Category: Investing

Investing in Road Infrastructure stocks? Here’s one strategy.

This post is not buy/sell/hold advice. Please see the disclaimer at the end before reading further

While the goose of private capex has been cooked, the Government of India is taking every step to boost public spending on infrastructure.  The focus is currently on roads. In 2015-16, NHAI awarded about 50 projects to build 2,624 kilometres of roads. A budget of US$22.35 billion has been set out by the Indian Government for infrastructure projects, for which highway construction will play a major part.

As Bala writes in this brilliant piece infrastructure companies have many moving parts that make them unsuitable as buy and hold investments, not least of which are – cyclicity, incalculable extraneous and confounding factors such as commodity prices and the lumpy, often misleading nature of their earnings.

On the other hand Infrastructure is one of the handful of sectors in this market that shows earnings visibility and a clear growth highway ahead.

So how to negotiate this paradox?

Proposed strategy: PROTECT DOWNSIDE RISK (And the upside will take care of itself)

Since the opportunity size is so large, if we can find companies where the downside risk is protected, it should be profitable. Let me lay the downsides for you and the mitigating techniques while researching potential Infrastructure companies to invest in.

Risk 1: Uptick in Commodity Prices leading to Working Capital Problems

Commodity prices are cyclical and have been in their trough for the past two years. It is expected that the uptick in key commodity prices will begin from 2018. Steel, cement are some critical inputs for the construction sector.

Steel – In the recent years India has imposed anti-dumping duty on steel and China has rolled back on capacities. This suggests domestic steel may go up in price.

Cement – Cement is priced by a cartel of producers in India. Further the government has put it in the 28% GST category.

This is sure to increase burden of raw material costs on Infrastructure companies.

Mitigation: Find Companies with Low Leverage and low P/B

Like any sector emerging from a multi-year downturn, most infrastructure companies are currently saddled with debt. Take the following precautions:

  1. Consolidated earnings – When screening companies, check both the standalone and consolidated balance sheet. Construction/Infrastructure companies in India tend to be conglomerates with diversified interests in power, real-estate and (sometimes) loss making foreign subsidiaries. Always check the consolidated financials to get a real picture of financial health.
  2. Price to Book value – use this metric for relative valuation as P/E can be misleading, given that earnings are lumpy (more on this later) and P/E does not capture bloat in balance sheet
  3. Mix of project/order type with the company – While leverage is not a disqualifier in itself, too much debt on the books puts some companies out of the competition for BOT (Build-Operate-Transfer) projects. BOT projects have higher risk of exposure to commodity price related working capital problems. On the other hand BOT projects have higher entry barriers than hybrid and EPC (engineering, procurement and construction) models that require upfront commitment from the government to take on 40% of the burden of costs. It follows logically that EPC models (where the government takes on the full burden of working capital) will face more competitive bidding than BOT projects, which will enjoy higher margins. Companies with low leverage and healthy balance sheets will enjoy a huge advantage to bid and successfully execute BOT projects.

Risk 2: Lumpiness in Earnings

The public infrastructure sector has one key buyer: government. The project lifecycle is long with 100% buyer concentration. This impacts the nature of orders – sometimes you win the bid, sometimes you don’t.

Additionally, infrastructure companies can record “revenues” as time of the order or at time of complete transfer of ownership and risk. Accounting distortion is common in this sector.

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“Lies, damn lies and statistics”

Mitigation: Look at Cash EPS and Execution History

While the EPS of the company can be misleading. Cash EPS, which is a measure of Cash Flow from Operations / Dilute Equity outstanding would be a better measure of the health of the company. Again, due to the lumpy nature of infrastructure orders – do not look for consistency in Cash EPS but rather, its relative value compared to EPS.

Execution history is important. Companies that have suffered cost overruns in the past due to poor capital allocation or working capital management can be avoided. A leopard and management, rarely change their spots.

In Sum: The past is not the future

Road Infrastructure itself is a Rs 7-lakh crore opportunity. NHAI has 62000 crores worth of bids up in the next 6 months. Funding for Infrastructure is cheaper than it was in the past – interest rates are lower offering companies with debt significant relief in their existing interest payments while taking on new projects. Further, the Reserve Bank of India (RBI) has allowed companies in the infrastructure sector to raise External Commercial Borrowings (ECB) with a minimum maturity of five years and with an individual limit of US$ 750 million for borrowing under the automatic route.

Further, risk of input costs and overruns have been transferred from the building company, to the government under the Hybrid Annuity Model (HAM) and the EPC (engineering, procurement and construction) model. So the company executes and keeps the money, which is not trapped in working capital. We may be at the cusp of a unique wealth making opportunity in the stock markets. Stay vigilant.

DISCLAIMER:

This post is not BUY/SELL/HOLD advice but a statement of my personal analysis and opinion. I hold road infrastructure stocks so my views are biased.

I am not registered with SEBI under SEBI (Research Analysts) Regulations, 2014. As per the clarifications provided by SEBI: “Any person who makes recommendation or offers an opinion concerning securities or public offers only through public media is not required to obtain registration as research analyst under RA Regulations”. No BUY/SELL/HOLD advice is offered on this blog, in any form whatsoever. Views expressed are my own and not of my employer. Stock Markets are very risky and can cause a permanent loss of capital. You should seek professional advice.

Kriti Nutrients and Sanwaria Agro: Soya and Edible Oils back in focus

This post is not buy/sell/hold advice. Please see the disclaimer at the end before reading further

Soya products and the edible oils are areas I have been closely following. India imports  67% of its demand for edible oil. This is economically unsustainable due to several reasons. There are a few key factors about the industry:

  • The demand for edible oils is inelastic and insulated from macroeconomic conditions as cooking is a basic need for survival.
  • India has failed to be self-sufficient in edible oil production due to misaligned incentives for farmers and low agricultural efficiency, which causes Indian soya to be globally uncompetitive in prices.
  • Soya has applications beyond cooking oil in cattle feed (poultry), food proteins, value added products (like soy milk).
  • China is driving the global demand in soya and increase in prices of the raw material.

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The Indian government unfortunately has not recognized the importance of self-sufficiency in cooking oils and has not made it a policy priority. However with GST and the financial demise of large listed companies like Ruchi Soya, the space has opened up for smaller organized players with good balance sheets like Madhya Pradesh based Kriti Nutrients. I would prefer companies based in M.P and Maharashtra as they have the competitive advantage of sourcing Soya from local growth belts.

The financial health of Cooking Oil and Soya companies has been tenuous. Edible oil and Soya products is a low margin and commodity business. Bad macroeconomic and industry conditions have wiped out many companies big and small (e.g. Ruchi Soya). Only a few remain investment grade.

The cyclicity in the business is through the supply side – introduced by dependence on raw materials like Soya and Sunflower. The production of edible oils and soya products is subject to the vagaries of the monsoon and Indian agricultural conditions. The demand side itself is not cyclical as cooking oil is in demand around the year. This makes companies with good inventory management stand out.

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Kriti Nutrients : Improving on all parameters

Due to these factors discussed, it is also wise, when investing in the edible oil sector, to look for companies that are not pure play edible oil manufacturers but look to be mini-FMCG or food processing companies – thus diversifying their risk.

Kriti Nutrients: Offers products such as Soya flour, Sunflower oil and produces Soya liechestien for Nestle (probably for use in their baby food products). Kriti management though conservative has shown an intention to launch value added products albeit slowly. With access to M.P’s soya-belt, they are well positioned to capture new product categories like Soya milk and protein foods when the market is made. It also makes me believe they are a good acquisition or partnership candidate for large FMCGs like Britannia and Nestle. Fun fact: Inventory turnover of Kriti Nutrients is better than Nestle’s. All of this is not discounted in the price as Kriti trades at multiples that are normal to the edible oil industry.

Sanwaria Agro: The company is more of a food-processor than Kriti Nutrients, which leans more towards being an edible oil company. In addition to edible oil and soya chunks; Sanwaria offers flour and even basmati rice. The price has run up significantly in the past few months.

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Sanwaria Agro, Investor Presentation

In sum, a few reasons to be bullish about the edible oil/soya product businesses are listed below:

  • Unorganized to organized: GST pushes the unorganized market towards an organized market benefitting large and mid-sized listed players with low leverage and good inventory management
  • Push to pull: Domestic demand will see growth as the country moves towards self-reliance in edible oil and competitively priced soya products
  • The business has emerged out of a multi year down-trend, so valuations are reasonable
  • Reliance on monsoons is going to decrease and agricultural incomes are set to rise incentivizing farmers to grow soya and edible oil cash crops – securing supply side cyclicity
  • Protein intake increasing in a vegetarian country and the addition of value added products will see increased demand for soya chunks, tofy and other soya proteins as well as soya milk in the medium to long term
  • Health and quality consciousness: Soya oil is healthier than its counterpart – mustard oil, which is the dominant variety of cooking oil in India

DISCLAIMER:

This post is not BUY/SELL/HOLD advice but a statement of my personal analysis and opinion. I hold Kriti Nutrients since lower levels so my views are biased.

I am not registered with SEBI under SEBI (Research Analysts) Regulations, 2014. As per the clarifications provided by SEBI: “Any person who makes recommendation or offers an opinion concerning securities or public offers only through public media is not required to obtain registration as research analyst under RA Regulations”. No BUY/SELL/HOLD advice is offered on this blog, in any form whatsoever. Views expressed are my own and not of my employer. Stock Markets are very risky and can cause a permanent loss of capital. You should seek professional advice.

Taneja Aerospace: Speculation’s swift knife, whither will it turn?

This post is not buy/sell/hold advice. Please see the disclaimer at the end before reading further

  • Taneja Aerospace and Aviation Limited (TAAL) operates the Hosur Airstrip, 30 minutes from Electronic City Bengaluru
  • The airstrip is 2km long and can accomodate Boeing and Airbus class of narrow-body aircraft, with in-house hangar and repair facilities
  • The government under its low cost flying or UDAN (Uday Desh Ka Aam Nagrik) scheme recently airmarked TAAL’s Hosur Aerodome as a hub for low-cost domestic flights
  • Inspite of many triggers in place TAAL has historically failed to produce returns on assets making it a speculative grade stock

Continue reading “Taneja Aerospace: Speculation’s swift knife, whither will it turn?”

Grauer and Weil: Are the Risks worth the optionality of future growth?

This post is not buy/sell/hold advice. Please see the disclaimer at the end before reading further

  • Grauer and Weil is one of India’s largest companies in the Electroplating and Coatings chemicals business.
  • It is a diversified conglomerate of both commodity and speciality chemicals, with interests in paints and real estate.
  • The diversified businesses may be holding down growth in the core chemicals business
  • Management decisions need to be closely monitored

Continue reading “Grauer and Weil: Are the Risks worth the optionality of future growth?”

The New World: Karuturi Global and how (not) to invest in Ethiopia

The African nation of Ethiopia is famous for its cuisine, long distance runners and arabica coffee. Few however think of Ethiopia as a rising African power.

  • Since 1990, the rate of return on foreign direct investment in Africa has averaged 29%, nearly tripling FDI in Europe.
  • The Ethiopian economy has grown at a rate of 10% over the last 10 years.
  • Ethiopia has its own space program.

Continue reading “The New World: Karuturi Global and how (not) to invest in Ethiopia”

Thoughts on using the Discounted Cash Flow for Small Caps

Interesting lecture by Professor Aswath Damodaran on intrinsic valuation, where he breaks down the use of the Discounted Cash Flow assumptions in some detail:

Interesting how the students approach DCF and seem to collectively conclude one of the Professor’s portfolio stocks (Twitter!) is overvalued by 1000%+.

It appears that in his investment decisions the Professor can take a contrarian position vis-a-vis his own field of study – where he is counted as among the best. A lesson for all the excel snobs amongst us. Stay humble.

Perhaps this is also because – as his lecture amply demonstrates – the DCF calculation has a lot of moving parts. When you have a lot of moving parts, the risk of error in each moving part gets multiplied to give you an overall risk of error with valuation using DCF.

So it helps to keep it simple while doing valuations. Here’s why I stick to a conventional, back of the envelope calculations like the Price Multiple Model to begin with. I wrote about how an investor can use the Price Multiple Model as a first step valuation, and combine it with other models.

Apart from the complexity, there are other problems with using the DCF for small caps:

  • The Small Cap Risk Premium is hard to determine and there is no sure way to know it exists!
  • Small Caps are subject to cyclical risks, which can lead to wrong factor assumptions in valuation
  • It is hard to predict steady returns with young companies
  • Cost of debt can be hard to calculate for Small Caps that are not investment grade or do not have a debt rating assigned to them

In valuing a Small Cap, it helps to understand intangibles first. It is a case-based approach that takes into account promoter quality, market size, competition, input prices, the balance sheet and scuttlebutt among many other factors.

In short – investing in small caps is a little like Venture Capital investing. Numbers are needed for comfort, before you take that leap across the void of permanent Capital Destruction.

The Simplest Free DIY Valuation Model Explained

All good investment decisions are grounded in numbers. The need to do back of the envelope calculations, to determine the right price for a potential investment will often arise in our search for value.

Here’s a link from Invest Excel which offers a free and easy to use valuation tool for download. This post is an attempt on how best to use this free tool to time your investments and gauge whether a stock is overpriced or underpriced using the Price Multiple model.

Pros of this Price Multiple Model:

  1. Ease of use. This is the simplest of many valuation methods out there.
  2. It works best in the current bull market where price multiple ratios like P/E are a fair estimate of how a stock is rated or priced by the market.

Cons of this Price Multiple Model:

  1. Price Multiples are forward looking and can be misleading, depending on the stage of the company’s business cycle and whether we are in a bull (high PE) and bear (low PE) phase.
  2. The model does not take growth in cash flows into account for calculating the fair price of a stock.
  3. The model is sensitive to assumptions, increasing the scope of midjudgment.
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Table A : The Inputs

This is the “input” table of the excel sheet.

What you put in here are the factors that will determine the numbers you get in the subsequent “output” tables.

EPS in Year 0

This field is the value of EPS, or Earnings Per Share of the company as of today. It is easy to get this number by dividing the current market price (P) by the P/E ratio, both of which are publically available. Simple math.

EPS Growth Assumption 

The first of many assumptions the model requires to calculate fair value. This is an estimate of how much you expect the Earnings Per Share (The E in P/E) from the last step to grow incrementally year on year. There are a few considerations in accurately estimating this percentage growth:

  • EPS can vary due to seasonality and stage of the business cycle – and since this cell requires an “average” value, would make sense to take a conservative estimate of EPS growth.
  • I take 20% above, because I factor in operating leverage that I am expecting to kick in from incremental sales of a software product. For a more mature business, like FMCG, I would take a more reasonable EPS growth value (calculated using a regression line or Log EPS)
  • You can also borrow this number from Analyst or Research Reports that calculate estimated year on year EPS growth.

Forward PE Assumption

In the last phase we assumed a growth in E, now we will make an estimate of the growth in the PE (the Price Multiple) itself.

Note that these are independent assumptions, i.e. the percentage of EPS growth year or year that you assumed in the last step will not impact your assumption of the forward PE, or relative valuation, the company will enjoy 3 years later.

It is called forward PE, because it is an estimate of how you believe the stock will be PE rated going forward, or how it will be valued by the market in the future. Our model uses a 3 year forward PE estimate, i.e. if it is 2017 today, what Price Multiple the market will give this company in 2020.

In the above example, I have assumed the EPS growth to be 20% but forward PE independently to be 30.

There are a few considerations in assuming the forward PE number:

  • The “fair” PE is usually based on how the market rates a particular sector or industry. For instance consumer defensives like FMCG have a “fair” PE rating of 30+ in the current Indian Bull Market.
  • See how the company’s peers are rated by the market in different stages of growth, to arrive at PE rating for your company.

For instance, pure play Software Services companies like Infosys and TCS have a fair PE of about 20 but since I am evaluating a Software Product company – the forward PE would be discounted slightly higher, in line with other product companies like Oracle Financial Services, Ramco Systems etc which enjoy loftier valuations. Therefore, I take the forward PE to be 30 in 3 years.

Current Dividend Per Share

This is the payout per share that you receive from the company in terms of dividend. It is not used in the calculations of the fair price estimates in this model. In my case the company pays no dividends (as it is re-investing all its free cash flows for growth) so I take it to be 0.

Desired Return Per Share

This is what yearly return you desire as an investor, from your investment in this stock.

I am being extra conservative here to be happy with an inflation beating 10%.

Feel free to take a number that matches the % Growth in EPS value or 20% in this case, or alternately, a number closer to the Cost of Equity in India, which is around 15%

Now, having plugged in the inputs in all the above steps, we come to seeing the “output” of the calculations below:

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Table 2 : EPS Growth Estimates

Based on the EPS Growth Assumption that we plugged into table 1 we can see the Earnings per share compounding at a growth of 20% over a 3 year period.

In my case the EPS is estimated to double in 3 years. Sweet.

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Table 3: The Finale

All our hard work pays off in this table, where we see the price is expected to be after 3 years.

If the dividends grow, then you would see the value of the share bumped up further – with the dividend payouts added as well (Zero in my case, so no such bump expected).

The Present Share Value for Good Value is what we call the “fair” value of the stock as of today.

This is calculated based on the returns we expect (10% in my case) and expected share price in 3 years. Since the stock is currently trading at 129, it is at 49% discount to what the fair price of the stock should be. A discount, or value buy!

Hope it helped. This is a very simple and useful model but remain mindful of other factors like cycles, market sentiment and other leading indicators that may disrupt the assumptions made to arrive at a fair value.