Wednesday, July 27, 2016

How to Pick Winning Stocks?

Which are the next great Indian companies? A million dollar question or a billion dollar question depending on whether you are a retail or institutional investor. Some of the best emerging market investors of the foreign institutional kind have filtered through more than thirty countries to zero in on India. Screening sectors come next. Still, the next step, picking great companies for investment is inherently tough as it demands multi-dimensional research across two dozen fundamental metrics. Looking beyond the obvious is lesson number one. How neat it would have been if someone would filter out the noise, crunch the numbers, and condense the disparate data into one single recommendation, an actionable idea that empowers. The challenge is formidable as the only enabler is deep domain knowledge. Tomorrow is already passé in this business, as timing is everything. Success here is staying ahead of the curve to capture the inflection points in time. 

Seasonal Magazine undertook this challenge recently, and here is how we went about it:

When we set out to identify India’s great companies in the making, one thing was sure, we wanted it to be as inclusive of good values as possible. This was not to be about outperformance in any one metric like profit growth or zero debt or stock outperformance. Everything mattered including sustainable employment creation to meaningful corporate social responsibility programs.

Having said that, we should also add that this is not an endeavor to find the largest charitable organizations or the greatest philanthropists around. Business, at its heart, is about making maximum profits that translates to maximum value to its promoters and investors. But we made sure that profit making is not of the mindless kind, but coupled with maximum value to all stakeholders including employees and smaller suppliers and associates, and, of course to the society around. 

Why Respect for Equity is most important:

Our research team started off with Respect for Equity, as it is one of the most fundamental values of an enterprise, but which is getting eroded rapidly thanks to the new principle of continuous equity dilution followed by large startups especially e-commerce firms. At its heart, Respect for Equity implies only a few things, but which are getting increasingly difficult to follow.

Firstly, it accords value to how big an enterprise can be planned by how small an equity capital base. Many big-pocketed industry groups can fund many businesses from scratch and make them profitable brands, if they are determined to do it. But at what cost is the issue.

Take Tide Water Oil for instance. The maker of Veedol brand of automotive and industrial lubricants. Not a large company by any measure with an annual revenue run rate of around 1000 crores rupees and profit run rate of around 100 crores. Of more importance, perhaps is the fact that it is a noted brand among consumers with instant recognition across India in its sector.

The beauty of Tide Water Oil is that it was built with an equity capital of not even 1 crore rupees. Yes, until recently (when it went for a 1:1 bonus issue) its equity capital was just 85 lakh rupees! Such tiny equities translate to large earnings per share (EPS), which expands the share price like nothing else can. That is how investors in Tide Water Oil witnessed a nearly 40 times share price surge within the last 12 years.

Incidentally, Tide Water Oil is a Joint Sector firm, with the Public Sector Undertaking Andrew Yule & Company being its promoter. But more such tiny equity wealth creation sagas can be found in the pure private sector than in PSUs, with ready examples being the likes of MRF, Eicher Motors, Bosch, Kitex etc.

The second factor with regard to Respect for Equity is how reluctant is a business to expand its equity and therefore dilute its earnings per share. Businesses are always aiming for growth and the greatest temptation for any promoter is to invest so as to scale up. And what if there are large investors willing to invest huge funds into promising businesses? If the promoter is willing to dilute his holding for fresh money coming in, his existing public investors almost follow suit, and that is how this problematic culture of scant respect for equity has developed in India. Dilution at the drop of a hat.

But what if there is another way out to scale up without expanding the equity and causing dilution? Eicher Motors is a case study in this regard. During the last 10 long years, Eicher’s equity has remained a modest Rs. 27 odd crore rupees. Didn’t Eicher scale up reasonably within these 10 years? Forget the sales that shot up by six times and even the profits that shot up by 20 times, what was most impressive about Eicher’s scaling up was that it invested big time in three different ventures – Royal Enfield Bikes, Volvo Eicher Commercial Vehicles, and Eicher Polaris Utility Vehicles, without adding a rupee to the equity capital base!

The strategy was most impressive as the rapid scaling up was also on negligibly small debt, and that is what sent the share price of Eicher soaring by a 100 times within the last ten years.

How Eicher could do this is simple enough to understand, but difficult to practice for many companies. Without investing through equity or debt, Eicher ploughed back a significant portion of its earnings back into the company’s various divisions and joint ventures to fund expansion and drive growth. Also of note is the fact that it raised funds by getting out of many businesses including its legacy tractor business, so that the money could be better utilized in promising divisions like Royal Enfield and Volvo Eicher.

All the while, it also maintained its strategy of paying decent dividends, if not generous ones.

While Respect for Equity directly translates into steadily rising EPS (and thus stock prices) in growth phases, there is an added advantage to this simple strategy. During sluggish phases for growth, it delivers a level of comfort to the public investors that high levels of corporate governance (or transparency) as well as financial prudence is followed by such companies.

Companies with Respect for Equity also enjoy better valuations or rating in the market by way of higher P/E and P/BV multiples, while the reverse is true for serial diluters. While not a rule, it is generally observed that both transparency and financial prudence suffer in companies where there is little respect for equity. Such companies are often thought of as taking the easy way out in raising finances, and even worse as cutting corners when it comes to the transparent usage of funds.

Why low Debt / Equity is important:

After considering Respect for Equity, our research team has considered the crucial Debt / Equity ratio. Once upon a time a D/E ratio of 0.5 was venerated as the optimum level to which companies can go on leveraging without getting into trouble. It was pure commonsense too, as what it meant was any company could take on significant debt, even up to half of their Networth or Book Value (Current Shareholders’ Equity), which is equity capital plus preference share capital plus reserves from past years’ profits.

What this means is better explained with an example. GMR Infrastructure, during FY’15 end, had a Networth of Rs. 7894 crore. It could have raised debt of up to Rs. 4000 crore for all its ambitious projects, by adhering to a 0.5 Debt/Equity level. That is not a small sum for an infrastructure player that registered only Rs. 11,000 crore in sales during FY’15. But only if you are tracking GMR closely would you know what they did against this prudential limit of Rs. 4000 crore. By the end of FY’15, their total debt was over Rs. 42,200 crores! More than ten times the prudential limit, or a D/E of 5.35 times!        

Unsurprisingly, GMR’s FY’15 bottomline ended in a staggering loss of Rs. 2161 crores, driven by a senseless annual interest cost of over Rs. 4000 crores. The chain reaction is even more damaging. Such losses erode Networth even more, thereby inflating Debt/Equity figures further, and that is how companies end up with a risk of insolvency due to mounting debt.

Now, there are fans of every such debt-ridden company, including GMR, who would project the kind of mammoth projects GMR has undertaken, and what turnarounds in a  couple of such projects would mean to the company. True, GMR’s projects are quite impressive, including the two state-of-the-art airports it has constructed in India, and turnarounds, stake sales, or IPOs of these SPVs can make a difference.

But ‘when’ is the crucial question before its public shareholders. The stock price is already down from its life-time high of Rs. 131 during 2007 to Rs. 12 now, a fatal loss of over 90%, and there is no respite in sight for investors, as the debt that the company once ambitiously took on is not going anywhere in a hurry.

Massive debt takers can still be ‘great’ companies for some stakeholders like employees and associates, but they are seldom great companies for all stakeholders including their public investors. The reason is simple enough to understand.

The propensity to take on debt, more debt, and still more debt doesn’t come naturally to all promoters or managements. Just like in the case of individuals taking personal loans, where everyone is not comfortable with the idea of taking personal loans that cross the limit of one’s total net worth, many promoters are wary and uncomfortable with such massive debt intake.

So, how do many companies end up in that way? Broadly speaking there are two kinds of promoters falling for this debt trap. One is the well-meaning type, who gets a little over-ambitious during bull runs and low-interest periods (those two phenomena happen almost always simultaneously!) and goes in for massive debt levels flouting the prudential limits for D/E like 0.5 or even 1.0. Then the low-interest period ends, so does the bull run, and he starts getting into trouble.

The other type of promoter going in for high debt is someone who has already figured out how to make personal gains by dipping his hand into the debt funds, and cooking the books to show that everything is neat and clean. He takes more and more debt whenever it is available, and steals more and more from it, as much as he can without upsetting the applecart that banks are supposedly funding to its safe destination. On the long term, he figures out that he can escape even if everything goes wrong and his limited liability company gets liquidated.

However, the sad thing is that even the first-type or the well-meaning promoters too silently fall into stealing from the debt pool eventually, as there is no other go to keep the show running. The interest and penal interest keep mounting, one debt restructuring leads to nothing but next round of restructuring, and there you have the vicious cycle of debt’s death grip.

That is why RBI under Dr. Raghuram Rajan recently decided that enough is enough, and that the only way to save the banks as well as these companies is to divide their debt into two parts – serviceable and non-serviceable. Approximately speaking, an annual interest outgo that is lower than a company’s EBITDA (Earnings before Interest, Tax, Depreciation, & Amortization) signals fully serviceable debt, while anything above that signals that a component of the debt is unserviceable, and the new RBI norm encourages companies and banks to convert that unserviceable portion of debt (which should not be more than 50% of total debt) into an equity stake in the company favouring the bank.

A further interesting observation with regard to Debt/Equity level and Respect for Equity is that companies that falter on one of these crucial metrics tend to falter on the other too. Of course, it should be a no brainer, as fresh money coming in at frequent intervals without much accountability is a lure hard to resist for such promoters. Often, the modus operandi is that fresh equity investments are sought from non-promoters via QIP, stake sales etc to not only bring in funds via the equity route, but to jack up the Networth so that D/E levels can accommodate even more debt! And the reverse too is often attempted – i.e. to rationalize high debt, and to bring down D/E down, equity expansions are attempted whenever possible, under one pretext or other.

What goes wrong when Respect for Equity and low D/E are violated:

What goes so wrong for stakeholders when norms like Respect for Equity and low D/E are flouted by companies? Well, in fact, nothing much goes wrong for many stakeholders like promoters, preference share capital holders, employees, suppliers, vendors, distributors, and even nothing goes wrong for its lenders. At least until the debt turns into an NPA, bankers are gung-ho with such companies, because every bank loves big, performing credit. Unscrupulous bankers are even often seen encouraging bad practices like equity expansion so that more credit can be offloaded to such companies.

The only stakeholder who does get hurt in this circus is the public investor who believes all these tall growth stories by the promoters and falls in love with the company and its stock. The strange thing is that public investors get hurt even when the party is going on fine for others like promoters, employees, and lenders. Needless to add, the party does finally end for all, especially the bankers, and that is when you hear them wondering aloud whether someone is a willful defaulter.    

Coming back to answering our question – what goes wrong for public investors when high D/E and low Respect for Equity are followed – it is pretty straightforward to understand.

At the end of the day, everything has a price, or better put everything has a valuation. Every company out there, whether profit making or loss making, whether having little debt or massive debt, has something called an Enterprise Valuation (EV) which is basically the full price at which the entire company can be bought by say a competitor.

While price-to-earnings (price / EPS) is preferred for valuing profit-making firms, it can’t be applied to loss-makers. However there are multiple ways to value both profit-making and even loss-making companies, like price-to-sales (market-cap / sales) and EV to EBITDA. Even for heavily indebted companies, with heavily eroded market capitalizations, the Enterprise Value (EV) is impressive as it is nothing but market capitalization plus debt minus cash.

Prudent companies slogging along the greatness path in a sector will have Enterprise Valuations dominated by market capitalizations, while serial diluters cum heavily indebted firms in the same sector would have comparable EVs dominated by debt.

So, precisely speaking, what the second type of promoter is saying is only that, “no, we would rather expand the operations and our enterprise valuations through taking more and more debt and by expanding our equity because that is more ‘convenient’ to us because we get to handle all that money.”

It is a far cry from the other model, the great company model, where the promoter is basically saying that, “no, we would scale up and make ourselves more valuable (higher enterprise value) only through minimum equity and growing market capitalization (soaring share price) because we are not interested in handling all that unnecessary, risky debt as well as bloated equity.”

Mind you, from a ‘convenience’ point of view, the equity expansion and debt expansion route is highly attractive for promoters or management as they get to handle all that money, whereas in the great company model, the promoter should sell a part stake through a prior publicized move to take advantage of the growth in share price which can’t be carried out often due to the negative sentiment attached to it, as can be seen from the recent cases of Kaveri Seeds and VRL Logistics, and even in more respected wealth creators like Eicher Motors and Page Industries.

While it is difficult for such prudent promoters to sell stake often, the same can’t be said of their public investors, who can always take advantage of the soaring share prices in such companies. In other words, growing Enterprise Valuations primarily through rising market capitalizations is a more democratic or equitable wealth creation route as public investors too benefit from it, whereas eyeing a higher EV through higher equity and higher debt is unadulterated selfishness by such promoters.      

Why Promoter Holdings & Pledges matter a lot:

Two other metrics that Seasonal Magazine is employing for identifying great companies, deserves special mention at this juncture, viz. Promoter Holding and Promoter Pledges. While internationally, and especially in developed markets, a high promoter holding is the exception rather than the rule, the reverse is true in a developing market like India dominated by family promoted businesses even in the listed sphere. Additionally, high promoter holding can even be looked upon as a negative in developed markets, whereas in India it is a definite positive factor to look out for.

Emerging great companies in India should ideally have promoter stakes upward of 50%, and even more importantly, the promoter stake should remain stable with no frequent down revisions. Drop in promoter stake happens through direct stake sales to institutional investors, or in open market to unidentified public investors, or through equity expansion/dilution routes like QIP. A steadily falling promoter stake even if it is from 60-70% or more to lower levels, especially sub-50% levels is an early warning signal to watch out for. In other words, if the promoter thinks that a significant portion of his personal funds are better taken out from the company and invested elsewhere, it signifies that the management’s outlook for the business is poor.

There are three caveats, however. One is that tiny stake sales by the promoter to meet his personal expenses should be ignored. Secondly, there are certain mature companies even in the Indian market that thrive for its public investors too, even with low, negligible, or zero promoter stakes. Famous examples include Infosys, L&T, ITC etc. But they should be treated as exceptions rather than rules; most other Indian companies are better off with a high and steady promoter stake. Thirdly, most private sector banks like HDFC Bank, ICICI Bank, Federal Bank etc too have zero or negligible promoter stake due to regulatory constraints.

Closely connected with the concept of Promoter Stake should be the lookout for Promoter Pledges. Since promoters can’t sell their stake to a great degree and still retain control of their companies, lenders like banks, NBFCS, and certain market intermediaries offer them loans against stake pledges. While it appears harmless at first looks, as a difficult-to-monetize asset is easily monetized under this route, the potential for huge harm lies in the fact that the asset under consideration – shares – is the most volatile asset that can be pledged.

If share prices move up, everything is fine, but if share prices breach a certain threshold level, and the promoter doesn’t make good the loss of the lender by pledging more of his shares, the lenders are free to dump the collateral (shares) in the open market to try and recover their loan amount. It will cause a sharp fall in the share price, often breaching the 20% circuit limit and there have been instances where 50% of a stock’s value was eroded in a day! Promoters who pledge a significant portion of their shares (say, more than 25% of their stake), resort to it despite knowing everything about this risk, and expose themselves as having scant respect for their own stake as well as other investors’ money,  which is a warning signal like no other.

The only two caveats here are minor pledges by promoters to meet personal needs, and reasonable pledges some promoters undertake in favour of the company, to avail facilities like enhanced working capital.

Why Dividend Yield should never be overlooked:

The next most important metric this Seasonal Magazine study has considered for identifying great companies is the Dividend Yield offered by them. It is perhaps the greatest irony of stock market that most investors who eventually switch from fixed income instruments like bank fixed deposits, bonds, and NCDs, into equities or mutual funds, seeking faster capital growth, disregard their core competence in assessing an instrument by its yield!

To cut a long story short, what is the assurance that a public investor gets when he puts his hard earned money into a company’s stock? All other stakeholders in a company have assurances galore – employees have salaries, vendors have contracts, and promoters or management enjoy heavy remunerations. In contrast, a public investor in stock has no such assurance that the share price would keep rising. Even worse, it may not even hold at his investment level and may even slip considerably causing huge investment loss.

Only one assurance remains for public investors, and that is spelled dividend. Even that is not a real assurance as companies can change dividend policy any day. But there are several companies that won’t change their dividend policy overnight for obvious reasons like upsetting the market, and for less obvious reasons like dividends being the primary source of remuneration for even the promoters.

But when one looks at many great companies today, you won’t find great yields like 5% or more. However, there are many early investors in such companies that enjoy a yield of not 5% or 10%, but much much higher than that, as each investor’s yield is calculated at the stock price at which their investment happened.

That is why, even today, one of the best strategies to identify emerging great companies – not current great companies per se – is to look at their dividend yield. When a company is willing to share real cash - your rightful share of the profits - with you on a regular basis, that is something to appreciate.

Dividends also provide great cushion when a company’s growth enters cyclical downturns. When share prices of such dividend paying companies correct, their yields surge, and new investors come in who are specifically looking to lock in to the investment at great yields that beat even bank FDs or bonds. So, eventually the share price too appreciates in the medium to long term.

A recent example of this phenomenon has been the leading gold loan NBFC, Manappuram Finance. On 10th September 2015, when Manappuram stock had a 52-Week Low, its effective dividend yield was an astonishing 9%, which beats FDs squarely. Prudent investors started picking the stock steadily for this yield, and fortunately the business also turned around, and today such investors are enjoying a capital appreciation too of 3X within 10 months when the stock soared from 20 rupees to 60 rupees.

But the real power of dividends can be seen from the fortunes of long-term investors in Manappuram who are getting Rs. 4 lakh as dividends alone each year for the 1 lakh they had invested in 2005. That is dividends alone, while the capital appreciation has been over 80 times during these 11 years. That is how dividends make great companies.                    

Other metrics that shouldn't be ignored:

Some of the other metrics that Seasonal Magazine has employed in identifying emerging great companies of India include FII & DII Holding, Growth in Margin, Price / Book Value, Price / Earnings, Profit Growth, Profit Margin, Return on Assets, RoCE, Return on Equity, and Sales Growth.

1 comment:

  1. Outstanding article which clearly explains what to look while investing for wealth creation.



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