Lessons learnt from this bull market of high quality businesses

A friend of mine recently sent me a link to an excellent and candidly written article on the mistakes learnt over the past decade from stock market. Here's the link:

http://altaisadvisors.com/blog/2017/10/20/some-mistakes/

I have known Vishal from Altaisadvisors for a while although we haven’t been in contact for past 1 to 2 years. It was pleasant to go through his latest thoughts through this article. I can’t agree more with their thoughts although there are some points where I prefer to have a different take. Hence I thought to note it down in this blog.

I am writing this blog entry after a long long time. The purpose is to note down my current thoughts and to check their correctness a decade from now. Obviously, I shall be wrong on some of them and right on some. However, if you can tell right now that I am obviously wrong on certain points, then I would welcome to hear your thoughts in the comments section below. Infact, counter arguments are most welcome.

1. Selling good businesses too early: Totally agree with this.

2. Going down the Quality curve: This is so true.

3. Waiting for a little lower price to buy: I think it is too early to reach any conclusion on this point. We are in the bull market for high quality businesses (mostly mid-cap and small-cap businesses) since past 3-4 years wherein any business that has been successful in creating a perception of high quality (just perception is enough) has run up. I would reach a conclusion after the current investment style of high quality business goes out of favour.

5. Not experimenting enough in the portfolio: How can one disagree with this? One has to keep on experimenting on a small portion of the portfolio. I would only prefer to experiment when there is dis-interest in the stock market rather than when there is so much investor interest. In a bull market most of the stocks are likely to do well and hence one may reach wrong conclusions about the success of the new strategy under experimentation.

6. Having a very large cash allocation: I neither disagree nor agree with this. I prefer to wait for a complete market cycle (bear/bull market to next bear/bull market) to take a call on this point. However, I could be wrong in waiting for a complete cycle to reach a conclusion.

7. Holding on to the non-performers for too long: Can’t agree more with this. As soon as one realizes one’s mistake one should cut the losses and move on.

8. Thesis change, market view changes: Totally agree that one has to have an open mind about the developing thesis. I would only add that if one had not identified the new data points clearly before market recognizes it, then one can remain happy about the investment working out but not to note this case down as an investment success. Basically, if an investment works out for different reasons than the ones identified before the market recognizes it, then one has to be honest to not note it down as an investment success.

9. The need to be Contrarian: Totally true. Can’t add more.

10. Focusing on macro: Which follower of Munger and Buffet would dare to disagree with this?

Finally, I would want add one observation that is unrelated to above.

Today, the BSE mid-cap and small-cap indices have closed at an all time high (yet again). I am sure there shall come a time when the current favoured style of investing in high quality businesses becomes less popular (some other investing style or asset class may become more popular). At that time, the current high valuations of these mid-cap and small-cap businesses may come down. This does not mean that it is going to happen tomorrow. What I don't know is when is this going to happen. It may happen in next 5 months or 5 years. However, I have no doubt that it is going to eventually happen.

It is hard to find genuine investment ideas these days because I see several company's management have begun to speak what value investors like to hear. I wouldn't be surprised if in a few years a fraud is discovered in few of such businesses pretending to be of high quality.

Wish you a safe (investing) journey!

My reply to concerns about Engineers India Ltd.

Recently, an analyst wrote to me about the following concerns in regards to Engineers India Ltd (EIL):

1. Refining overcapacity in India.
2. The slowdown in order book of EIL.

This was my reply to him:

XXX, India's current refining capacity is around 190-200 mtpa. This includes private refiners - Reliance and Essar whose capacity is around 70 mtpa. Essar supplies a part of its output to Indian Oil Corporation and maybe to others as well. Majority of private refinery's output is exported for it is not feasible for them to sell at the controlled fuel prices. Total demand for petroleum products in India is between 140-145 mtpa. So there is some over capacity but I am not overtly concerned about it. I believe some 10 to 20% overcapacity is required to account for disruption like terrorist attack, breakdown or other unknown/unknowable events.

If all the fuel prices are practically de-controlled and Reliance and Essar can run their fuel retailing business in India profitably, then this concern is valid for EIL.

Businesses operate within the economic ecosystem and cannot help but get affected by the up and down economic cycles. This gets reflected in the order book. When the economic cycle turns and order books increase in respond to that, Mr. Market cheers and takes the share price of the business to the sky. The future is never clear, and you pay a very high price in the stock market for a cheery consensus. Uncertainty is the friend of the buyer of long-term values, as Buffett says.

My original blog post parsing the business of EIL is here.

All those who have acquired foreign country citizenship can now invest directly in Indian stocks

FYI for all those who have acquired foreign country citizenship - Foreigners can now invest directly in Indian stocks.

This is a great opportunity to be able to earn in a high income country and simultaneously be able to invest in a high growth country.

Check this out - http://economictimes.indiatimes.com/markets/regulation/foreigners-can-now-invest-directly-in-indian-stocks/articleshow/11331305.cms

Revised Certificate of Deposit (Fixed Deposit) rates for NRE accounts

FYI for all those in the US and other countries - All the major banks in India have revised Certificate of Deposit (Fixed Deposit) rates for NRE accounts from 3.25% - 3.9% range to 9% and above i.e. an increase of more than 125%!

Wish you a great New Year!

Pricing Power and Cera Sanitaryware

The single most important decision in evaluating a business is pricing power. If you've got the power to raise prices without losing business to a competitor, you've got a very good business. And if you have to have a prayer session before raising the price by 10 percent, then you've got a terrible business.

- Charles Munger / Warren Buffett

In the current business environment, how many businesses can confidently say that they are able to pass on the 'Cost Push' on account of inflation?

Not Voltas, Blue Star or Steel companies.

How many businesses are not afraid of goods getting dumped from China?

Not L&T and BHEL. They have been lobbying with the government for more than past 6 months to have anti-dumping duty on imported power equipments from China.

In this context, checkout the following interview of the executive director of Cera, Mr. Vidush Somany. From this interview, one can get answers to the above two questions.

I believe, Cera has got a reasonable pricing power.

http://www.business-standard.com/india/news/qa-vidush-somany-cera-sanitaryware-ltd/456189/

More Two-wheelers and Cars means more profit for EIL

Checkout the following article to see why I feel the demand for fuel is going to increase a lot in India. More vehicles means more fuel demand; More fuel demand means more crude refining capacity needed which in turn implies more demand for the services of Engineers India Ltd.


I am not concerned about the recent decrease in the sales growth of cars. In the month of October 2011, even after the 30% crash in sales of cars, on an average, about 4400 new cars were sold each day of the month, including Sundays and Holidays. Also, 42000 two wheelers were sold each day of the month, again including Sundays and Holidays. We are not even talking about the fuel guzzling commercial vehicles.


Also, on a mass scale, we are not going to replace oil as fuel in vehicles so soon. If petrol and diesel were soon to be replaced by batteries or other fuels; Ford, Tata, Peugeot and Maruti Suzuki wouldn't be setting up new car manufacturing plants with petrol and diesel engines.


http://articles.economictimes.indiatimes.com/2011-11-27/news/30447027_1_indian-dream-middle-class-maruti-suzuki

Engineers India Limited (EIL)

NSE: ENGINERSIN; BSE: 532178; ISIN: INE510A01028

November 19, 2011. Current Market Price: Rs. 229. Sensex 16372. Nifty 4906.

52 Week High/Low: 352 / 215

Buy for duration of at least 3 to 5 years.        

Investment Summary: A business serving one of the fundamental aspect of human civilization i.e. Energy.

In the Berkshire Chairman’s letter to Shareholders, 2007, Warren Buffett writes: “Charlie and I look for companies that have a) a business we understand; b) favorable long-term economics; c) able and trustworthy management; and d) a sensible price tag”.

Analysis of EIL with respect to the above four filters:

a)    Simple Business to understand:

EIL is a Public Sector Unit. It has two business lines – provide consultancy services and execute Engineering, Procurement and Construction (EPC) contracts.

Consultancy business is a high margin business (Net profit margin of 35% to 40%) and requires negligible capital expenditure. This business contributes approximately 30% to 35% to revenues.

Majority of EIL’s EPC contracts are on an Open Book Estimate (OBE) basis i.e. contracts are open ended for design changes and changes in raw material costs are directly passed-through to the customer. Hence this too is a safe business model and requires minimal capital expenditure. It also protects EIL from escalating raw material costs. Profit margin is 10% to 12% and contributes approximately 65% to 70% to revenues. Since there is minimal capital expenditure, this business too earns high Return on Capital Employed (ROCE).

Excluding Investments, Cash and Fixed Deposits, EIL has a negative working capital.

It is a zero debt company and as on Sep 2011, has net cash of around Rs. 1625 Cr.

Moat (Moat means a competitive advantage over present and future competition):

EIL operates in the Energy and Infrastructure sectors i.e. Petroleum Refining, Petrochemical plants, Offshore as well as Onshore Oil and Gas exploration, Oil and Gas pipelines, Mining and Metal, Strategic Crude Oil Storage, Ports and Terminals etc.

EIL has worked on over 50 refinery projects in India. It has worked on 9 grass root refinery projects from concept to commissioning. It has been involved in the establishment of 7 out of the 8 mega petrochemical complexes in India. It has worked on 205 offshore platforms, 35 oil and gas processing projects, 37 pipeline projects and 26 mining and metal projects. EIL has thus accumulated a vast database of knowledge through is operations since 1965. It is not easy for a big business house with deep pockets to get access to this knowledge database. Thus, there are sufficient barriers to entry.

Also, having worked on the majority of the refineries and petrochemical plants may provide some sort of stickiness from customers for new as well as maintenance and expansion of existing plants. I believe this provides EIL with sufficient pricing power.

b)    Long Term Economics:

Energy is one of the fundamental requirements to sustain human civilization. I believe that five to ten years from now, Indians would be using a lot of petrol, diesel and gas than at present. This would require setting up of new refineries and pipelines as well as expanding the existing ones.

Plastic is one of the major end products of petrochemical plants. Each passing day, we are using more and more plastic which makes me believe that the per capita consumption of plastic is going to increase a lot in the years ahead.

All this shall ensure that there is a steady demand for the services of EIL.

Thus, this is a business earning high ROCE and RONW (Return on Net Worth) and requires minimal capital to keep growing.

c)    Able and Trustworthy Management:

EIL employs some of the brightest minds of India and has one of the lowest attrition rates for a service industry i.e. less than two percent. Being majority owned by Government (80.40%) and there being no stock option plans, there is no incentive for the management to jack up the stock price through fraudulent means.

Management is planning to diversify into energy related sectors like Nuclear, Solar, City Gas Distribution, Water and Waste Management and Fertilizer. While this may sound risky, EIL has a history of successfully diversifying into Mining and Non-Ferrous Metallurgy in 1973 and into infrastructure sectors in 2001.

d)     A Sensible Price Tag:

Excluding interest income and income from investments, Adjusted Profit after Tax (APAT) for the year ending Mar '11 is Rs. 442 Cr.

Average  APAT from Mar ’09 to Mar ’11 is Rs. 341 Cr.

At the current market price of Rs. 229, market capitalization is Rs. 7726 Cr. Net Cash is Rs. 1625 Cr. Therefore, Enterprise Value (EV) of the business is Rs. 6100 Cr.

1.    Using the average APAT from Mar ’09 to Mar ’11 of Rs. 341 Cr, market expects EIL’s APAT to grow perpetually at 4.40%.

2.    Using the Mar ’11 APAT of Rs. 442 Cr, market expects EIL’s APAT to grow perpetually at 2.80%.

Compare this with the actual top line CAGR from Mar ’07 to Mar ’11 of 49%; Operating profit CAGR from Mar ’07 to Mar ’11 of 47%; PAT CAGR from Mar ’07 to Mar ’11 of 38%.

Note: I own shares of EIL. My average purchase price is Rs. 248.

Over long periods, stock price follow the performance of the business.

Divide the amount you want to invest in EIL into at least five parts. Invest the first part and if the price goes down, buy more and so on…

Expect average annual return of 15% to 20% over 3 to 5 years.

The following table indicates the compounded value of 100,000 at 5%, 10%, 15% and 20% for 10, 20 and 30 years. It must be noted that how relatively small differences in rates add up to very significant sums over a period of years:

	5%	10%	15%	20%
10 years	162,889	259,374	404,556	619,174
20 years	265,330	672,750	1,636,654	3,833,760
30 years	432,194	1,744,940	6,621,177	23,737,631

                                                                                                          Priyank J. Sanghavi

                                                                                                          priyankjs1@gmail.com

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