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Safal Niveshak StockTalk #5: Graphite India

Welcome to the fifth issue of the Safal Niveshak StockTalk.

This time I delve deeper into a small-cap company, Graphite India Ltd. (GIL). GIL, despite being a small company, is India’s largest manufacturer of “graphite electrodes”, one of the most important components used while manufacturing steel using the electric arc furnace (EAF) route.

Before we dive deeper into GIL, here is a brief overview of the sections of this report…

  1. About GIL
  2. GIL’s Shareholder Value Creation Model
  3. Safal Niveshak’s 20-Point Checklist
  4. Intrinsic Value Assumptions
  5. Financial & Market Snapshot
  6. “Should I Buy GIL?” Checklist

1. About Graphite India

GIL is India’s largest manufacturer of graphite electrodes, which are utilized in electric arc furnaces (EAF) in which scrap is recycled to produce steel.

Graphite electrode demand is primarily linked with the global production of steel in electric arc furnaces. Between the two basic routes for steel production – (1) Blast Furnace and (2) Electric Arc Furnace (EAF) – the EAF route to steel production has increased over the last two decades from 26% to about 32% at the global level.

The share of EAF is expected to grow further in years to come due to its inherent favourable characteristics of (a) an environment friendly and less polluting production process; (b) low capital cost; and (c) faster project commissioning time. (Click here for a simple explanation of graphite electrodes and EAF)

Another factor that is driving the EAF route to steelmaking is the increasing prices and unavailability of key blast furnace raw materials like iron ore and coking coal. Thus, while graphite electrodes account for just 2-3% of the cost of making steel, these play a major role in the steel manufacturers’ profitability.


2. GIL: Shareholder Value Creation Model

Here is a simple model I’ve created to showcase what all goes into the creation of free cash flow for GIL. Free cash flow, as you know from our past discussions, is what ultimately creates shareholder value.

This chart will help you understand the working of GIL and also serve as a helpful tool in analyzing other similar companies.



3. Safal Niveshak’s 20-Point Checklist

Keeping in mind the simplicity aspect that is otherwise missing in other company analysis reports you would come across, I’ve analyzed GIL by answering 20 important questions that span its:

  1. Business performance,
  2. Financial performance,
  3. Management quality, and
  4. Competition.

Here is the complete 20-point checklist with my explanations.

Before we move ahead, here are the symbols that I’ve placed against each checklist point and that will tell you at a glance whether I have a positive or negative view on that particular point.

   Indicates my positive view

   Indicates my negative view

Let’s get started.

A. Business

1. Can I, in one sentence, say exactly what the company does?
Yes. GIL manufactures graphite electrodes that are a very key component in the manufacturing of steel using the electric arc furnace (EAF) route.

2. Does the business have high uncertainty?
GIL’s business is dependent on the steel manufacturing industry, which is cyclical in nature. So yes, cyclicality in steel industry is what defines the uncertainty in GIL’s business. The uncertainty however gets reduced due to the rise in steel production using the EAF route, where GIL’s product (graphite electrode) is used.

3. Has the business got an enormous moat?
GIL is one of the very few small companies in India that can boast of a moat – competitive advantage that largely restricts the entry of new players in the market.

The moat is created by the restricted supply of needle coke – the key raw material used in the manufacturing of graphite electrodes. With there being a handful of suppliers of this raw material globally, it has been impossible for new players to enter the graphite electrode market. Currently, only about 8-10 players globally manufacture this product and no new player has entered the industry over the past 30 years.

This competitive advantage is clearly visible in GIL’s realization (revenue per unit sold) over the past few years. As you can see from the chart below, despite some volatility in volume sales over the past few years, GIL’s average realization has improved consistently on a year-on-year basis, except for a drop in FY11.


Data Source: Ace Equity, Safal Niveshak Research

The management expects realization to improve again in the current financial year (FY12), which I believe is a good possibility given the increase in volume sales that global graphite electrode manufacturers (including GIL) have reported recently.

4. Does the business generate strong free cash flow?
Yes. Despite the cyclicality in its business, GIL has consistently seen a good growth in its free cash flows (except the FY05-FY07 period when the company expanded its capacity). A combination of good operating margins and decent working capital management has led to this consistent rise in free cash flows in the past.


Data Source: Ace Equity, Safal Niveshak Research

5. What is the bargaining power of suppliers and buyers?
GIL depends on a few suppliers for its requirement of needle coke, which is the most important raw material used in the production of graphite electrodes. Thus, it doesn’t enjoy any bargaining power here, and generally has to pay up the price demanded by the suppliers of needle coke.

However, GIL’s lack of bargaining power on the suppliers end gets converted into a good bargaining power against its buyers. This is because since EAF-based steel manufacturers must use graphite electrodes to keep their factories running, and that there are few electrode manufacturers worldwide, they have to pay the price asked by companies like GIL. Moreover, since graphite electrodes form just around 2-3% of a steel manufacturer cost, they don’t mind paying a higher price for the product.

B. Financial Performance

6. Does the business have a consistent sales and profit growth history and is there room for future growth?
Yes. GIL has grown its consolidated sales and net profits at an average annual rate of 18% and 24% over the past 9 years, which is a good pace of growth. As for the future, I see the company maintaining a good growth rate – largely led by rising demand for graphite electrodes on the back of rising EAF-based steel manufacturing worldwide and in India.


Data Source: Ace Equity, Safal Niveshak Research

7. Are EBIDTA margins higher than 15%?
Yes. GIL’s average operating margins over the past 10 years have been around 20%. This gives the company a lot of leverage to spend greater money on sales and marketing to grow its business over the long term.


Data Source: Ace Equity, Safal Niveshak Research

8. Is its operating cash flow higher than net profits?
I have a neutral view here. Owing to a weak inventory management, GIL’s operating cash flow has suffered in the past, and has been lower than its net profits for 4 of the past 10 years. But this isn’t a big worry for GIL given that its inventory levels are largely defined by the steel cycle, which in itself has been volatile during these years.


Data Source: Ace Equity, Safal Niveshak Research

9. Is the debt to equity below 0.5 times?
Yes. GIL’s debt to equity ratio currently stands at just 0.2 times. While this ratio was high at 1.3 times five years back, GIL has done well to gradually pay off its debt to bring the ratio down to a very comfortable level as of now.


Data Source: Ace Equity, Safal Niveshak Research

10. Is the current ratio greater than 1.5?
Yes. GIL’s average current ratio has been 3.7 times over the past 10 years, which is a comfortable number and shows an overall good working capital management.

As a general rule, a current ratio of 1.5 or greater suggests that a company can meet its short-term operating needs sufficiently. However, a higher current ratio can also suggest that a company is hoarding assets instead of using them to grow the business. While this is not the worst thing in the world to do, it is something that could affect long-term returns.

11. Does the company have a good dividend history?
Yes. In terms of dividend payout (amount of dividend paid as percentage of net profit), GIL has averaged around 27% over the past 10 years. This is a comfortable level from a shareholder’s point of view. What is more, GIL’s current dividend yield (dividend per share divided by current stock price) is around 4.2%, which is attractive for investors.

What this implies is that if you buy the stock at the current price and GIL continues to pay Rs 3.5 per share as dividend in the future (the amount it paid last year), you will earn a minimum return of 4.2% per year from the stock even if the stock price does not move or even if it falls.

12. Is the Altman Z score > 3?
Yes. It’s at 3.1, which makes GIL safe against any possible bankruptcy. Read more on the Altman Z-Score.

13. How capital intensive is the business?
It’s highly capital intensive, thanks largely to the high inventory levels that the company maintains. On an average, GIL has employed Rs 11.7 billion of capital per year over the past 10 years. Its FY11 sales were Rs 14 billion. So the sales to capital ratio is around 1.2 times, which makes it a highly capital intensive business.

14. Has it got a high and consistent return on capital and return on equity?
While GIL’s average return on equity has been around 20% over the past 10 years, it has been marred by high volatility. However, given the cyclicality of the business, I would expect the number to revert to a higher level once the demand situation improves going forward.


Data Source: Ace Equity, Safal Niveshak Research

C. Management Quality

15. Is the management known for its capital allocation skill and integrity?
GIL’s management has guided the company well over the past few years, so the track record in terms of integrity seems fine. As far as the capital allocation part is concerned, well, the company has been hit owning to the cyclicality of the steel business. It has however still done better in terms of free cash flows, which have been rising year after year. So, overall, I’m comfortable with the company’s management and its capability to guide the company in the future.

Also, the fact that the GIL’s promoters have increased their stake in the company consistently over the past few years raises my confidence.


Data Source: Ace Equity, Safal Niveshak Research

16. Has there been any substantial equity dilution in the past?
Not substantial, but yes, over the past 6 years, GIL’s equity capital base has risen by around one-third (33%). This has been largely owing to the conversion of its FCCB (foreign currency convertible bonds) into equity.

17. Are management’s salaries too high?
No, GIL’s top management compensation has been under reasonable levels in the past.

18. What has management done with the free cash in the past?
GIL has reinvested a lot of free cash back into the business. A good part has also been doled out to shareholders as dividends.

D. Competition

19. Does the business face high competition?
Not really. In India, GIL’s biggest competition is HEG, which is also a large player in the graphite electrode industry. But as we discussed above, due to bottlenecks on the supply of needle coke, no new player has entered the industry over the past 30 years. So competition remains limited for GIL. And whatever it is, it hasn’t impacted the company’s business at all.

20. Has the management focused on market share or profitability in the past?
A combination of both, which is good.

4. Intrinsic Value Assumptions

Before I move into calculating the intrinsic or fair value range for GIL, let me make one thing very clear.

Intrinsic value isn’t a definite figure but just a ‘calculated’ value. In fact, the calculation of intrinsic value of a business mostly throws up a highly subjective figure. And this figure changes as estimates of variable like future cash flows are revised (given that the future is unknown).

Anyways, what I have done here is rather than arrive at a single intrinsic value figure for GIL, I have calculated the value using 5 different methods and then arrived at a ‘fair value range’ for the stock.

1. Net present value based on a 2-stage 10-year DCF
The discussion about the calculation of net present value using a discounted cash flow model (DCF) can be found in the 7th lesson of my free course on investing – Value Investing for Smart People.

I have done a 2-stage DCF analysis for arriving at the intrinsic value for GIL.

But as a reference, here is the formula for calculating the NPV:

NPV = CFi / (1+k) + CF2 / (1+k)2 + … [TCF / (k – g)] / (1+k)n-1

Where:
PV = present value
CFi = cash flow in year i
k = discount rate
g = growth rate assumption in perpetuity beyond terminal year
TCF = the terminal year cash flow
n = the number of periods in the valuation model including the terminal year

I have calculated GIL’s future cash flow for the next 10 years, assuming 2 different rates of growth in cash flows of 10% (years 1-5), and 8% (years 6-10).

As for the discount rate, I’ve assumed it at 15% assuming the average cost of capital for the company. My expected terminal growth rate for the company’s cash flows – expected growth in cash flow after 10 years and till eternity – is 2%.

Based on these numbers and after reducing the net debt (debt minus cash), the present or discounted value of future cash flows for GIL is coming at Rs 213 per share, which is also the stock’s intrinsic value using this method.

2. Earnings Power Value (EPV)
After DCF, the second most reliable measure of a firm’s intrinsic value is the value of its current earnings. This method is known as ‘Earning Power Value’ or EPV. This value can be estimated with more certainty than future earnings or cash flows, and it is more relevant to today’s values than are earnings in the past.

The formula for EPV of a company is:

EPV = Adjusted Earnings x 1/R

Here, ‘R’ is the cost of capital.

GIL posted an average adjusted EPS (earnings per share) of Rs 12.5 over the past five years (I have taken the average EPS of last 5 years given that this is sort of a cyclical business).

Now, if GIL’s profits were to stagnate and remain at Rs 12.5 per share going forward, and applying the EPV formula here, I multiply Rs 12.5 with 1/15% (15% is the approx. cost of capital for the company).

This gives me a value of Rs 83 per share, which is GIL’s intrinsic value as per the EPV calculation.

3. Pricing relative to 10 year average P/E ratio
True value investors, as Graham has prescribed, won’t pay a price based on the stock’s latest P/E or the company’s latest earnings. They will take a much longer term view…as long as 10 years.

Here, I have attempted to estimate the intrinsic value of GIL using the company’s last 3 years average earnings, and last 10 years average P/E ratio. So the formula is:

Last 3 Years Average EPS x Last 10 Years Average P/E Ratio

GIL’s average P/E ratio for the past 10 years has been around 7 times, while its last 3 years’ average EPS has been Rs 13 per share. Based on the formula, GIL’s intrinsic value is coming to Rs 90 per share.

4. Graham number
Graham number is the formula Ben Graham used to calculate the maximum price one should pay for a stock. As per this rule, the product of a stock’s price to earnings (P/E) and price to book value (P/BV) should not be more than 22.5 i.e., P/E of 15 multiplied by P/BV of 1.5.

But why did Graham specifically used a P/E of 15 and P/BV of 1.5? Why didn’t he use some other numbers?

Well, he thought that nobody should be willing to pay more than the AAA bond yield at that time. AAA bond yield at that time was 7.5%. Therefore, AAA P/E was arrived at 1/7.5 or 13.3, which was rounded up to 15. Similarly he thought that nobody should pay more than 1.5 P/BV for a stock.

Graham insisted that the product of the two shouldn’t be more than 22.5. In other words,

(P/E of 15) x (P/BV of 1.5) = 22.5

Put another way:

(P/E) x (P/BV) = 22.5

Price(sqr)/(EPS x BVPS) = 22.5

Price(sqr) = 22.5 x EPS x BVPS

Take the square root of both sides, and you get the equation for the Graham Number.

Fair Value Price = Square Root of (22.5 x EPS x BVPS)

However, since GIL’s is a cyclical business, and thus will never command a P/E valuation of 15x, I’ve used a P/E of 8x and P/BV of 2x, to use “16” instead of “22.5” as prescribed by Graham in his formula.

As such, for GIL, the Graham formula will stand as such:

Fair Value Price = Square Root of (16 x EPS x BVPS)

Applying this formula, GIL’s intrinsic value comes to around Rs 110 per share.

5. Dividend discount model
As we have discussed in the DCF method above, the value of a stock is worth all of the future cash flows expected to be generated by the firm, discounted by an appropriate risk-adjusted rate or discount rate. Now, as per the Dividend Discount Model or DDM, dividends are the cash flows that are returned to the shareholders.

Hence, to value a company using the DDM, you calculate the value of dividend payments that you think a stock will throw-off in the years ahead. Here is what the formula is:

Intrinsic value = Dividend per share/Discount rate

The modified formula for valuing a company with a constantly growing dividend is…

Intrinsic value = Dividend per share/(Discount rate – Dividend Growth Rate)

Given that GIL has paid higher dividends over the years, we use this ‘dividend growth’ formula for calculating the stock’s intrinsic value.

Assuming a discount rate of 15%, dividend growth rate of 10%, and the latest dividend of Rs 3.5 per share, and inputting these numbers in the above DDM formula, I get to an intrinsic value of Rs 70 per share.

Fair Value Range
I have calculated 5 different intrinsic values for GIL using 5 different methods. So much for the ‘target prices’ you hear on business channels every day as if these were the holiest numbers!

As you can see from the above calculations, the ‘target price’ isn’t such a holy number and can differ based on the method used to calculate it.

Anyways, based on the above calculated intrinsic values for GIL, I can arrive at a ‘fair value range’ for the stock. Here is how I calculate it:

High End of the Fair Value Range = [Average of above five intrinsic values] Low End = [(Average of above five intrinsic values) – (0.5) x (Std Dev)]

Based on this, the fair value range for GIL’s stock is Rs 85 to Rs 115.

Assuming a margin of safety of around 25% to the higher end of this range, I would be comfortable buying GIL’s stock at any price less than Rs 85.

Given that GIL’s current price is just around this level, if I have surplus cash to invest, I will be happy to buy the stock at the current levels.

Overall, I believe GIL fits the category of a “good investment available at the right price”.

If one is thinking of making a quick buck, this isn’t the right company. But if one has patience, the stock has the ability to give good returns over the long term.

The best things about GIL is that it is a focused business, is cost competitive, and operates in an industry with high entry barriers. What is more, the promoters believe in the story and have thus consistently increased their shareholding over the past few years.


5. Financial & Market Snapshot


Data Source: Ace Equity, Safal Niveshak Research


Data Source: Ace Equity, Safal Niveshak Research

    
Data Source: Ace Equity, Safal Niveshak Research


6. “Should I Buy GIL?” Checklist



Your feedback is important
So that was my take on Graphite India as part of the Safal Niveshak StockTalk initiative. I’ve tried to be as comprehensive in my analysis, while trying to keep the report very simple. Let me know what you think of this report and the improvements therein.

Do you think I’ve missed mentioning something specific here? Can the Safal Niveshak 20-Point Checklist be modified or expanded any further? Do you find this report simple enough for your understanding?

Your answers would help me in making the Safal Niveshak StockTalk report, and the entire initiative, more beneficial for you.

Also, if you want to see your choice of stock covered here, just send me your request using the following form. If you can’t see the form below, click here.
[gravityform id=4 name=SafalNiveshak StockTalk title=false description=false]


Disclaimer: The author of this report, or any of his family members, does not own the stock(s) mentioned herein. The opinions in this report are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stock(s) mentioned or to solicit transactions or clients. The information in this report is believed to be accurate, but under no circumstances should a person act upon the information contained within. I do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.

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About the Author

Vishal Khandelwal is the founder of Safal Niveshak. He works with small investors to help them become smart and independent in their stock market investing decisions. He is a SEBI registered Research Analyst. Connect with Vishal on Twitter.

Comments

  1. Ramanand says:

    Hi Vishal,
    Fantastic analysis as usual! However, when considering competition, have you considered direct imports of graphite electrodes? Can Chinese manufacturers dump electrodes at a fraction of ruling market prices in India, thereby denting GIL’s revenues/market share/profit?

    Thanks & Regards

    • Hi Ramanand, thanks for your feedback! As for threat from Chinese manufacturers, the company has not faced any of it in the past largely because of the long-standing contracts it has with its customers (steel manufacturers).

      Also, given that graphite electrodes form just around 2-3% of a steel manufacturer’s cost of production, it finds it more feasible in carrying on buying the product from a reputed name like GIL then get it from an unknown Chinese player. GIL is among the world’s largest producers of graphite electrodes, and accounts for 6.5% of total global production. It thus has the scale and competitiveness to beat any low-cost Chinese producer.

  2. Mansoor says:

    Excellent StockTalkVishal, timing was perfect and couldn’t be happier to see a small cap review. You do a lot of work behind any selection, it’s commendable. Also, your stock buy checklist is a wonderful thing to go through before every selection. Thanks for doing this.

    • Thanks for your feedback, Mansoor! Well, the first task of stock selection happens from you readers. I then pick out the stock from the ones that have the most number of requests and are great businesses. Regards.

  3. RichFellow says:

    Well done Vishal,
    In one of ur previous blog too u have shared about GIL, I think u have emotional attachment with this stock…LOL.
    I too have a soft corner for Graphite, In 2007-2008 crash i bought this in range of 35-40 and sold it in three digits.
    Even though it is good stock i am planning to invest in few other underperforming stocks like M&M, GAIL, COX & KINGS.
    Can i switch from Coal India to Graphite?, what do u think Vishal?

    • Hi RichFellow, thanks for your feedback. Well, I don’t have any emotions attached to this stock. 🙂 It’s just that GIL had figured in one of my previous posts on dividend stocks, and then I studied the company deeper and found it interesting. As for a suggestion on Coal India, while I personally do not like this company for some fundamental reasons, I won’t be able to provide my concrete views here. I might do a post in the future why I don’t like Coal India, but will do a deeper analysis on the company first.

  4. You missed the PDF report here on this report or is it me who is not able to find out.

    Once again, Kudos to great work!! Am safal niveshak evangelist now… 😉

  5. Dear Vishal,

    Graphite is a small cap stock. You have rightly reduced the PE value for Graham number calculation. However, considering it is a small cap stock, it is better to assume the MOS from lower end of the fair value price. In that case, the sensible buy price will be Rs. 63.75.

    • Hi Ajay…Indeed that would only add to the margin of safety for an investor with respect to Graphite’s stock. However, I have been taking care of this conservatism in the way I calculate the IVs (like in the case of Graham number calculation above, or in the discount rate assumptions I take for calculating DCF value). Even then, your point of giving an MoS to the lower end of the price range makes ample sense.

  6. Anil Kumar Tulsiram says:

    Hi Vishal
    Thanks for your in depth analysis of Graphite India. I have a slightly different view of this company. On the face of it on all parameters this company appears to be an attractive investment at the current valuation and I also do not have any problem that this company is in an industry which have low single volume growth. But I think this company does not offer any protection from permanent loss of capital from the risk of slowdown in steel consumption in China, which I think is possible as China’s past growth engine (US and Europe) both are in trouble. I agree that most of the countries and industries will suffer if China growth slows down, but in case of steel industry, it might take even decades for the industry to absorb the resultant excess supply. Further Graphite India inventory management is consistently declining from 2005 and currently inventory accounts for almost 50% of its standalone sales. Below are my comments in detail.
    1. Indirect bet that steel consumption in China will not slow down: China capacity is approximately 600 million metric tons per annum (MTPA). China accounts for 46% of the world’s crude steel production. That is more than the European Union, plus the U.S., plus Japan all put together. Even on per capital basis, China consumption is almost 40% higher than US (2009 figures). Further almost 50% of its steel consumption is in real estate and infrastructure. Now if the growth slows down in real estate and infrastructure, which is believed by some market participants, it will hit hard the global steel industry and consequently graphite electrode industry. Just a 10% decline in consumption of steel in China will produce surplus of 60 MTPA which is equal to India’s steel capacity. Going by doubling of China’s capacity during the past decade this excess capacity may take long time to get corrected and the consequent decline in prices and steel production will hit hard graphite industry. (China produces merely 9% of its steel by electric arc furnace route which requires use of graphite electrodes, but any substantial decline in steel consumption will hit the entire industry and its supply chain equally).
    2. Low single digit volume growth in medium term: Historically volume growth in the Graphite industry was 3% pa (Source Graftech annual report 2011) and it expects it to decline to 2% pa in the medium term. In the past Graphite India has gained volume by increasing its market share. Now if steel consumption in China continues to grow in low single digit then it is possible that going forward it continues to gain market share, but it will be at the cost of margins. And in worst case scenario of decline in China’s steel consumption, there might be excess capacity hitting the prices, margins and volumes. Now low single digit growth in volume perse is not bad, if one is assured of ample free cash flow which can be distributed as dividends or share buybacks. But if low single digit volume growth is combined with risk of huge decline in volumes for extended period of time, that is quite risky and for this reason alone I may prefer not to invest in Graphite India.
    3. Inventory accounts for 50% of the standalone sales of the company. From 2010 onwards, inventories are maintained consistently at this high levels. Infact from 2005 onwards there is consistent decline in inventory turnover ratio which decline from 3.7x in 2005 to 2.0x by 2012. Now the company may be trying to protect itself from fluctuation in raw material prices or there may be some window dressing or anything else. But I am not comfortable with the company which blocks such a huge amount in inventory.
    4. Data inaccuracy: During 2005-07, Graphite India undertook major capex expansion plan in its Durgapur plant and consequently both its standalone and consolidated free cash flow were in negative during this period. In your analysis, you have shown positive cash flows.

    • Hi Anil, thanks for your excellent analysis of the risk called “China” that Graphite faces, and this is one reason I don’t prefer commodity stocks. But since there was a great amount of request from readers of Safal Niveshak, I analysed the company and presented my take on the company. I have been wary about these risks that you mentioned and have taken care of the same while calculating my intrinsic value assumptions for the stocks. As for the FCF chart, as I indicated in another report, I had taken the data from the database I used, and realized later that they were using an incorrect formula for calculating FCF. So I’ve corrected the graph in the above report.

      Thanks again for your invaluable inputs on the stock! It is contribution like these that I believe will help the growth of the Safal Niveshak tribe. Regards.

  7. Dear Vishal,

    I do understand that most of the review request would be for cheap small and midcap stocks from the readers. It is the low value, multibagger illusion and the quick appreciation (in small cap/mid cap) is what traps the retail investors in investing in such stocks. Trust me, it is only an illusion. You can make serious money by investing in quality largecap/giant stocks, if you enter at right price. Even if you enter at a wrong price, over a little longer period that mistake will get covered (unless you are invested in a very bad stock). Small retail investors (me included, albeit I have come out of this habit after very bad experiences) always get trapped in the midcap/small cap stocks without really understanding the potential downside. There are several examples available in the market from each sector and I am sure most of the retail investors are already trapped in such stocks hoping to get huge returns than investing in a high value large/giant cap stock and are sitting on huge loss and hoping for a chance to get out and are still playing the dangerous averaging game to reduce/recover losses. Quality large cap stocks will never erode your capital, there could be a notional loss but you can always recover. Averaging down may also work in such stocks to certain extent.

    Let me explain for the benefit of the readers, Just get in to a 5 year price chart comparison of Infosys and 3I infotech. I am sure many retail investor would have bought 3I infotech considering the huge potential and the strong fundamentals projected at that time and not to forget the strong promoter group behind this stock. 5th July 2007 price of 3I infotech was 162 (adjusted for all bonus) and todays price is 8.55 (5 dividends paid in this period). 5th July 2007 price of Infosys was Rs. 1980 and the current price is Rs. 2470 (10 Dividends paid in this period). You can clearly see how the value erosion happens in a small cap stock. Again go back to 2005 to 2008 period and even in 2009 pessimistic time, everyone was talking about the huge potential of 3I stock and many self declared analyst (paid / unpaid) on the channels and broker reports identified it as a multibagger. In Infosys, even if you had purchsed at the peak price of 2130 in OCT 2007, you would not have lost on capital (returns may be lower).

    Furthermore, in March 2009, 3I price was 26 and Infy price was 1239 (see the fall rate). Between 2007 and 2009 3I’s highest price level was 163 and Infy’s highest price point was around 2130/-. As usual retail investor sees a big fall in the price from 163 to 26, with so much written about this company in the news paper and channels, usually ends up investing in 3I assuming that it is a cheap value stock (at that time dividend yield and book value will be shown as compelling reason to buy in to this stock.). Even after buying at the lowest point during the lowest market sentiment time (march 2009), today the capital would have got eroded by 2/3 of its value . On the contrary, a largecap stock like Infosys purchased at such pessimistic time even at a high valuation at that point of time in comparison with peer stock and market, would have yielded you such an handsome returns.

    Bottom Line: Midcaps and Smallcap stocks can give huge returns and turnout to be a multibagger. But for every Multibagger there are more than 10 stocks that will erode your capital. It is better not fall into this trap when you cannot afford it and the same applies even when you can afford it. It is so painful for a small retail investor. Infact, most retail investor leave stock market once and for all by burning their fingers in investing in such stocks. Such stocks are only for professionals, who can continuosly monitor the stock performance and understand all the reasons for investing or exiting the stock. Most retail investors cannot do that. They may be succesful in few cases (mostly by sheer luck) and would have lost more than that in many other cases.

    Vishal, although you are highlighting in many instances that the stocks discussed in this blog are not for everyone to buy and requesting all to carryout due research before buying and to invest according to their risk profile. Most of the retail investor don’t exactly understand the risk profile. If you shoot a question, they may say I can afford but ask them when the stock is down by 50%, the same investor will say how can I get my capital (forget the profits). Also, most of the retail investors are not that much capable of doing such research on their own. I hope with your initiative you may be able to educate them (me included). I am sure most of them end up just buying it based on the values you have indicated. I do agree the values you have arrived at are quite safe value and the losses may be limited even if they buy it, but they would certainly be better off investing in large cap quality stocks. My humble request to you is to discuss safe quality large cap stocks (like the ones discussed already in stock talk – Infy, Tata steel) that will give steady long term returns and serve the pupose of investing in stocks and protect the capital of the investor. There are still plenty of such stocks available to write about.

    Regards

    Ajay

    • Yes, you are right Ajay about this “multi-bagger illusion” that people have with mid and smallcaps, which leads them to believe that if a stock is a mid or smallcap, it has a great chance of earn them stupendous returns in the long run. And as you rightly pointed out with the case of 3i, here is what I read in a research company’s Nov. 2011 report on the stock – “The focus of the management is very clear for the long term. So we advise investors to ‘Hold’ the stock.” In the next 7 months, the stock has lost almost 75%! That’s a mid cap becoming a smallcap!

      But again, as I’ve always maintained, the problem doesn’t lie with the stock being a mid or smallcap. That’s simply how the market categorizes stocks. The problem lies in people’s understanding of businesses, and the misunderstanding that just because a stock is a small-cap, it can be a multi-bagger.

      If one can understand a business well, and more importantly understands the downside, then it’s fine if he is agnostic about the market cap category where the stock falls into.

      So in that sense, I don’t really agree with your point that mid or smallcap stocks are only for professionals, who can continuously monitor the stock performance. If a small investor can also understand the reasons for investing or exiting such stocks, there is no point staying away from the opportunity.

      What’s “INFOSYS or HDFC” now, were “infosys and hdfc” 15-20 years back. There are so many other examples of smallcaps, which have been (and still are) safe businesses (Page Industries, TTK, Shriram Transport, Elgi Euip, LMW, City Union, Mah. Seamless, Clariant Chem, Voltas, etc.). Better still, these have been business that have always been there for the taking – simple to understand, run by good managements, market leaders.

      So it’s just that small investors who have burnt their fingers with small-caps have done that because they did not find out how big the fire was with which they were playing. And that’s why they pounced on “vivid” stories like Temptation Foods, MIC Electronics, Compact Disc, HCC, Lakshmi Energy, 3i Infotech, etc.

      As you said it right, despite any attempt I make to get this realization through that readers must carry out their own research before acting on whatever I write, I know that this isn’t going to happen till the time the realization comes from within.

      That is why I’ve always promoted StockTalk not as a recommendation service (which it won’t ever be) but as one that teaches you what steps you need to take to research a company on your own (like the kind of checklist you should use, and the ways you can calculate the intrinsic value).

      So yes, while I do believe that big companies have better relative strength, for investors who can put in the effort to identify simple businesses with strong balance sheets, and worry more about the downside than the upside, even mid and smallcaps can be great wealth creators over the long run.

      As Peter Lynch says, “In this business, if you’re good, you’re right 6 times out of 10. You’re never going to be right 9 times out of 10.”

      Whatsay?

  8. Manav Choksi says:

    Hi Vishal,

    Many congratulation son putting up a wonderful investing website! On the post above by Anil Kumar stating China a s a risk; I think only 5% of China’s steel production is through EAF route and in China the electrode suppliers are quite fragmented and the quality is inferior as well. China, I believe is not a significant playing field for Graphite, HEG, Graftech etc. So China shouldn’t be much of a issue I believe.

    Also, have you looked at this company called AIA Engineering?

    Regards,
    Manav

  9. Vishal,

    Great work. I myself am an investor in Graphite India., though not coz of this report:). It is amazing the amount of information you put into each of your reports. Keep up the good work. I have learnt quite a lot from your website.

    Thanks

  10. Dr.Jaswant C Gandhi says:

    Dear Vishaljee:
    I had been a Professor of Management.I have written and spoken extensively on subjects like Marketing, Finance,organizations,el.al. I have come across a number of equity analysts also.But, the way you and your team submit detailed but in very simple and understandable way,the analysis of stocks is deeply appreciable.I would be happy to recommend your site to my management alumni. God Bless You and your team. Keep up the good work.

  11. Chirag Shah says:

    One other indication is that there has been a lot of Insider Buying happening in this stock over the last 1 year. Since Octorber 12 till now, almost 7.1 mn shares have been purchased by Insiders.

    Vishal, I think one of the indicators you should add is how much buying is being done by insiders. This has always been a good indicator for where the management and others who have bought heavily into the company (and know about its future plan) feel where the business is going.

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