Investment Quotes

"If you understood a business perfectly and the future of the business, you would need very little in the way of a margin of safety. So, the more vulnerable the business is, assuming you still want to invest in it, the larger margin of safety you'd need. If you're driving a truck across a bridge that says it holds 10,000 pounds and you've got a 9,800 pound vehicle, if the bridge is 6 inches above the crevice it covers, you may feel okay, but if it's over the Grand Canyon, you may feel you want a little larger margin of safety..." 

- Warren Buffett 

Its Time for Annual Reports

It is that time of the year when investors start receiving the most

critical communication tool from the company, namely the

annual report. An annual report provides a summary of how

a company has performed in the year that went by, and how

it is likely to perform in the forthcoming year. 

For companies, it is mandatory to send a hard copy of the

annual report to each and every shareholder. While a lot of

shareholders merely keep annual reports aside or throw them

away with old newspapers, there are important cues which

savvy investors pick. 

In fact, for the general public, the annual report is the only

financial document that they get to see. Hence, for existing

shareholder, it could be the best source of information to

determine the financial health of a company and to learn about

any problems or opportunities in the business environment. 

Here are some important things that you could look for

in a balance sheet.

Balance sheets can be designed in any shape and size. Also, there is

no mandatory rule which specifies the quality of paper to be used

in an annual report. 

Hence, while some companies come up with a plain vanilla annual

report with simple fonts, simple colours and pay little attention to

page layouts and displays, there are companies which use

high-quality paper, take special efforts to design it and ensure

that the annual report is really presentable to their shareholders. 

“How the annual report looks and feels conveys its image and

speaks volumes about the ability of a company to market itself

in the corporate world. Quality of paper used in the annual report,

many a time, is proportionate or signifies how well the company

is doing,” said Alok Churiwala, managing director, Churiwala Securities. 

Sending the annual report by courier or speed post, as compared to

ordinary post, could denote how important an investor is for the company.

Management discussion and analysis

------------------------------------------

This section is of prime importance for research analysts as well

as fund managers. It gives you an overview of the previous year

of operations and how the company performed. 

Besides this, most importantly, the management shares its

vision for the coming year, updates on projects which are

in the pipeline and thoughts on future projects. However, investors

should keep in mind that unlike the numbers, this section is unaudited. 

“Management discussion and analysis is very important to me in

case of multinational companies, where there is less communication

by way of conference calls or analyst meets during the year,” said

Anand Shah, head (equities), Canara Robeco Mutual Fund.

This section gives you important clues as to the direction in which

a company is thinking, how they think the year ahead is going to be

for the industry and how the company will fare.

Financial statements and strength of balance sheet

-----------------------------------------------------

Shareholders like to look at the income statement as it denotes

how the company is performing in its business, how much profit

the company is making and what is it earning from its core

operations. Portfolio managers and analysts are concerned

about the strength of the balance sheet. 

“I look at things like inter-group loans, investments, cash and debt

position in the balance sheet prior to making an investment decision,”

said Vaibhav Sanghvi, director (funds management), Ambit Capital. 

There are things like auditors qualification, or one-off expenditure

which raise a red flag and need to be considered further by analysts.

Then, there are things like cash flow statement which is sacrosanct

for most analysts.

Careful of Low Valuation Stocks!!

Many stocks are trading at highly attractive valuations;  basically low price to earning (PE) multiple or high book value (BV) compared with market price.  It could be due to various reasons such as poor financial performance, operational difficulties, company specific problems, hostile business environment and contingencies and so on.  In such case, attractively valued PE stocks could be a fatal for less informed retail investors.  Investors should stay away from mysteriously attractive valuations unless they know the real reason behind this.

Quality stocks always come at a premium to peer groups.

Investors can easily spot companies that are loss making and trading at pathetically dismal valuation considering their turnover and asset.  Loss could be one reason for low valuation, but not everything.  However, one critical lesson for retail investors is that focus on management quality and corporate governance.  There are many ways to trace companies that are commanding low valuation due to corporate governance.  The following could few for low stock valuations:

·         Stocks posting excellent numbers but trading at at low valuations.  Why are investors not offering rich valuation if the numbers are so robust.  The reason could be dubious management.

·         Continuous underperformance of stock year after year.  This could be a pointer towards corporate governance issue. 

·         Look at institutional shareholding to understand whether the company is worth investing.  Declining institutional interest should be treated as an early warning by retail investors.

·         Companies reporting very high EPS but paying low dividends without any justifiable reason such as major capital expenditure plan.

·         Companies with promoters owning less than 26% and reporting robust earning, and thus, low PE multiple.  Promoters need 26% equity stake in a company to pass simple resolution and enjoy management control over a firm.  If companies are doing so well and simultaneously available at low valuation, why are such companies not subject to hostile takeover?  The simple reason is such companies have no value and competitors know this fact very well.  Therefore, carefully scan companies were promoters have little stake but have no excellent financial numbers to show.

·         Adverse comments made by the statutory auditors in recent past.  If the statutory auditors are not comfortable with the financial presented to them, why should shareholders trust those numbers??

·         Exodus of independent directors from the board of directors

Investors should make efforts to dig reasons for the alluring valuations.  Remember nothing comes cheap.

Find Some Growth Stocks Where Ratios Will Not Work

Some of the companies with negligible revenue from core business but mega plans under implementation are worth look. 

The Price to Sales Ratio is a valuation ratio that indicates how much investors are ready to pay for each rupee of sales.  It can be calculated as the market capitalization divided by sales.  The one with low ratio is considered as value pick.   However, the price to sales ration can not always be considered to pick the growth stocks.  In recent results, a few companies have little or nothing to show by way revenue and profit from their core business operations.  Many of these companies have mega future plans that could completely transform companies’ business profile and size of operations.  Such stocks are difficult to value as traditional parameters such as earning per share, price to earning multiple, dividend yield etc.

Some of them also present huge opportunities and these stocks could be multibaggers once project starts going on stream.  Investing in such stocks makes sense before their core business goes on stream and start contributing to the top line as immediately after this as it is most likely that such stocks would witness re-rating.  Generally, such stocks rally once plans start materializing or at least some visibility emerges on project implementation.

Investors should be clear on two fronts: first, these stocks are long term bests and there is no point expecting overnight results.  Second, before investing in such companies, investors should make some basic checks like management credentials, project implementation skills, experience, corporate governance norms, financial backing by group, industry dynamics and size of the business opportunity and so on.

One can look at the following companies from power sector can for long term investment:

·         Adani Power: Projects are under implementation for 10000MW.

·         Reliance Power: 16 large projects, combined capacity of 33,480MW

·         Indiabulls Power: 6,600 MW (thermal power), 167MW (Hydropower)

·         KSK Energy Ventures: Nine plants are under implementation with combined capacity of 8,900 MW

·         NHPC: 11^th plan target is 5322 MW.

·         Jaiprakash Hydro Power: Plans to add power generation capacity of 13,500 MW (mix of thermal & hydro).

This investment is only for the bravehearts who can take the risk of losing entire capital.  This is because project implementation is dicey and could lead even to company’s fall,  long gestation, project delays, funding issues, regulatory and policy issues, pricing barriers, market entry, volatile commodity prices etc.

Raising Capital: Why Promoters Go for QIPs & Preferential Issues??

Qualified Institutions and Placement (QIP) and Preferential Allotment are quickest, easiest and cost effective ways of raising capital, and therefore, the promoters prefer these routes over the time consuming rights issues or follow-on offers.

Rights issue and follow-on issues are mainly bogged down by lengthy, tedious and time consuming procedures, while QIP and preferential allotment are less time consuming as that do not require submitting and seeking approval of issue prospectus as in the case of right issue.  A placement document is required to be submitted with stock exchanges were shares are to be listed against full fledged issue prospectus for right issues.

In QIP, no prior regulatory approval is required for issue document placed with QIBs, which are basically institutional investors.  The assumption is that institutional investors, to whom the shares are offered, are supposed to be well informed investors and a detailed prospectus approved by the regulators is not needed.

Besides QIP, many companies have raised money in the recent past through Preferential Allotment of shares to promoters and strategic investors as well.  The purpose of allotting preferential shares to promoters is to maintain promoters stake at a comfortable level post equity dilution through QIP issue.

One of the reasons for introducing QIP was to invite risk takers to the market.  A company that wants to come out with an IPO and list has to fulfill certain basic criteria such as profitability track record, net worth and so on.  Companies in certain industries such as direct-to-home and airlines where gestation period is long, will not able to float an IPO due to the non-fulfillment of the eligibility conditions.  To allow such companies to raise money from the stock market, the Disclosure and Investor Protection Guidelines allowed them to float IPO provided 50% of shares are reserved and allotted to Qualified Institutional Buyers.

It is not only promoters, but even institutional investors prefer QIP and Preferential Allotment.  This is because if institutional investors decide to buy shares from the open market in bulk, the price of the stock shoots up. They are saved from this possible impact cost when he buys a stake through QIP or Preferential Allotment.

QIPs & Preferential issues have flexible structure.  QIP is popular because the issuer can use other financial instruments convertible into equity shares, except warrants.  Preferential issues allow companies to allot optional convertible warrants.  Optionally convertible warrants are not available to QIBs.  However, preferential issues come with a lock-in period, while QIP has no lock-in, with the only condition that shares should be sold through the recognized stock exchanges. 

With companies favoring QIP and preferential allotment, small and retail investors are being deprived of opportunities to invest in such companies.  Suppose retail investor is holding shares of a company about whom he is confident.  He is convinced about its future prospectus and would like to hold these shares for long term.  Now if the company wants to raise additional equity capital the retail investor is on losing side.  This is because, he is being deprived of the investment opportunity in favor of a handful of institutional investors and promoters.

How Important is to Know Changes in Promoters’ Holding

Many promoters have increased/decreased their equity stake last recent quarters.  Reviewing the change in shareholding pattern, specially that of promoters, could be useful to the investors. As a rule of thumb, higher promoters stake is perceived as positive and a lower equity stake could mean low confidence of promoters in their own company.  Rise in promoter stake is considered positive as promoters will commit additional fund only when they are optimistic about future growth of their company. 

Rise or fall in promoters holding is to be studied by looking at two aspects, First what is purpose of promoters in raising or reducing their equity stakes, second, the methods promoters have adopt to increase or reduce their ownership.

An increase in promoter stake does not always constitute a sign of confidence.  It is also necessary to see whether fresh funds have come in.  If fresh fund have been invested, where will there be invested.  Answers to these questions would help investors to determine whether jump in promoter stake is beneficial to the company. 

In few cases, promoters put in additional funds to retire debt and strengthen their balance sheet.  This is certainly positive for the shareholders. 

Similarly, companies that have gone for share buy back also see rise in promoters stake.  The core objective of a buyback is to create wealth, but it also increases promoters equity stake at no additional cost.

On the contrary, when companies that have opted for rights issues promoters forced to step in to bail out the unsubscribed portion, there is an unintentional rise in promoters stake.  Shareholders declining to subscribe to rights issue and promoters chipping to rescue the issue does not qualify to be positive development. 

Similarly, a decline in promoter holding should also be analyzed in detail.  Decline in promoter holding can be due to various factors such as fresh issues of equity shares to non-promoters through QIB, offer of GDRs and so on.  Also, it could be due to reason such as issuing fresh share towards employee stock option, or it could be due to offloading/issuing of fresh shares to strategic/financial partners.

Many companies have garnered financial resources through offloading fresh equity shares to QIB (Qualified Institutional Buyers).  As a matter of fact, QIBs have helped many companies to remain afloat during difficult times of 2009.

However, promoters offloading their holdings in the open market is a warning signal.  Some dubious companies announce positive development periodically, promoters keep on offloading equity stake at the same time.  It is well laid-out trap for investors.

While studying the change in shareholding pattern, particularly that of promoters, it is imperative for investors to establish whether it is beneficial to the company.  For instance, cash coming into the business is positive for company.   However, rise in promoters stake due to merges or buyback means little for investors in real terms. 

Establishing whey promoters’ equity stake has gone up or down is not an easy task in many mid/small companies.  Therefore, investors have to be cautious and find out the nature of transaction that has led to change in promoters holdings.