty for shareholders because transmission earns more than half the profit and the left-over businesses of gas trading and processing are low margin and commodity businesses respectively.
Given these circumstances, the stock appears overvalued at current levels. It has already shed 10 per cent in the last week but further downside appears likely. Shareholders may exit now and watch the stock for acquisition at lower levels.
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