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Poke the Box: Look at the Sky…but Please Ask Why

Let’s Start with Safal Niveshak
Just in case you missed any of this on Safal Niveshak over the last few days…

Released StockTalk 2.0 report on leading oil and gas exploration and production company Cairn India. See some interesting discussion in the Comments section of the report.
Shared Charlie Munger’s wisdom on living a happy life and getting rich.

Mental Model of the Week: Social Proof

Have you ever been in a situation when you looked at the sky, or at something, just because someone else was staring there? Like in this image below…

I remember playing a few of such pranks during school days, when a group of us friends started looking at the sky and then giggling at passers-by following us in doing so.

It’s another matter that I did not realize then that I was getting the passers-by to indulge in what psychologists call as “social proof”.

As per Wikipedia, social proof is – …a psychological phenomenon where people assume the actions of others in an attempt to reflect correct behavior for a given situation. This effect is prominent in ambiguous social situations where people are unable to determine the appropriate mode of behavior, and is driven by the assumption that surrounding people possess more knowledge about the situation.

In simple words, social proof is all about ‘what-you-think-I-think…what-you-do-I-do”.

Social proof is what is at work in canned laughter – what you hear in comedy shows. The reason such laughter exists is because it causes the audience to laugh longer and more often when humorous material is presented and to rate the material as funnier.

In fact, you will hear the laughter even when there’s nothing to laugh about. I propose they add such laughter to business channels as well, so that people stressed hearing the experts can get a few laughs. 🙂

Social proof applies especially to the way we decide what constitutes correct behaviour. We view a behaviour as more correct in a given situation to the degree that we see others performing it.

Whether the question is what to do with an empty popcorn box in a movie theatre, how fast to drive on a certain stretch of highway, or what to put on the plate at a dinner party, the actions of those around us will be important in defining the answer.

Social proof works to both our advantage and disadvantage. When someone shouts “Bomb!” at a packed theatre, it pays to run with others for safety without being analytical.

It also helps us find books we’ll like (Amazon reviews), restaurants to eat at (Zomato, Burrp), and places to travel (TripAdvisor). We don’t make our decisions in a choice vacuum. Our social circles influence our actions and our purchases, and that’s normal.

Anyways, social proof also works in stock market investing.

Why do you think most of us are always on the lookout for others’ opinions on the stocks we own or want to own?

Social proof is the reason you will find most fund managers owing similar stocks in their portfolios. The thinking is – “If I outperform, I will be a star…but if I underperform, I will be like others!”

But then, Somerset Maugham said, “If 40 million people say a foolish thing, it does not become a wise one.”

You will scold your child who misbehaves and then says, “But everybody else is doing it.” Have you ever scolded yourself for investing like everyone else is doing?

Social proof also works at a bigger level…inside companies. That is what drives most CEOs to act like their peers. So they will acquire companies just because a competitor is doing so. And they will conduct accounting frauds just because many others are doing so!

Warren Buffett on Social Proof
Here is what Warren Buffett wrote to his managers in September 2006, when his peers in corporate America were all under the spell of social proof to justify their misdoings…

The five most dangerous words in business may be “Everybody else is doing it.” A lot of banks and insurance companies have suffered earnings disasters after relying on that rationale.

Even worse have been the consequences from using that phrase to justify the morality of proposed actions. More than 100 companies so far have been drawn into the stock option backdating scandal and the number is sure to go higher. My guess is that a great many of the people involved would not have behaved in the manner they did except for the fact that they felt others were doing so as well. The same goes for all of the accounting gimmicks to manipulate earnings – and deceive investors – that has taken place in recent years.

You would have been happy to have as an executor of your will or your son-in-law most of the people who engaged in these ill-conceived activities. But somewhere along the line they picked up the notion – perhaps suggested to them by their auditor or consultant – that a number of well-respected managers were engaging in such practices and therefore it must be OK to do so. It’s a seductive argument.

But it couldn’t be more wrong. In fact, every time you hear the phrase “Everybody else is doing it” it should raise a huge red flag. Why would somebody offer such a rationale for an act if there were a good reason available? Clearly the advocate harbors at least a small doubt about the act if he utilizes this verbal crutch.

Avoiding Social Proof
How to get over the social proof tendency? Here is some advice from Peter Bevelin’s Seeking Wisdom…

The 19th Century American poet Ralph Waldo Emerson said: “It is easy in the world to live after the world’s opinion; it is easy in solitude to live after our own; but the great man is he who in the midst of the crowd keeps with perfect sweetness the independence of solitude.”
What is popular is not always right. If you don’t like what other people are doing, don’t do it. Warren Buffett says: “We derive no comfort because important people, vocal people, or great numbers of people agree with us. Nor do we derive comfort if they don’t.”
Disregard what others are doing and think for yourself. Ask: Does this make sense? Remember the advice from Benjamin Graham, the dean of financial analysis – “Have the courage of your knowledge and experience. If you have formed a conclusion from the facts and if you know your judgment is sound, act on it – even though others may hesitate or differ. You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.”

Stimulate Your Mind
Here’s some amazing content I read during the week gone by…

It takes years to build a reputation, but a few moments to destroy it. Ask Rajat Gupta, the poster boy of what was right with Indians, and now, what is wrong with Indians.
Daniel Kahneman shares some wonderful insights on how your brain leads you astray, and how you can make sense of this senseless world. Watch the video or read the transcript.
Was Einstein the world’s worst husband? Wife ordered to keep room tidy, serve three meals a day – but expect NO affection… and she must stop talking when he demands it!
Why hotels don’t offer you toothpastes? Here’s the resolved mystery.
The world’s largest democracy is preparing to snoop on its citizens. Watch out for what you talk on phone or browse on the Internet!

Poke of the Week – Ask “Why?”

“Why can’t I buy that toy, papa?” “You already have another one like that.” “But why can’t I buy one more?” “You won’t like playing with two similar toys. Isn’t it?”

“Why are you saying this?” “I know that dear, because I was a kid myself!” “Why have you grown up, papa? If you were still small, you could have played and enjoyed with me and my toys!”

“Everyone has to grow up, my baby!” “Why papa?”

Why? Why? Why?

If you’re a parent of a small child, you most likely hear this question several times during a day – “Why?”

While all children are inquisitive, there are some who love to prick your brain by asking questions until they find a satisfactory reply from you. My 8-year old daughter falls in this very category of hyper-inquisitives.

I find myself bombarded with her questions every now and then. There are some questions that I have replies for. And then there are many for which I have no replies.

But I enjoy her questions as they most often force me to think beyond the obvious to pull out the answers that satisfied her inquisitiveness.

There is a reason a child asks so many ‘Why?’ questions. And this is something most of us adults don’t understand.

The reason is that when a child asks a question on a subject she is not familiar with, she has no point of reference. She’s coming from nowhere in her inquisitiveness regarding her question.

It’s same as you walking into a space scientists convention. Would you be able to understand the intelligent discussion that’s going on, or even ask a simple question that didn’t give the scientists the hint that that you don’t fit in with the crowd?

I bet most of us couldn’t, because most of us have no point of reference regarding space science. Similarly, a child will continue to ask questions till the time she gets something that she understands and appreciates.

So ask questions. Don’t be afraid to show your ignorance!

Give yourself a license to expose your lack of knowledge about a particular subject, and ask “why is that?”

That’s the fastest way to get a little wiser each day.

By the way, can you please tell me if we call oranges ‘oranges,’ why don’t we call bananas ‘yellows,’ or apples ‘reds’? 🙂

If you haven’t done it already, sign up here to receive Poke the Box in your email…and get ready for stimulating Friday mornings.

Keep poking.

Look at the cloudy sky.

Keep asking why.

Till next Friday…

Vishal Khandelwal
Chief Poker – Poke the Box

How to Be Happy and Get Rich

I have been re-reading Poor Charlie’s Almanack over the past few days in preparation of my upcoming Mastermind course.

This is my fifth reading of this wonderful book, and it seems I am going through it for the very first time.

Unlike what many people think, this book is not a ready reckoner on how to become a successful investor. In fact, it’s much more than that.

It’s a book on how to live a happy, sensible and rich life and in the process become a better thinker and investor.

As you read through the book, some of Munger’s ideas will inspire you, and some will make you uncomfortable. But all will challenge you to think outside the box.

The third chapter of Poor Charlie’s Almanack captures “Mungerisms”, where Munger dispels hundreds of ideas on subjects ranging from life, investing, academia, financial engineering, accounting, money management business, and managements.

Safal Niveshak StockTalk: Cairn India

Statutory Warning: This report may cause a reaction, and acting on it can be injurious to your wealth.

Note: This StockTalk analysis has been written by Sridhar V. Sridhar owns the stock, so the following analysis may be biased. Be careful!

Cairn India is one of the largest independent oil and gas exploration and production companies in India. It, along with its joint venture partners, account for more than 20% of India’s domestic crude oil production.

The company is primarily engaged in the business of oil and gas exploration, production and transportation. Its average daily gross operated production was 205,323 BOE (barrels of oil equivalents) in FY12-13. The company sells its oil to major refineries in India and its gas to both PSU and private buyers.

Business overview
The oil exploration and production business is a high-risk venture globally, and investors need to be aware of this.

The business involves bidding for projects based on initial assessment of potential resources, which may or may not materialize or get fully exploited.

In layman terms, it is difficult to assess with precision as to exactly how much oil exists below the ground. However, players having the right skills and technical know-how have a reasonable estimate of the resource potential, and how they can exploit it.

Further, it’s a highly-capital intensive activity, where the gestation period of a project can range anywhere between 7-12 years or more.

Nature of industry
As mentioned above, the business itself is challenging because it’s a long-gestation activity, highly capital intensive, requires high technical skills & project experience, etc.

Further, revenues are subject to two factors – the amount of output and oil price.

The government may have certain restrictions on the amount of output, and it may also impose royalties on the producer.

Further, oil prices are benchmarked to international oil prices, hence there is oil price risk plus foreign exchange conversion risk in a company’s dealings with customers.

In simple terms, revenues are linked to international oil prices quoted in US dollar per barrel, and gets converted into Indian rupees, thereby getting exposed to oil price and forex risks.

Key players: ONGC is the leader in the Indian oil & gas exploration and production industry. Then, there are companies like Oil India, Reliance Industries, Essar Oil and several other players.

Cairn is not an oil marketing or distribution company, hence we are not discussing about HPCL, BPCL, etc. here, though these companies also might have exploration arms/units.

Exploration and production companies are also referred to as upstream oil companies, and marketing/distribution companies are known as downstream. (I tried my best not to use such complex terms -but if you read them elsewhere, this might be of help :-)).

Competition: Competition comes from large players such as ONGC, RIL, etc. However, crude oil being an essential commodity with more demand and limited supply in India, these companies can be expected to have a stable pricing.

Petrol, diesel, LPG and kerosene are subsidized in India, and the subsidy burden is taken up by ONGC, the largest exploration and production behemoth in India.

Private players are not affected by this subsidy burden, hence those including Cairn, RIL, etc. have a significant edge over PSU players.

Cairn is contributing to about 25% of the domestic consumption as per recent estimates.

A major portion of our oil supply is from imports and predominantly from Middle Eastern countries such as Iraq, Saudi, Qatar, and Kuwait.

Paying for oil increases the import burden and also widens the Current Account Deficit. The situation worsens when the payment has to be made in US dollars because the rupee deprecation increases the outflow of foreign exchange.

Hence, the Indian government is taking steps to encourage domestic production and aiming to have a better energy security for the country. This is a positive for players such as Cairn, ONGC, and RIL.

Entry barriers: The industry has high entry barriers given the huge upfront costs required (that run into billions of dollars), uncertainty about reserve potential and actual results, environmental and social impact, permissions or approvals from Govt., royalty to Govt., etc. Some point are discussed below under the “Moat” heading.

Cairn’s financial performance
1. Growth in Revenue, Profits: Before you start questioning the numbers, remember that Cairn is relatively a new player in the oil and gas space. And this business takes several years to break even, and profits come in after this stage.

This is the cause for the change from negative to positive numbers during 2006, 2007 and later periods.

All figures in Rs Crore except %; FY change in 2008 has been incorporated in FY09
As the business has gained stability and with steady growth in the number of wells and output in Rajasthan, the potential for growth is high.

Cairn’s sales and profit growth have been excellent over the past 2-3 years, and we can expect moderation in future. But I hope the consistency would remain.

I don’t want to paint a rosy picture, but if some new production happens, and if government gives approvals for higher output in future, we can expect accelerated growth for the company.

Even if we take a conservative 15-20% annual growth in sales, it would add consistent earnings to the company’s cash reserves.

The company’s margins are pretty high, since the project is now commercialized and is in a steady growth state.

2. Returns on Equity/Capital: Cairn’s ROE and ROCE during FY12 were 16.4% and 18.1% respectively. I did some calculation based on March 2013 results and the ROE comes to around 25% for FY13.

We still need to wait for the annual report to get a better insight into this. However, looking at the past trends, I see improvements though it may not confirm the rule book.

The opportunity for returns to improve is high, and if you understand this business, Cairn has crossed the introductory, exploration stage and is in the production and commercialization mode in many wells across Rajasthan Block.

Given the long-term nature of the business, the growth will continue for several years until it reaches a saturation point.

3. Moat: You might think that a moat is irrelevant here given that this is a commodity-oriented business.

Of course, Cairn deals with a commodity, but think of it as a toll-bridge, or a company selling products that must be purchased for essential needs. If you want to use petrol, diesel, LPG, kerosene, petrochemical products/byproducts, etc…you will somehow end up buying this commodity which is short is supply.

Moreover, this is not like other commodities which can be recycled and reused.

Once you use it, it’s exhausted – it’s a non-renewable resource. Whether you drive a car or two wheeler, you will be paying for fuel. And similarly for cooking gas, inverters, generators, and machinery (factories), you will be using fuel that is derived from crude oil.

We cannot go back to “bull and cart” era and neither can we do without fossil fuels, as solar, wind and other forms may not replace traditional fuel so quickly. So there is a demand and it is durable and sustainable.

Secondly, not every company can get in to oil and gas exploration. The Rajasthan block that is explored by Cairn and ONGC in a 70-30 Joint Venture is one of the biggest resources in India (probably KG basin might get closer to it).

How many companies in India can set up a block like Rajasthan or the KG basin, which requires enormous investments that are in the range of billions of dollars?

Finding a block itself is not easy, and if you found one you need multiple approvals, environmental clearances, huge capital, employee base, etc. So there is a hurdle/wall which makes it difficult for several competitors to enter.

4. Potential: The Rajasthan basin is estimated to have over 7 billion barrels of oil per day, and Cairn is currently producing roughly 200,000 barrels per day. So there’s a huge growth potential ahead for the company.

5. Debt/Leverage: Cairn is debt free and is capable of generating a stream of free cash flows in future.

How’s the management?
Cairn’s management quality is sound and consists of a strong team of technical and managerial personnel.

Last year there was some news on management changes when Rahul Dhir left Cairn to pursue another assignment. However, with the entry of Vedanta, the results have been positive as they retained the same brand, experts, technicians, and managerial personnel.

So, despite the entry of a new promoter, the business model and its functioning are running well.

If you are not a great Vedanta fan, you don’t have to agree with me, but Cairn’s functioning style is completely different from those of Sterlite, Hindustan Zinc, Sesa Goa, etc.

What’s the valuation?
A. DCF (using free cash flows): Rs 385

Historical Cash Flows: This is just to understand the past trends and have a base to start with.

Note: The year 2008 has been left blank because due to the FY change in 2008, the numbers are incorporated in year 2009. For example the financial year ending in 2008 December has been extended to March 2009 and has been incorporated in 2009 figures. Prior to 2008, the company’s financial year ended in December. The cash flows in the past have been inconsistent due to the development stage of the projects.

A brief of my assumptions are below.

Free cash flow (or Owners Earnings) from 2013 (estimated) till 2022 have been considered. Stage 1 Growth: 15% (for years 1-5). Stage 2 Growth: 10% (for years 6-10) – based on production growth trends
Discount rate: 15%
Terminal growth rate: 5% (after 10 years)

Here are the FCF estimates for the next ten years…

The present value of future cash flows and terminal value comes to Rs 385.

B. Dividend Discounting & Terminal Book Value Method: Rs 330

Key assumptions:

Book Value Growth: 7.3% (average of last 6 years)
Current Book Value: Rs 253 (consolidated for 2011-12)
Estimated Book Value as of Year 10 is based on 7.3% growth over 10 years.
Risk Free Rate: 7.3% (10 year govt bond yield as on June 14, 2013)
Dividend: Based on dividend for 2012-13 being taken as a conservative figure for future years. Not a good estimate, but on a conservative basis we can expect dividends to remain constant or grow gradually

All figures in Rs Crore except %
C. Relative Valuation method: Rs 570
Production assumptions under this method are:

Rajasthan – 180,000 barrels of oil per day (bpd)
Ravva – 21,000 bpd
Cambay – 4,500 bpd

Other assumptions:

Oil Price: $80 (Cairn sells at 10-15% discount to brent, and a lower price to account for commodity cycle risk)
No of production days: 300 (assuming lower working hours, holidays, etc)
US-INR Rate: Rs.54

Disclaimer: Most of the above analysis involves estimates about future business environment, which may or may not materialize, hence readers are requested to do their own due diligence.

Final Intrinsic Value
In summary, here are the approx. intrinsic valuations calculated as per various methods…

Discounted free cash flow – Rs 385
Dividend discount & terminal book value – Rs 330
Relative valuation – Rs 570

Based on these, the fair value range for Cairn’s stock comes to around Rs 365 to Rs 425 per share.

Assuming a margin of safety of 30% to the average of this range, the safe purchase price for Cairn is Rs 275.

Don’t ignore the risks!
Crude oil price dependence: Cairn’s revenue is based on crude oil prices, and any decline in oil prices can impact the revenues.

Foreign currency risk (Rs. Vs $ rates)

High cost of exploration: This can be a challenge if there are unexpected costs that add up making the project less profitable.

Judgment of reserve estimate: The approach taken by Cairn in judging estimate has been reasonable or on the conservative side.

Govt. approvals/permissions: This is an integral part of the business, and also serves as a Barrier to Entry. Given that we are an energy-deficient country the Government realizes the importance of exploration and has been encouraging the sector. However, getting timely approvals can be a challenge. If the business plans and execution is good then getting these approvals in place should not be an issue though it can be time consuming.

Potential shale oil supplies: Recently the US as well as other countries have initiatives shale gas exploration, which is a different method of exploration that is expected to bring in new supplies. Sale exploration involves fracturing from rocks below the surface. If there is a bumper output from shale production, oil prices can decline, and competition may arise. However, the above is mitigated to an extent because shale exploration process is highly complex, expensive and the costs involved will motivate suppliers to price oil higher, because the process is currently more expensive than conventional exploration. (I’m not an expert in this – someone from oil industry can comment on this.)

Demand: Some industry experts view that demand may reduce or saturate, and there are talks about shale boom leading to high supply-low demand situation. But if we look at India itself, which is within our Circle of Competence, the demand for fuel is very high – be it for petrol, diesel, gas variants, etc. I recently heard from local autowala that CNG prices have been increased on various occasions. And they still have to use it as CNG has fitted vehicles are becoming common.

Challenges and barriers mentioned above such as high cost, uncertainty, environmental or social issues, royalty fees, etc. are sometimes discouraging many global players in to venture in to this space. Nevertheless Cairn, BP and several other are exploring select pockets of opportunity.

Recent developments
The company’s Chief Executive P. Elango recently said, We plan to drill more than 450 wells in Rajasthan block over a three year period, a significant increase from the current rate of 25 wells drilled in FY2013.

“The Rajasthan block’s current production is at around 175,000 bpd (barrel’s per day). We expect to exit FY2014 with a production in the range of 200,000-215,000 bpd.”

Cairn’s current production comes from five fields – Mangala, Bhagyam, Aishwariya, Raageshwari and Saraswati. The Mangala field, the management has said, is producing at plateau rates of 150,000 bpd.

Aishwariya commenced production in March and is expected to ramp up to approved rate of 10,000 bpd over the next few months.

Bhagyam, the second biggest oilfield behind Mangala, is expected to ramp up to the approved rate of 40,000 bpd by the second half of current fiscal.

Disclosure & Disclaimer: I, Sridhar V, hold Cairn as part of my personal portfolio and may have recommended to others. Readers are advised to do their own independent assessment and take professional advice before taking any decision. You can expect some errors or forward looking statements, so do your own research as well.

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Poke the Box: Believe in Yourself…and Please Like Me

Let’s Start with Safal Niveshak
Just in case you missed any of this on Safal Niveshak over the last few days…

Released second StockTalk 2.0 report…on India’s leading commodities exchange, MCX. See some interesting discussion in the Comments section of the report.
Answered five key questions on rupee’s depreciation, and whether things can get worse.

Mental Model of the Week: Liking

“The deepest principle in human nature is the craving to be appreciated.” ~ William James

We want to be liked and accepted. We believe, trust and agree with people we know and like. We do things for people we like. We like the people who like us (check your Facebook now! :-)) And if we feel that a person likes us, we tend to like them back.

Now, likability comes in many forms – people might be similar or familiar to us, they might give us compliments, or we may just simply trust them.

Companies that use sales agents from within the community employ this principle with huge success. People are more likely to buy from people like themselves, from friends, and from people they know and respect.

Also, we like those who are physically attractive, popular, or those we have positive associations with. We also like and trust anything familiar.

Aristotle said – “Personal beauty is a greater recommendation than any letter of introduction.”

Studies show that we believe that physically attractive people have a more desirable personality than average-looking or unattractive people. Experiments show that attractive criminals are seen as less aggressive and get a milder punishment than ugly criminals.

But like the 6th Century Greek writer Aesop wrote, “Appearances often are deceiving.”

The best con artists always behave as though they are not acting in their best interest. The 16th Century Italian political philosopher Niccolo Machiavelli said in The Prince – “Princes who have achieved great things have been those who have given their word lightly, who have known how to trick men with their cunning, and who, in the end, have overcome those abiding by honest principles.”

Look at stock market investing. Most often, we like a stock after it has run up sharply (Titan, Asian Paints, Page), while we hate things that have dropped in price.

We are attracted to fast-growing companies and fast-rising CEOs, as we see our own aspirations in them, want to become like them, and want to associate with them. All this without worrying what that fast growth may lead to, which is often a rapid decline!

Now, while the “liking” tendency is deeply ingrained in our minds, to avoid falling deep into it, it’s important to…

Concentrate on the issue and what you want to achieve, not on appearances.
Not depend on the encouragement of others.
Not automatically mistake people’s appearance for reality. It may be a social mask!
Not automatically mistake fast-growing companies or fast-rising investments with great returns. They may turn out to be WMDs for your portfolio.

Better, seek an enemy or devil’s advocate who may dislike what you are doing and tell you exactly why he/she things so.

As Benjamin Franklin wrote, “Love your enemies, for they tell you your faults.”

Anyways, despite often reading nonsense on Safal Niveshak, I hope you would continue to like me! 🙂

At least, I wish you continue to like me on Facebook! 🙂

Book Worm
Seeking Wisdom from Peter Bevelin is one of the most amazing books I’ve ever come across on human behaviour and mental models. Here is an excerpt that Bevelin carries in this book where Warren Buffett is talking to analysts at the New York Society in 1995, about the three timeless ideas for investing…

His [Benjamin Graham] three basic ideas – and none of them are complicated or require any mathematical talent or anything of that sort – are:

that you should look at stocks as part ownership of a business,
that you should look at market fluctuations in terms of his “Mr. Market” example and make them your friend rather than your enemy by essentially profiting from folly rather participating in it, and finally,
the three most important words in investing are “margin of safety” – always building a 15,000 pound bridge if you’re going to be driving 10,000 pound truck across it …

So I think that it comes down to those ideas – although they sound so simple and commonplace that it kind of seems like a waste to go to school and get a Ph.D. in Economics and have it all come back to that. It’s a little like spending eight years in divinity school and having somebody tell you that the ten commandments were all that counted. There is a certain natural tendency to overlook anything that simple and important.

Stimulate Your Mind
Here’s some amazing content I read during the week gone by…

Next time I speak in public, I’ll hire a few dummy clappers! Why? Clapping is contagious, and the length of an ovation is influenced by how other members of the crowd behave. 🙂
Can Murthy 2.0 save Infosys 3.0? Forbes India tries to find the answer by asking five close Infy watchers.
Failure can hurt. If you’re feeling it deep within your heart, here’s Leo Babauta of Zen Habits on how to deal with failures.
Fear is an unavoidable part of being human. It’s a daily reality. But is fear our real enemy? Is fearlessness the way to go? Seth Godin answers.
You still haven’t read Cialdini’s amazing book called “Influence: The Psychology of Persuasion”? Spend the next 12 minutes watching this video to learn about the six universals that guide human behavior that Cialdini has written about in his book.

If you can’t see the video above, click here.

Poke of the Week – Believe in Yourself

“When you doubt your power, you give power to your doubt.” ~ Honore de Balzac

Remember that voice you often hear in your head?

The voice that says – “You can’t do it! You’ll never be good enough! You’re going to fail!”

This voice scoffs at you whenever you set out to achieve something. It criticizes you when life gets difficult and you are down in the dumps. It holds you down when you struggle to get up after a fall.

You see, self-doubt not only bothers you when you have it, often it slips past your barriers and gets over you. And when you let it loose, it destroys your confidence, strips logic and reason from your mind, and steals happiness from your heart.

In return, it leaves you with only fear and insecurity.

I have faced such situations several times in the past, and continue to face them day in and day out. The more I fight my self-doubt, the more it fights back.

However, I have also realized that with self-knowledge and understanding, I can use self-doubt for my benefit…and I am learning to do just that.

Most often, in life, what should concern us is not the way things are, but rather the way we think things are.

If I think I can’t do a thing, I will act in such a way that I will never be able to do that thing.

It’s a self-fulfilling prophecy: As I think, so I am.

You must have found yourself in similar situations in the past when you realized that you were not able to achieve some things because you believed from the very start that those things were unachievable.

When it comes to investing, despite the fact that Benjamin Graham and Warren Buffett’s amazing ideas have been with us for decades, the reason most people don’t invest sensibly is because they think they can’t.

So we will remain in the comfort of the crowd, buy what others are buying, look for signals on forums, blindly trust others with their money, and rarely get down to do the independent homework of finding great investments.

Again the reason is that we would believe the world but ourselves, negating what Graham said years ago – “You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.”

The critic in your head or outside of you won’t let you believe yourself…but you have no option but to believe in yourself if you really wish to live a life on your own terms.

Watch this video and you will know that anything is possible if you believe in yourself…

If you can’t see the video above, click here.

If you haven’t done it already, sign up here to receive Poke the Box in your email…and get ready for stimulating Saturday mornings.

Keep poking.

Believe in yourself.

Till next weekend…

Vishal Khandelwal
Chief Poker – Poke the Box

5 Questions on Rupee Depreciation…Answered

The past few months have seen a sharp depreciation in the value of Indian Rupee against the US Dollar (US$). From about Rs 53 per US dollar in early-May 2013, the rate now stands around Rs 60.

Data Source: Yahoo Finance
I have been facing a lot of questions from friends and readers of The Safal Niveshak Post asking for explanation of rupee’s depreciation and its impact on their investments.

Safal Niveshak StockTalk: MCX

Statutory Warning: This report may cause a reaction, and acting on it can be injurious to your wealth.

Note: This StockTalk analysis has been written by Sunny Gupta.

Most tribesmen reading this would know about the business moat (read how a business moat looks like) and its importance, and how identifying businesses with strong and durable economic moat is key to investment success (when properly combined with other important ingredients like margin of safety).

It is also evident that businesses that possess strong and durable economic moat tend to have little competition, high margins (or return on invested capital, ROIC), low working capital needs and low to zero debt.

Poke the Box: Focus on Process, Get Worldly Wisdom, and Buy Happiness

Let’s Start with Safal Niveshak
Just in case you missed any of this on Safal Niveshak over the last few days…

Released first StockTalk 2.0 report…on India’s leading automotive battery maker, Amara Raja Batteries. See some interesting discussion in the Comments section of the report.
Here’s the Safal Niveshak Investor Manifesto that I shared recently on my Facebook Wall. Print it. Stick it. Follow it. Or simply junk it.
Can money buy happiness? A tribesman, Jana Vembunarayanan, writes that it can…and explains how to get more happiness when spending your money. On a side note, given that Jana resides in the US and the rupee has touched 60 to a US dollar, he certainly seems to be happier sending money home. 🙂

Mental Model of the Week: Process vs Outcome

“Individual decisions can be badly thought through, and yet be successful, or exceedingly well thought through, but be unsuccessful, because the recognized possibility of failure in fact occurs. But over time, more thoughtful decision-making will lead to better overall results, and more thoughtful decision making can be encouraged by evaluating decisions on how well they were made rather than on outcome.” ~ Robert Rubin, American economist.

Research has identified a common trait amongst successful performers in fields where probabilities play a big role – they all emphasize process over outcome.

Look at investing, and look around you. Most investment experts selling their services always highlight the outcome – so much return in so many months or years – and never the process they used to get this outcome. This is simply because, while the outcome is there for everyone to see (availability bias), investors rarely ask the question whether that outcome was due to the skill of the expert (a proper investment process) or merely luck!

This is not to say that results don’t matter; obviously they are extremely important in measuring success. But if the results have been largely thanks to luck, they may not come in as expected in the future.

What is more, if you focus only on the outcome, you are less likely to achieve it. Instead, if you focus on the process, the outcome will take care of itself.

Thus, judge decisions – especially yours – not only on results, but also on how they were made. This matrix may be of some help to you…

Book Worm
Seeking Wisdom from Peter Bevelin is one of the most amazing books I’ve ever come across on human behaviour and mental models. Here is an excerpt that Bevelin carries in this book where Charlie Munger is talking to students of Stanford Law School in 1997, about how to get worldly wisdom…

I’ve long believed that a certain system – which almost any intelligent person can learn – works way better than the systems that most people use. What you need is a latticework of mental models in your head. And you hang your actual experience and your vicarious experience (that you get from reading and so forth) on this latticework of powerful models. And, with that system, things gradually get to fit together in a way that enhances cognition.

And you need the models – not just from one or two disciplines, but from all the important disciplines. You need the best 100 or so models from microeconomics, physiology, psychology particularly, elementary mathematics, hard science and engineering [and so on].

You don’t have to be a huge expert in any of those fields. All you’ve got to do is take the really big ideas and learn them early and well. You can’t learn those 100 big ideas you really need the way many students do – where you learn ’em well enough to bang ’em back to the professor and get your grade and then you empty them out as though you were emptying a bathtub so you can take in more water next time.

If that’s the way you learn the 100 big models you’re going to need, [you’ll be] an “also ran” in the game of life. You have to learn the models so that they become part of your everused repertoire.

Stimulate Your Mind
Here’s some amazing content I read during the week gone by…

Coffee did not boost my creativity, so I opened a coffee shop that does. (Keep your speakers on)
Bill Gates writes about three things he has learned from Warren Buffett…things that are not just about investing but more important in life, like time.
Charlie Munger has long talked about the importance of knowing where you are going to die so that you don’t go there. Here’s another proof that eliminating stupidity is easier than creating brilliance.
In order to find success as an investor, the question you must ask isn’t “Am I smart enough to be a good investor?” but rather “Am I rational enough to be a good investor?” Why? Here’s a framework from Daniel Kahneman, one of the best thinkers of our times, that will help you condition your brain (hopefully!) for a better investment behaviour it the future.
Email seems pervasive in your lives. You check email on the bus. You check it first thing in the morning, and last thing at night. You even check it while reading Safal Niveshak’s posts. 🙂 In short, you suffer the tyranny of email, but here are a few simple yet effective ways to save you.
Amartya Sen writes a hard-hitting piece on why India trails China. Things are just getting worse here, he says.
Stop giving excuses for not exercising for the lack of time. Here’s a 4-minute workout for you.

Poke of the Week – Reverse

Often in life, when you are seeking solution to a challenge or problem, it pays to reverse your perspective, and look at things from a different angle.

Like in investing, when you are searching for successful businesses, it pays to study what makes business fail.

In his book “A Whack on the Side of the Head”, Roger Von Oech advocates that “reversing your perspective” is an effective technique for expanding your thinking. He provides the following example…

“For many years, 19th century English physician Edward Jenner worked to find a cure for small pox. After studying many cases, he reached an impasse in his thinking. Then he reversed his perception of the problem. Instead of focusing on people who had small pox, he switched his attention to people who never had small pox. He found that dairy maids rarely got the disease. It turned out that most dairy maids had had cow pox, a similar but usually nonfatal affliction. Cow pox had served to ‘vaccinate’ its victims against the more dangerous small pox. This led to Jenner’s concept of ‘vaccinating’ people.”

Von Oech then shares a wonderful quote by innovator Andrew Mercer – “You can’t see the good ideas behind you by looking twice as hard at what’s in front of you.”

You would relate to what Charlie Munger says when he quotes Carl Jacobi – “Invert, always invert.”

For Munger as an investor, this means stacking up all the reasons you like a stock. But then, before considering purchase, invert i.e., list all the reasons to dislike that same stock.

In a 1986 speech, Munger elaborated, “It is in the nature of things, as Jacobi knew, that many hard problems are best solved only when they are addressed backwards.”

Like the Greek philosopher Heraclitus said, “It is disease that makes health pleasant, hunger that makes fullness good, and weariness that makes rest sweet.”

You see, there is real value in “reverse experiences,” that is, we don’t fully appreciate something until we have thought about or experienced its opposite.

For example, just pull out experiences from your life and you would realize that…

Success is sweeter after you’ve tasted defeat.
Life seems more precious after having a near-death experience.
You love someone more after you lose him/her and then regain him/her.

If you are married, here’s a way to use the ‘reverse’ strategy to bring peace to your household. Spend a minute describing a current problem. If you’re the husband, describe it from your wife’s viewpoint. If you’re the wife, do the reverse. From my personal experience, it’s a great way to live happily ever after. 🙂

Watch this small video for how reverse thinking can completely change your perspective in life…

If you can’t see the video above, see here.

If you haven’t done it already, sign up here to receive Poke the Box in your email…and get ready for stimulating Saturday mornings.

Keep poking.

Exercise for four minutes.

Buy some happiness.

Till next weekend…

Vishal Khandelwal
Chief Poker – Poke the Box

Can Money Buy Happiness? Yes!

This post has been written by Janardhanan Vembunarayanan (Jana), the lucky tribesman 🙂 who recently attended Warren Buffett’s 2013 shareholder meeting in Omaha.

Dan Ariely recommended the book, “Happy Money-The Science of Smarter Spending“. I went to the public library and got the book. It is a very good read and here are my notes.

What This Book Talks About…

Most of us seek professional advice on how to earn, save and invest our money. When it comes to spending money, we follow our intuitions. Research shows clearly that our intuitions are wrong most of the times. This book explains how to get more happiness when spending our money. It uses 5 principles…

Buy experiences
Make it a treat
Buy time
Pay now, consume later
Invest in others

1. Buy Experiences

In 2010, according to the U.S. Bureau of Labor Statistics, the average American household earned about $62,000 before taxes and spent a total of around $48,000. Housing costs along came to $16,500, which accounts for 27% of the cost. This clearly shows that we spend a lot of money in housing either in the form of rent or mortgage. Does buying a big beautiful house increase our happiness?

There is almost no evidence that buying a home or a newer, nicer home increases happiness.

Between 1991 and 2007, researchers tracked thousands of people in Germany who moved to a new house because there was something about their old house they didn’t like. Immediately after settling in to their new abodes, these movers reported being much more satisfied with their new homes than they’d been with their old ones. Humans are adaptable creatures, however, and research show that people often get used to whatever they’ve got. So we might expect that this initial spike in housing satisfaction would wear off, leaving people no happier with their home than they were before moving.

But that’s not what happened.

Satisfaction with the new home only were off a little bit, and in the subsequent five years, movers remained significantly more satisfied with their new home than they’d been with their old one.

Sounds promising, but there’s just one problem…

While movers satisfaction with their houses increased substantially, their satisfaction with their lives – their overall happiness – didn’t improve at all.

Long after the crash of 2008, almost 90 percent of Americans continued to describe home ownership as a central component of their dream.

In a carefully controlled study of more than six hundred women in Ohio, homeowners weren’t any happier than renters, though they were 12 pounds heavier.

Virgin Galactic, is a company which makes it possible for people to pre-book a ticket for a six minute spaceflight.

But wait it will cost $250,000 per person. Does this make any sense? Excerpt from the book…

As a child, Marcia Fiamengo, thirty-year-old nuclear engineer, dreamed of being an astronaut. When she and her husband John (also a nuclear engineer), first heard about Virgin Galactic, they talked about buying two tickets – when they were old and retired, since the six-figure fee was out of their price range as young professionals. Then in 2010, Marcia’s life change in an unexpected and devastating way. John became sick and passed away when Marcia received the money from John’s life insurance policy, she couldn’t imagine doing anything with it, and put it away while she grieved.

And then one day…

What better way to use this money than to honor their dream and buy a ticket to space? As Marcia put it, John’s death reminded her that “life is short and fragile” These amazing experiences shouldn’t be put off until a better time. You may never get the chance to experience them.

This story reminded me of the movie “Up”…

The point the authors are trying to make is…

Purchases which buy experience makes people more happier than the materialistic ones.

The happiness I got from visiting Berkshire Annual Meeting is much greater than the Laptop that I purchased. You see the difference.

I am standing in front of Buffett’s house 🙂

2. Make It a Treat

I used to drink ‘Cafe Mocha’ from Starbucks everyday. When I started drinking it used to be a treat. After sometime I did not have the same enjoyment. So why I am drinking it? It is because of the Habit. Should I spend $3.25 everyday for it, even though I do not really enjoy? Why am I not enjoying?

Because we lack mercury’s amnesia, the enjoyment of chocolate coffee typically declines over a period of time

So, what is the solution?

Switch to regular coffee at home or work. This helps to save some money. Once in a while treat myself with Starbucks Coffee and it becomes a treat for me. The point authors are making is…

Limiting our access to the things we like best may help to “re-virginze” us, renewing our capacity for pleasure. It also helps us to save money.

3. Buying Time

Today lots of professionals are making a decent amount of money. But the only problem is, most of them do not have time to do what they want to do.

At Intel an employee receives 350 emails every week. It takes 20 hours to manage them. Around 30% of the emails are unnecessary. What did Intel do?

Intel recently experimented with “email-free Tuesdays” encouraging a group of employees to spend four hours unplugged from email and phones, giving them an uninterrupted period to, you know, think.

This feeling of time affluence has important implications for happiness once these employees leave work for the day.

Google Engineers spend 20% of their time on pet projects, that are outside their day to day work. Some of the innovative products like Google Sky and Gmail came out of this.

When people at google talk about what they like, it’s one of the things they like about. It is culturally important. Knowing that it exists causes people to fee more free.

4. Pay Now, Consume Later

In today’s world most use credit cards, It follows the policy of “Consume now and pay later” The problem with this is, we overspend. American household had an average of more than $6000 in credit card debt in 2010. By doing the opposite – by paying upfront and delaying consumption we get the following.

Less spending
More happiness

Delaying consumption allows spenders to reap the pleasures of anticipation. This reminds me of my childhood days. Deepavali is a festival of lights and it is very famous in India. I anticipate its arrival one month before. The excitement I receive in the anticipation is same as the enjoyment I have during the festival.

Tripadvisor.com business runs on this pleasure of anticipation.

Barbara Messing, Chief Marketing Office at Tripadvisor.com, says: I think of tripadvisor as being in the happiness business. We are really upstream in the planning process and I believe that people derive as much pleasure from that phase as from the trip itself.

5. Invest in Others

Bill Gates and Warren Buffett asked American billionaires to pledge the majority of their wealth to charity. Buffett decided to donate 99% of his wealth to charity. He claims his happiness increased when he gave.

DonorsChoose.org is an online charity that makes it easy for anyone to help students in need. Public school teachers request what they need on the website. The requests can range from pencils to microscopes. Anyone can donate any amount to the project that most inspires them.

In all research has shown that spending money on others provides a bigger happiness boost than spending money on yourself.

Makes sense, isn’t it?

Safal Niveshak StockTalk: Amara Raja Batteries

Statutory Warning: This report may cause a reaction, and acting on it can be injurious to your wealth.

Read any legendary investor on his key rules of picking up great stocks, and a parameter that will stand at the top of the list will be to seek out companies that have no or less competition, and operate in an environment that allows for steady and rising sales, profits, margins, and return ratios.

Such companies are far and few to be found in a hyper-growth, hyper-competitive, and hyper-entrepreneurial market like India.

Amara Raja Batteries Ltd. (ARBL) seems like one of those companies on the face of it. But does it really pass the test of a safe, profitable business from key angles that a sensible investor would look from?

What about the valuations? After all, even if a business is good, what determines an investor’s long-term returns is the price at which he buys that good business.

Let’s try to find all this by understanding ARBL’s business, the industry it operates in, factors that are working well for the company, and ones that can go wrong.

First, the Business
ARBL is India’s leading industrial and automotive battery maker, and is a joint venture between the Galla family (26% stake) and the US battery major Johnson Controls (26% stake).

It is the second largest manufacturer (after Exide) of valve-regulated lead-acid batteries (VRLA; also known as “sealed battery”) in India, and finds companies from the automotive (~50% of total revenue) and industrial (~50% of total revenue) sectors as its key customers. Its key battery brands include Amaron, PowerStack, Quanta, and PowerSleek.

As per its FY12 annual report, ARBL had…

46% share of the Indian telecom batteries market (28% five years back)
32% of UPS market (23%)
26% of four-wheeler market (23%)
19% of four-wheeler aftermarket or replacement market (12%)

In order to understand ARBL’s business deeper, it’s important for us to understand the nature of the oligopoly or duopoly market, which is characterized by just 2-4 firms competing against each other…like the Indian industrial and automotive battery market where ARBL and Exide are the two dominant players.

One of the economics models that studies the duopoly market is called the “Bertrand Model”, which suggests that, in a game of two firms, each one of them will assume that the other will not change prices in response to its price cuts.

In other words, firms compete by setting prices simultaneously and consumers want to buy everything from a firm with a lower price (since the product is homogeneous – like a car battery – and the consumer does not incur any costs in searching for the products).

If two firms charge the same price, consumers demand is split evenly between them.

Now, while this is not true of the Indian industrial and automotive battery market as of now – Exide has a much greater market share than ARBL – things are definitely looking to head in that direction. If t his were to really happen, it will be great for ARBL given that its market share will increase at the cost of Exide till both companies have an almost 50% share.

A crucial assumption of the Bertrand model is that both firms have the same constant unit cost of production, so that marginal and average costs are the same and equal to the competitive price.

My analysis of operating and margins of both ARBL and Exide suggest that thing do fit into these assumptions, as both companies have almost identical average operating and net margins over the past 5-6 years (though ARBL has witnessed some weakness off late owing to higher Lead prices, which I will cover later).

Now, from duopoly, let us understand a bit about oligopoly that also characterizes a very few firms competing against each other.

Here are a few key characteristics of the oligopoly model (text in italics is as per Wikipedia), and how the Indian automotive and industrial battery market stacks up on each of them…

1. Ability to set price: Oligopolies are price setters rather than price takers.

This seems to be working for ARBL and Exide, though only to a limited extent. As I will discuss below, the companies have not been able to pass through the entire raw material price hike to customers…and especially over the past 2-3 years owing to some squeeze from its large customers, especially in the automobile industry.

2. High entry and exit barriers: The most important barriers are economies of scale, patents, access to expensive and complex technology, and strategic actions by incumbent firms designed to discourage or destroy nascent firms.

This is true for both ARBL and Exide. These two have been leading the industry for years now, with no meaningful competition from any other player.

Just ask yourself – in car batteries, you must have heard of just two brands – Exide or Amaron – and throughout the past.

3. Number of firms: “Few” – a “handful” of sellers. There are so few firms that the actions of one firm can influence the actions of the other firms.

This is also true of the Indian automotive and industrial battery market, where both ARBL and Exide seem to be tip-toeing the line, depending on what the other is doing. First ARBL caught up with Exide in terms of branding and reach…and now Exide is doing in terms of capacity expansion and technology upgradation.

4. Long run profits: Oligopolies can retain long run abnormal profits. High barriers of entry prevent sideline firms from entering market to capture excess profits.

This is great news for both ARBL and Exide. Given their relationships with leading automotive and industrial consumers, quality of their products, and the relatively low price of their products (compared to the consumer’s total product cost; a car battery costs just Rs 3,000-5,000), they are in a great position to earn good profits over the next many years.

5. Interdependence: The distinctive feature of an oligopoly is interdependence. Oligopolies are typically composed of a few large firms. Each firm is so large that its actions affect market conditions. Therefore the competing firms will be aware of a firm’s market actions and will respond appropriately.

It is very much like a game of chess or pool in which a player must anticipate a whole sequence of moves and countermoves in determining how to achieve his or her objectives.

For example, an oligopoly considering a price reduction may wish to estimate the likelihood that competing firms would also lower their prices and possibly trigger a ruinous price war. Or if the firm is considering a price increase, it may want to know whether other firms will also increase prices or hold existing prices constant.

Again, this is true in case of ARBL and Exide as we will understand in the analysis below.

6. Non-Price Competition: Oligopolies tend to compete on terms other than price. Loyalty schemes, advertisement, and product differentiation are all examples of non-price competition.

True again for ARBL and Exide. Both these companies have maintained prices close to each other’s products and largely compete on branding and special schemes for distributors and direct consumers.

Now, while this is great for ARBL because Exide will not be able to outperform it in terms of margins and growth in the long run, the negative side is that even ARBL won’t be able to lead the changes in the market for long, and neither outperform Exide on profitability on a sustainable basis.

In fact, despite the big difference in their respective revenues (ARBL is 50% of Exide’s sales), their margins are almost similar and return ratios also tend to move in tandem.

Overall, being in an oligopolistic market can turn out to be a huge positive for ARBL in the long term, but with the limitation that its only competitor Exide is not going to sit quietly.

Anyways, let’s now turn to how things are going specifically for ARBL as of now.

What Looks Good?
Here are a few factors that are working out fine for the company as of now…

1. Sales & profit growth: The duopoly nature of the market has benefited ARBL as it just has one competitor to fight, which it has done bravely over the past five years. This is given that, while Exide has grown its sales and profits at average annual rates of 16% and 34% respectively over the past five years, the growth for ARBL has stood at 22% and 61% (though on a lower base).

Rising earnings serve as a good catalyst for stock prices, which has been highly true in the case of ARBL. So it’s important to seek companies with strong, consistent, and expanding profits. Also, more important than the rate of growth is the consistency in such growth. While ARBL’s profit has grown in spikes over the past few years, I won’t consider it too volatile for discomfort.

As per some estimates, the Indian battery market is worth Rs 100 billion, with the automotive battery segment accounting for over 65% of the overall market value. While VRLA batteries have a 25-30% share, lead acid batteries dominate the market with a 70-75% share.

The market is growing at an average annual rate of around 15%, which I believe is going to provide enough growth opportunities to ARBL. The company has set its eyes on Rs 40 billion in sales by FY16, which seems quite achievable as it needs to grow at just 10% to achieve that.

Unless raw material prices don’t play spoilsport, I don’t see any issues in ARBL also growing its profits at a decent pace during this period.

2. Moat: While both ARBL and Exide have moats around them – brand recognition, stickiness in demand, distribution, and steady client relationships – ARBL has done better to grow its moat over the past few years.

This is clearly seen from the company’s steady gross and net margins (at 32% and 10% respectively in FY13), even in the face of rising cost of raw materials – which is Lead in this case.

Lead is the biggest raw material for battery companies, and forms around 85% of ARBL’s total operating costs…and 60% of sales. The rising prices of this commodity has been a tad negative for the company in the past as it has been unable to pass on the entire cost hike to customers given the slowdown in overall demand, and steady competition from Exide.

Exide is better placed on the raw material front. Lead forms less than 70% of its total operating costs and 45% of sales. This is given the company’s secures a part of its lead requirement from its captive smelters, which ultimately help it benefit on the cost front.

Anyways, the reason ARBL has not seen a major dent in its margins despite higher raw material prices is because of a steady decline in its sales and marketing costs, which stand at under 7% of sales currently, down from 11% a few years back. A declining sales and marketing as percentage of sales also gives an indication of expanding moat as the company is spending less to not just cover its turf but also grow its business steadily.

Finally, I did some scuttlebutt among my friends, a few car dealers, and on the Internet on ARBL vs Exide. The former (ARBL) seems to be winning hands-down in terms of user experience, and price versus value equation.

So the brand moat certainly seems to be working for ARBL, as seen from the faster growth in its sales volumes – 25% average annual growth in units sold during FY08 to FY11 – as compared to just 10% for Exide, though the latter’s volume sales are three times of the former.

3. Capital efficiency: ARBL’s deepening moat is also visible from its steady and marginally higher return on equity, which stood at 27% in FY13, up from less than 20% six years back. During the same period, Exide has seen its return on equity decline from 20% to 18%.

Overall, the capital allocation track record of ARBL has been good in the past, with steady and high return on equity, no acquisitions, and reasonable dividends (payout has averaged 15% over the last five years).

When assessing companies on these parameters, especially RoE, it pays to look at consistency. ARBL scores well on this test, plus its RoE is now better than the industry (Exide).

The low capital intensity of the battery industry has also helped ARBL in earning good returns in the past. The company, for instance, spent a total of Rs 460 crore as capital expenditure during the six year period of FY06 and FY12. Against this, it earned revenue of Rs 2,360 crore in FY12.

4. Balance sheet strength: ARBL, like Exide, also has a clean balance sheet with negligible debt. The entire capacity expansion over the past few years has been funded through cash generated internally, plus the company has also been left with steady positive free cash flows (at least over the last five years).

The batteries industry also has a small working capital cycle, which is seen in case of both ARBL and Exide. ARBL’s average receivable and inventory days have stood at 56 and 47 over the past five years (as compared to 30 and 75 respectively for Exide).

So, if you were to go by Warren Buffett’s rule of seeking out companies with conservative financing, ARBL will clear the test – on both fronts of clean balance sheet, and steady positive FCF.

What Can Go Wrong?
1. Overconfidence in its abilities: The biases that we individuals suffer are also imminent at group and corporate levels. This can especially be said of companies that have witnessed a recent spurt in growth and that too against the tide of slowdown in its consumer industries.

I see ARBL sailing in this boat, and it comes our clearly from the company’s FY12 annual report (the latest available), where the management writes – “We have created a business plan with stretch targets. We are confident that we will be able to catalyse growth and meet aggressive targets through stronger capabilities.”

While there’s no doubt that the company finds itself in a good position as of now as far as its capacities and future demand assumptions are concerned. But if the slowdown in automobile and telecom industries were to persist for some more time, it can create some problems for the ARBL.

We already saw some hints of that in the just concluded FY13, when margins came under some pressure as the company was not able to pass on the hike in Lead prices to consumers, owing to slowdown in demand plus increased competitive pressure from Exide.

2. High Lead prices can play spoilsport: A large part of ARBL’s sales and profit growth over the past few years have been driven by volumes – more batteries sold – than better prices.

So, between FY04 and FY11 for which data is available, while ARBL’s volume sales grew at 36% per annum, selling prices improved by just 3% per annum. This is despite that Lead prices rose by 18% per annum during the same period (FY04 to FY11).

So a clear-cut pricing power is not seen for the company, which is largely the case of competition from Exide, which sails in the same boat.

Anyways, a sharp rise in Lead prices can negatively impact ARBL’s profits and margins going forward, especially given that Lead forms around 80% of the company’s total operating costs and thus has a great bearing on margins.

What is more, the impact of higher Lead prices will be greater on ARBL than Exide, as the latter has its captive smelter capacities at its service that help it absorb some of the price hike.

What about the Management?
Given ARBL’s performance over the past few years, and especially the stability in its margins and return ratios, I am comfortable with the management’s execution capabilities and capital allocation skills.

However, there are two things worth mentioning about here…

ARBL’s Managing Director Mr. Jayadev Galla’s salary in FY12 was around Rs 17 crore, which was almost 10 times the salary earned by the MD of Exide, a company more than twice the size of ARBL. In fact, even the MDs of ARBL’s two big customers – Maruti Suzuki and Tata Motors – earn salary of Rs 3 crore and Rs 4 crore respectively, despite that these companies are much-much bigger than the former. This is a clear case of excessive compensation in ARBL.
Just to mention, the company’s management has a stake in Andhra Pradesh state politics, given that the MD’s mother is a minister in the state government. 🙂

Read through the Comments sections below for some more risks associated with ARBL, and a few corporate governance issues that cast doubts on the management.

Valuations?
I find it easy to value companies that have simple businesses and simple balance sheets.

Of course, there is a great probability that whatever valuations I work up won’t come out right (that’s the most interesting part about valuations :-)), but still I’ve tried to assess ARBL’s valuations.

I am not explaining how I arrive at these different valuations, as the calculations are all there in the excel sheet I shared earlier…just that I have done some slight modifications here and there in my valuation calculations to adjust for the sound business quality and competitive moat of ARBL.

So here are my valuations for ARBL based on different methods…

Average P/E Ratio Valuation – Rs 180
Earning Power Value – Rs 280
Discounted Cash Flow – Rs 320
Historical Earnings Growth – 325
Sustainable Earnings Growth – Rs 330

Some assumptions I have used for DCF calculations are:

Growth in FCF – 15% for first five years, and 10% for next five
Discount rate – 12%
Terminal growth rate – 2%

Based on this, my fair value estimates for the stock stand at Rs 250 to Rs 290.

On the face of it, ARBL looks fairly valued at this point in time, unless and until you want to be brave and buy the stock without any consideration for what Ben Graham said were the three most important words in investing – MARGIN OF SAFETY. That could be dangerous!

Anyways, just one more thing about ARBL’s valuations – the stock is currently trading at a price-to-earnings (P/E) multiple of 15x as compared to Exide’s 20x. In fact, ARBL has always traded at a discount to Exide largely on the back of the latter’s better-established presence in the industry.

However, if you were to consider the last few years’ P/E charts for both the companies, the discount is reducing. This is not just because Exide now commands a lower P/E multiple as compared to its past, but also because ARBL’s base P/E multiple has also risen to cover the gap.

Till ARBL does not do something really foolish, continues to be a simple business like it is now, and maintains a good growth record and clean balance sheet, I see the gap reducing even further. This could provide a fillip to the stock’s long-term returns, but only if you buy it after taking into account sufficient margin of safety.

You see, sensible investing is always about using “folly and discipline” – the discipline to identify excellent businesses, and wait for the folly of the market to drive down the value of these businesses to attractive levels.

You will have little trouble understanding this philosophy. However, its successful implementation is dependent upon your dedication to learn and follow the principles, and apply them to pick stocks successfully.

Never forget that, as an investor, it’s important to focus on decisions and not outcomes.

When I combine ARBL’s business quality with its valuations, I get a good business at fair valuations, which leads me to wait for a lower price before I can own the stock.

You don’t have to agree! 🙂

In the Comments section below, let the tribe know of your own analysis of ARBL…and also share your feedback, if any, on my report.

Before I close, here’s some information about the upcoming StockTalk reports.

I have received an amazing response from tribesmen for the proposal to collaborate to write StockTalk.

Based on the responses I have received and with a view to cover companies from diverse sectors, here is the list of upcoming StockTalk coverage so that you are prepared with your own analysis to participate in the discussion. This covers the next six months’ coverage…

If your name is in the list, please send me an email at vishal[at]safalniveshak.com, so that I can contact you directly to discuss the report format, deliveries etc.

If you chose to write a StockTalk but don’t find your name in the list above, please don’t feel bad as I will include you in the next list after this six months period is over.

Poke the Box: Seek Simplicity, and Become the Luckiest Person on Earth

Here’s the first issue of Poke the Box, Safal Niveshak’s new e-letter on money, investing, and human behaviour, which will be delivered to your mailbox every Saturday morning.

Sign up here to receive the newsletter in your email, and get ready for stimulating Saturday mornings.

Let’s Start with Safal Niveshak
Just in case you missed any of this on Safal Niveshak over the last few days…

I asked where all Safal Niveshak Tribesmen have gone? Well, a lot of them are still there, as the comments show. 🙂
Announced the August launch of a one-year course to help you reinvent the way you invest, work, and live. Pre-registrations have closed, but you can still take a look at what’s coming.
Announced StockTalk 2.0 to combine the intelligence of the Safal Niveshak tribe to do what Warren Buffett did 40 years ago. The first issue will reach you this coming Monday.
An amazing video that showcases the father of value investing Ben Graham giving a lecture (yes!), and also shares his students’ views on the legacy of the legend.

Mental Model of the Week: Occam’s Razor

“Occam’s razor is a principle of parsimony, economy, or succinctness used in logic and problem-solving. It states that among competing hypotheses, the hypothesis with the fewest assumptions should be selected.” ~ Wikipedia

In other words, all things being equal, the best solution to a problem is usually the simplest one.

In investing, simplicity is the way to long term success. As Warren Buffett says – “The business schools reward difficult complex behavior more than simple behavior, but simple behavior is more effective.”

While analyzing stocks, it pays to avoid businesses where a lot of hypothetical situations must go right for future success. Thus, search for simpler business that require fewer assumptions and hypothetical scenarios to work out for them.

I often wonder why does our society appear to be increasingly embracing the complex way of life, when “the simple way” clearly leads to awesome wealth and happiness?

As an investor, I am pretty sure if you can avoid complexity, you would do wonders. In fact, the principle of Occam’s Razor is an intelligent investor’s best friend. Having a simple investment philosophy would mean more time for life outside of investing!

If you need inspiration, here’s something from the world’s best behavioural scientist, Professor Daniel Kahneman, who follows a simple financial plan for himself – “Keep it simple and aim to beat inflation. Don’t try to beat the market. When it comes to investing, less is more. And if you try to do more, you’ll often end up with less.”

Leonardo Da Vinci said, “Simplicity is the ultimate sophistication.”

Anyways, while Occam Razor is very useful, it should not be seen as a substitute for good empirical testing. It relies on subjective assessment of simplicity, rather than an objective tests in evaluating arguments.

So, as Newton said, try to make things simple, but not simpler. 🙂

Book Worm
I am re-reading Seth Klarman’s “Margin of Safety”, and here’s an important part I touched upon again…

Warren Buffett likes to say that the first rule of investing is “Don’t lose money,” and the second rule is, “Never forget the first rule.”

I too believe that avoiding loss should be the primary goal of every investor. This does not mean that investors should never incur the risk of any loss at all. Rather “don’t lose money” means that over several years an investment portfolio should not be exposed to appreciable loss of principal.

While no one wishes to incur losses, you couldn’t prove it from an examination of the behavior of most investors and speculators. The speculative urge that lies within most of us is strong; the prospect of a free lunch can be compelling, especially when others have already seemingly partaken.

It can be hard to concentrate on potential losses while others are greedily reaching for gains and your broker is on the phone offering shares in the latest “hot” initial public offering. Yet the avoidance of loss is the surest way to ensure a profitable outcome.

Stimulate Your Mind
Here’s some amazing content I read during the week gone by…

What Warren Buffett would change if he ever edited Ben Graham’s The Intelligent Investor?
Prof. Sanjay Bakshi on why you should stop associating value investing with low P/E multiples. Just like Buffett did.
Do you know what differentiates the world’s best investor from 98% of CEOs?
How you can become the luckiest person on the planet?
Top 10 things you should be informed about in life.

Poke of the Week – Be Led Astray

“Expect the unexpected, or you won’t find it.” ~ Heraclitus

When we explore for ideas and information, sometimes we find things that are better or more exciting than what we were originally looking for. Thus, we need to keep our minds open to unsought-for possibilities.

Think of the times in your own life when one thing has led to something entirely different. How did you get interested in your line of work?

How about the times you’ve opened a particular book in search of a specific idea, and then found something even better in the inside pages?

As noted author Franklin Adams wrote – “I find that a great part of the information I have was acquired by looking up something and finding something else on the way.”

Inventor Charles Kettering said, “There will always be a frontier where there is an open mind and a willing hand.”

So, the next time you meet something unexpected, don’t ignore it. Instead, pay special attention to it. It may be a better idea God might have for you.

Idea Source: Roger von Oech’s Creative Whack Pack

Keep poking.

Get drenched in the rain.

Make time for yourself.

Be happy.

Till next weekend…

Vishal Khandelwal
Chief Poker – Poke the Box