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Archives for January 2013

Hero MotoCorp: Value Buy or Value Trap?

Hero MotoCorp Ltd. (HML) has been one of the biggest wealth creators in the Indian stock market history.

Over the last 10 years, the stock has returned around 24% per year, which is an amazing long term average.

On the business front, the company has been at the forefront of the 2-wheeler revolution in the country. Since 2001, it has been the largest 2-wheeler manufacturer in the world.

As far as its financial performance is concerned, its sales and profits have grown at average annual rates of 18% each over the past 10 years.

This growth has been without any damage to the balance sheet. Debt remains minimal, its working capital cycle is small, and cash generation has been tremendous.

In fact, the company has not seen a single year with negative free cash flow over the past 15 years, which in itself is commendable.

So the past ten years, as a whole, look beautiful.

Now, as an investor, it is easy for me to draw patterns from the past – especially if the past has been a great one – and expect the future to be the same.

This pattern-forming skill gets enhanced when you work too much on the excel sheet, which gives you the flexibility to “tweak” future growth rates any way you want!

Anyways, here is a view an analyst friend of mine recently shared with me about HML – “A company that has grown its sales and profits at 18% per year across market cycles is bound to do good in the future. If not 18%, even if it achieves 15% growth, I can earn a handsome return on my investment.

“You see the balance sheet is clean,” he continue, “…the cash flows are solid, the brand is well-known, and now the valuations are also decent.”

HML’s P/E, by the way is at around 16.4 times its trailing 12 months earnings, which is almost near its average P/E for the past three years.

As compared to this, its closest competitor Bajaj Auto is trading at almost 20x P/E, or at a 22% premium to the former’s valuation.

So, on a relative basis, HML looks much cheaper than Bajaj Auto.

“What is more, HML is near its 52-week low price,” my friend told me. “I have thus bought the stock and expect to make a lot of money from it!”

Now, I am not a sadist. But my fried may start hating me when he reads what follows next.

Is Hero MotoCorp a value trap?
If you have been reading me for some months now, the right side of your brain tells you – “Oh, you know the crap Vishal writes when he analyses companies! You’re already reeling in deep losses from his ‘recommendation’ on Opto Circuits. And now, he says that a great stock like HML can be a value crap…oh sorry, value trap!”

But then, the left side of your brain tells you – “What’s wrong in knowing Vishal’s reasoning for the same? He’s always told you to do your own research before buying stocks because it’s your responsibility as an investor. So, at least listen to him and then do what you think is fine.”

Now I can see you holding both your brains together, and then reading out the three reasons I, Vishal Khandelwal, think HML can be a value trap.

Here I go…

1. Exit of Honda, and especially when it was driving all innovations at HML, will continue to be painful for the latter.

Just look at the history of TVS Motor. After the exit of Suzuki from a joint venture, the company took many years to find its bearings.

I think it will be worse for HML as Honda has already become a strong name in the motorcycle market in India, and is leaving no stones unturned to shake up the hegemony of HML.

HML is also facing immense competition from Bajaj Auto, which has emerged as a more profitable 2-wheeler company, and thus commands a greater pricing power than the former.


After Honda’s exit, HML has faced trouble in retaining its core customer group. This I think will remain a challenge, again led by rising competition and better product launches by rivals.

2. HML is not defending its leadership. As Mr. Chetan Parikh highlighted in the second part of his interview, the company has not launched any marquee models for long. Splendour was HML’s trump card when I was in college, and it’s still the trump card.

Bajaj was guilty of doing this – not defending its leadership – with its Chetak model years ago, and paid a heavy price of it. In a market that is even more competitive and fast evolving, HML’s slow steps can cost it heavy.

What is more, HML, with a 32% share ,does not have a market leadership in the most vibrant segment of the Indian motorcycle market – the 125-150cc range. In fact, Bajaj Auto and Honda are tightening the noose here.

In the premium range (bikes more powerful than 250cc), Hero is a very small player anyways.

The company is now also getting squeezed in its dominant business of selling entry-level bikes (75-110cc), where it has a near-70% (and declining) market share.

Sales here are getting impacted for two reasons:

  1. Despite high interest rates and rising fuel prices, but due to improved income levels, more first time consumers are settling for the middle-of-the-road bikes (110-125cc) instead of entry-level bikes (75-110cc). Bajaj Auto and Honda are dominant players in the former category.
  2. Scooters, which carry engine power comparable to entry-level bikes but with a much cheaper price tag, are gaining market share. HML’s scooter market share at 16% is just half of Honda’s and isn’t serving a major purpose for the former.

3. HML is losing its moat. After the exit of Honda in FY11, HML has raised its spending on advertising. In other words, it is resorting to spending more and more money to protect its moat, which is weakening.

Led by higher advertising costs, the company’s profitability is on a consistent decline. This – declining margins – is one of the key factors to identify a potential value trap.

With competition intensifying, rising advertisement spends, and no major development on new launches, margins may remain under pressure. A lower margin will also reduce the company’s pricing power.

So, what to do with HML?
Considering the above factors, I believe HML’s valuations at 16.4x training 12-months earnings, which seem cheap and especially in comparison to Bajaj Auto’s valuations, are not so cheap for the kind of prospects I see for the company over the next five years (at least).

Also, my intrinsic value calculations (you can see my last StockTalk report for greater discussion on the methods I use) suggest that the intrinsic value for HML (after adjusting for 25% margin of safety) is around Rs 1,350. This is around 25% lower than the stock’s current price, which suggests that I value at the current price anyways.

As far as HML’s business is concerned, any reduction in interest rates and an improvement in consumer sentiment (especially in the rural areas where HML’s entry-level bikes are in greater demand than in urban areas) can help HML return to a high growth part in the future, competition poses a huge risk for the company.

I see intensifying competition hurting HML on two major fronts:

  1. Margins will remain weak as it continues to spend money towards advertising. Competition is eating into its market. Will HML’s profit margin recover sustainably? Well, that is a “too-hard” question. You should avoid situations where you have to answer this question.
  2. Sales growth to taper down as first time consumers shift to cheaper but equally power scooters, or to more powerful but slightly expensive bikes than what HML sells.

The company will also be spending a large part of its cash flows towards R&D (for most Indian companies, R&D is a sophisticated term for T&A, or trial & error) in a bid to come out with marquee models, so dividend may no more be a lure to buy the stock.

In all, I think HML has the potential to become a value trap unless it gets its act together. At least that is what the direction of its business is hinting at.

But please don’t believe me!
With the growing influence of stock analyst recommendations and the proliferation of financial bloggers, there is good reason to question their usefulness.

Here are two reasons you must doubt my above analysis of HML:

  1. Your level of conviction differs from mine. While I may be convinced based on whatever little analysis skills I have, that HML has the potential to become a value trap, you must not based your conviction on mine. This is simply because of the second reason.

  2. I make mistakes…and a lot of them! I don’t have a flawless process of analysing companies or stocks. I have a process that remains in evolution, and thus I am prone to make mistakes. But that must never hurt you because you must take my analysis with a pinch of salt, do your own research, and then add your won spices to the story. Then, if the story turns sad, please do not blame me for you ate your own cooking. 🙂

Whatsay?

Value Investing, the Chetan Parikh Way – Part 2

I recently had the privilege of meeting one of the highly regarded value investors in India, Mr. Chetan Parikh in his office in Mumbai.


Mr. Parikh is a director of Jeetay Investments Pvt. Ltd., a portfolio management firm. He is also associated with Capitalideasonline.com, a website dedicated to investor education.

Here is the first part of his interview.

In this second part, Mr. Parikh enlightens us on the mental models and checklist he uses to short-list companies for investment.

Over to Mr. Parikh.

—————-Art of Investing Workshop 2013————-
The 2013 journey of Safal Niveshak’s Art of Investing Workshop has begun. You can register to attend the Workshop in Kolkata, Bangalore, Chennai, or Hyderabad. Seats are limited, so please hurry!
————————————————————————————————

Safal Niveshak: Please explain the mental models you use to short-list companies for further research and to make your investment decisions. Please talk about some multidisciplinary models that have worked well for you in investing and life in general.

Mr. Parikh: It is paradoxical that to make sense of messy reality one has to deal with the highly abstract.

Any comprehension of any facet of the world, be it physical, natural or sociological needs insights (I hesitate to use the word theories) or more generically, mental models.

These mental models reduce the overwhelming complexity of reality to its crucial aspects which helps to make sense, like the equivalent of having specifications in engineering.

Use mental models to deal with complexity
Mental models are a powerful way of dealing with complexity.

It was Albert Einstein who stated…

The … goal of all theory is to make the …. basic elements as simple and as few as possible without having to surrender the adequate representation of ……..experience.

Furthermore, reality is multi-faceted (remember the blind men and the elephant) which also means understanding the interactions between these mental models as applied to the situation or problem being studied. This diagnosis should lead to more effective action.

There must be many ways on how one can use mental models, but I prefer to make my approximations of reality using simple diagrams drawn from systems theory as they better map the interactions and connections between the disparate mental models that find their place in those diagrams.

Whilst calculus teaches how to differentiate and integrate mathematically, I think that the mental models approximations help to differentiate and integrate conceptually.

Interactions can change depending on situation being studied. Take salt, for instance. Sodium and chlorine have a single type of interaction in all environments, but not hydrocarbons comprising of hydrogen and carbon.

For as the Sufi story goes: “You think that because you understand “one” that you can therefore understand “two” because one and one make two. But you forget that you must also understand “and”.”

It is when penciling in feedback loops that a lot of “why” and “what if” questions arise and the answers can come only through understanding, as distinct from information which is copiously available today and usually answers the “what” question and knowledge which answers the “how” question.

Of course, one needs the “whats”, “hows”, “whys”, and “what ifs” to answer the overarchingly practical “What the hell is going on here?” question.

An investor should be looking at possibilities in the future and the behavioral possibilities of any system or situation being studied depend on how structures and conditions change.

In many cases this makes prediction impossible and leaves a reasonably small subset of companies where the range of possibilities is not wide.

Alternatively, the price should have discounted the worst possibility. Given that understanding is not easy, given that information that does not fit our mental models is often discarded, we are often blundering “satisficers” according to Nobel Laureate Herb Simon.

“Bounded rationality” and behavioral biases often makes investors and managers view things in a manner that may not lead to desirable outcomes.

I have through my experience also learnt that there is a difference between my approximations of reality and reality itself. It has usually been based on…

  1. Ignorance masked as “knowledge”;
  2. Focusing too much on the short-term at the cost of trying to understand the long-term behavior and structure;
  3. Extrapolating in a “non-linear” world;
  4. Taking simplifications too far; and
  5. Applying the wrong mental models.

In short, faulty understanding of reality itself. For as G. K. Chesterton, the famous author, wrote…

The real trouble with this world of ours is not that it is an unreasonable world, nor even that it is a reasonable one. The commonest kind of trouble is that it is nearly reasonable, but not quite. Life is not an illogicality; yet it is a trap for logicians. It looks just a little more mathematical and regular than it is.

The only antidote I believe, to this is to remain a learner and to become what psychologist Don Michael calls “error-embracing”.

An experiment in investing
Here is a thought experiment on investing (adapted from a wonderful book, “Good Strategy Bad Strategy” by Richard Rumelt).

Imagine that you have found Aesop’s goose and it is not going to die, not going to mate, not going to eat or fall sick and will keep laying golden eggs every year worth Rs 1 crore.

There are no taxes and interest rates are to remain constant at 10 percent. You decide to encash your good fortune and sell the goose for Rs 10 crore to a gold miner.

Whilst the goose does have a competitive advantage (zero cost of production and a unique asset) in the gold mining business, the new owner will not become richer with the purchase. Unless a way is found to get the goose to lay more than Rs 1 crore worth of golden eggs every year.

Competitive advantage (or an economic moat) by itself does not lead to wealth creation. Only a growing competitive advantage (deepening and widening the economic moat) does.

Of course, if you were fearful and the buyer was greedy, you could have sold the goose for less than its economic worth and value would have been created on purchase, but let’s not assume irrationality.

Good investing comes from good business analysis more than good financial analysis.

Mental models that help to understand business strategies that lead to growing competitive advantage should be useful to investors.

Here are some from biology although there are many from other disciplines which I’m not listing.

a) Evolution as an algorithm: Innovation, formula that through trial and error creates new designs; Competition + variation + replication = natural selection + evolution; “Differentiate, select and amplify” resulting in novelty, knowledge and growth; Economic evolution dependent on physical and social (method of organization) technologies; In evolutionary systems, statsis will result in extinction; Economic equivalent of mutation and sexual recombination are business plans based on risk, relatedness and time horizon; Swarm intelligence.

b) Punctuated equilibrium: Removal of “keystone” species from ecosystems; Disruptive technologies, technology S-curves; Extrapolationism is not a good theory.

c) Co-evolution: Arms Race (Red Queen races) and thus the difficulty of maintaining sustainable competitive advantage; Organizational resources and business plans; Symbiosis and “switching costs”; Eras and stages of co-evolution; “All forms of life make one grand system” -Charles Darwin

d) Fitness: Designs are fit if they survive and replicate under the constraints of environment; Fisher’s fundamental theorem – average fitness of a population grows from generation to generation; The experience curve.

e) Adaptation: Evolution produces designs that reflect new selection pressures; Speciation; Usually resisted due to delusional optimism, psychological denial and loss aversion; Organizational structure – hierarchies, Skunk Works; Cultural norms and inertia.

f) Industry clockspeed: Fast clockspeed species have extremely short life-cycles; Sustainable advantage is a slow-clockspeed concept; Fast – clockspeed industries tend to generate hedging strategies.

g) Genes: Business genes or practices that perform the same role as genes in biology; Information stored in “organizational memory” and passed on between individuals and firms; Relationship between genes and organisms typically complex and indirect; Genetic engineering has begun the process of short cutting the process of species evolution, proactive chain (organizations, technologies, capabilities) will shortcut industry evolution; Business double helix and cycles between vertically integrated industries and horizontally disintegrated industries.

Let me elaborate. Differentiation is vital to evolution. As Robert Goizueta, the late CEO of Coca-Cola said: “In real estate it’s location, location, location. In business it’s differentiate, differentiate, differentiate.”

There is an absolutely amazing presentation by Mr. Rajiv Bajaj of Bajaj Auto which is one of the clearest expositions of good business strategy that I’ve come across.

I’m grateful to Mr. Darshan Engineer and Mr. Dhaval Shah of Siddhesh Capital Market Services Pvt. Ltd. for drawing my attention to this presentation and link.

There are some mental models from biology that one can apply to this presentation although there are many from other disciplines too.

Here are some of them from the presentation. I’ll like to thank my colleague, Mr. Anish Jobalia, for making the notes.

Scooter strategy (Speciation)
‘Speciation’ is the evolutionary process by which new biological species arise. ~ Wikipedia

  • When we make a scooter, it has to come out of the same center from which comes the motorcycle. If we create a completely different platform, it won’t work
  • One of the key difference between scooter and motorcycle is: In a motorcycle, one has to change gears, in a scooter one doesn’t have to
  • Bajaj has to be paranoid about leadership in motorcycles. What if tomorrow someone made a motorcycle where you didn’t have to change gears
  • If scooter technology is put in motorcycles, it can be done but price to pay is fuel economy
  • Technology of ability to deliver high mileage as well as no gear technology would be meaningful to motorcycles
  • Once we have that technology, it’s a piece of cake to make a scooter. This way we can make a scooter with a high mileage
  • If we make a scooter, it will come from womb of a motorcycle. Then it will be de-risked completely

Three wheeler and RE 60 strategy (Speciation)

  • Bajaj is the largest 3 wheeler maker globally
  • As a leader, one has to attack oneself, strengthen oneself and guard oneself – Defense strategy
  • People who use 3 wheeler deserve much more like a 4 wheeler : water cooling, fuel injection, steering wheel, seat belts etc
  • Better 3-wheeler is a 4-wheeler
  • Provide it at the same cost structure of a 3-wheeler
  • It takes nothing to make a 3-wheeler (no high capital, no technology)
  • Idea is to create a entry barrier to the high EBITDA business so that nobody would be able to copy the technology, certainly not China

ASEAN market strategy (Co-evolution)

  • Entered Philippines and Indonesia 6 years back
  • Approach was different in both markets: In Philippines went as Bajaj but along with Kawasaki because it already had the network while in Indonesia went by themselves
  • Result was that in Philippines they are market leader (45% market share) while in Indonesia merely 2% market share
  • Tie up with Kawasaki was to overcome the first mover disadvantage
  • In Indonesia, people do not come into the showroom. Only way to reach them is through mass media
  • To overcome this disadvantage, had to find a clever entry strategy i.e. Kawasaki

KTM Strategy (Co–evolution)

  • We never pursued KTM for technology
  • Started working with KTM in 2008 and by 2011, Bajaj had finished designing, manufacturing and shipping them back to Europe
  • Chose to invest in KTM (47%) for guerilla marketing
  • Bajaj is trapped in a value for money proposition. People would not buy the best of the motorcycles from Bajaj priced at a premium
  • So invested in KTM

Hero as a competitor (Punctuated Equilibrium?)

  • Biggest mistake Hero is making is that they are not defending their leadership
  • Splendor has remained static for too long
  • Hero thinks their brand is ‘Hero’
  • Have to do something about the design, performance and price
  • This is what happened to Chetak 15 years before. One day world moved past Chetak

Royal Enfield – Siddharth Lal (Fitness)

  • Was clear from start that he would never participate in mainstream
  • Strategy was to be a niche player and employ a guerilla strategy
  • Never acts like a leader

Mr. Charlie Munger, the father of the “mental models” approach to thinking, once said: “Those who will not face improvements because they are changes, will face changes that are not improvements.” This is what evolution is about.

Safal Niveshak: How do you typically find ideas and what is your selection process before an idea gets added to your portfolio? What types of questions are on your investing check list?

Mr. Parikh: The first part of the question has been answered in my previous interview) and on Jeetay’s website.

We have different checklists depending on whether we are evaluating a potential purchase or whether we are reviewing an existing holding.

We would tend to emphasise business strategy more for a company with “moats” and catalysts and valuations more for the Grahamian sort of bets.

Broadly the sort of questions would test our understanding about…

  • Business;
  • Its strategy in relation to its competitive advantage and industry structure;
  • Its operating efficiencies and operating leverage;
  • Its capital structure;
  • Financial analysis with a lot of emphasis on cash flows and balance sheet; the management – competence, integrity and compensation;
  • Corporate governance and history of capital allocation.

Whilst evaluating the opportunities, we are looking for downsides.

Finally, if we think we have understood the business, we try to figure out the price we are willing to pay.

Wit, Wisdom, Charlie: Elementary Worldly Wisdom from Charlie Munger (Issue #7)

This post is authored by Puneet Khurana, a Safal Niveshak tribesman.

Today I discuss the human trait that, despite all its glory, has lead to disastrous consequences for many individuals and societies and specifically in investment world.

In fact, if there is one trait which, even though I do frequently observe in successful people in various other human endeavors, is very rare to find in the top strata of investing community.

In Munger’s speech, he calls it…

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Is It Ethical to Invest in Stock Market?

Here is a comment I received on a recent post from a tribeswoman.

Vishal, I have been reading your articles for a while. You come across as an open-minded, sincere and conscientious person. And since you are also spiritually inclined, I have one question for you: Is it ethical to invest in stock markets?

My argument is: The basis of capitalism and the industrial economy are rooted in principles that are often conflicting with all the spiritual ideals that you have presented.

The kind of business monopolies that Buffett and Munger love are often exploitative, psychopathic monsters that intensify the rich-poor gap by creating concentration of wealth.

And how about the harm caused to the ecology because of use-and-throw products, concentration of resources, reckless exploitation of nature and dehumanization of people.

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The Most Important Investment Letter You Must Read Now

One of the few investors Warren Buffett respects a lot is Howard Marks. Marks is the CEO of Oaktree Capital and is one of the most famous investors who manages to keep a low profile, despite managing almost US$ 90 billion.

Marks is also the author of an amazing book – The Most Important Thing: Uncommon Sense for the Thoughtful Investor. In its ultimate praise, Warren Buffett writes, “This is that rarity, a useful book”.

Apart from the investing gems he has shared through this book, Marks also writes regular memos for investors where he outlines his investment philosophy, in line with what Buffett does via his annual letters to shareholders.

Here is what Buffett has to say about Marks’s memos – “When I see memos from Howard Marks in my mail, they’re the first thing I open and read. I always learn something…”

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Value Investing, the Chetan Parikh Way – Part 1

I recently had the privilege of meeting one of the highly regarded value investors in India, Mr. Chetan Parikh in his office in Mumbai.


Mr. Parikh is a director of Jeetay Investments Pvt. Ltd., a portfolio management firm. He is also associated with Capitalideasonline.com, a website dedicated to investor education.

He had obtained his MBA from the Wharton School. He had written for ‘Investment Week’ which was a popular weekly financial publication in India and developed a statistical model for them. His writings have been published in Business Standard, Business World, Economic Times and Business India. He has been rated as amongst one of India’s best investors by Business India. He is a visiting faculty member of Jamnalal Bajaj Institute of Management Studies, Mumbai.

Like my meeting with Prof. Sanjay Bakshi, this meeting was also like a dream come true for me, having met a guru who has been a great teacher in my investing pursuits over the past few years.

What follows below is Mr. Parikh’s answer to just a couple of my questions. I will publish the entire interview in parts.

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Wit, Wisdom, Charlie: Elementary Worldly Wisdom from Charlie Munger (Issue #6)

This post is authored by Puneet Khurana, a Safal Niveshak tribesman.

Few years back, while buying a book on Amazon, I ended up buying two more books along with the intended purchase.

It was due to a feature of Amazon, which tells you what other buyers have bought along with the book you are trying to purchase. I never heard of these books earlier but after few more clicks, I was convinced enough to buy and hence my purchase.

Little I knew at that time, that psychologists have a special term for the kind of behavior I just displayed. It’s called…

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My Stock Market View (and a Prediction) for 2013

Readers who follow me of Facebook or Twitter know that I’ve been sounding a tad bearish in recent times.

Some have ever termed me a permabear* for my thoughts on the near term future of the Indian economy and the stock market.

While I am not into the game of predicting the future of stock prices – near term or long term – I occasionally speak of concerns when I see them.

These are my points of view and not predictions. And this time isn’t any different!

These days, I’m hearing a lot of predictions about a beautiful and steady rise for the Sensex in 2013. I do not want to insult you with another prediction.

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