Continuing Customer Businesses and Stock-picking

We discussed product characteristics of a consumer business, consumption pattern and what role it can play in stock investing in the last post. Taking the theme forward, this time we look at continuing customer businesses and their role in stock-picking. You must have observed that there are many businesses that do not toil that hard to get a large chunk of their customers, those customers are already there, and it’s only for the net incremental customers they focus their energies. Are you wondering what do I mean?

Let’s look at this dimension of assessing business advantage a little more closely.

1.      Housing Finance Companies – These are businesses where customers are continuing y-o-y and generate revenues for the company for a long time. Take example of a Gruh Finance. It gives loans for 10 years or longer. Once a customer is acquired, he/she is a source of income for Gruh for the next decade or so. No more investments needed in retaining this customer, except of course the right customer service & home loan rates. Isn’t it a great business to be in? Theoretically speaking, one can move his loan from one HFC to another, but that number is not so large. Compare this with a Videocon manufacturing TV sets or a Whirlpool doing refrigerators that has to toil hard, against all competitors, to acquire every single customer every year.

2.     OEM suppliers – In businesses like auto ancillaries and other OEM suppliers, we have companies with an assured customer and offtake. Take example of Motherson Sumi, Amtek Auto, Suprajit Engineering etc. In that sense, they have customer continuity with large auto companies or  industrial giant supply chains. The downside is however in their bargaining power. Supplier companies are the price-takers and at times, struggle to protect their margins. Having said that, there can be quite a few that enjoy premium positioning in their supplies, quality control and delivery schedules.

3.      Rating agencies – Here is a business where the companies stick with a particular rating agency (CRISIL, ICRA, CARE, Fitch), and then you have annual surveillance to get the rating refreshed. There are numerous instances when after many years of rating association, a particular rating agency “stopped” understanding their business model in a favourable light and the company goes for a new rating agency. Still, it’s a fairly stable business insofar as continuing customers are concerned with little investment involved in customer retention.

4.     Cable & Telecom operators – In theory, you are a fairly stable revenue generator for your cable TV operator (Dish TV, Tata sky, Sun TV, Hathway or whoever you’re with) or your telecom operator (Airtel, RCom, Idea etc) over a period of time. In reality, however, there is fair bit of switching occurring in these segments due to consumer preferences, cost considerations, service standards, package offerings and so on.

5.     Tollway companies – These sound great from continuing customer perspective. Daily commuters have to pay to cross that road or bridge. It’s a different matter that in Indian markets, two of the better known names in this business are having a rough weather – Noida Tollbridge for uncertainty over its concession agreement terms, PILs filed against toll hike and IRB Infra over corporate governance issues.

6.     Habit forming businesses – I could have done without including these businesses here. The category title I have given is also not very accurate. But customers keep coming back to cigarettes, tobacco & liquor companies, however bad their products may be from health point of view.

There can be many more ideas where customer continuity is far more assured than normal businesses. Obviously, this cannot be the sole criterion of stock-picking. A good combo of business & financial factors coupled with this aspect of investing can make a lot of sense and create enormous shareholder value over a period of time. Do share your stock ideas and themes that look attractive from customer continuity perspective.

Consumer Stocks – Do Product characteristics of business matter?

There is a lot spoken about the boom in consumer stocks, the hyper valuations these consumer stocks are quoting at in the markets, demographics of Indian economy, ever growing middle class, etc.  In all this noise, one aspect that I find generally ignored is that there is very little discussion on the product characteristics of business or consumption patterns from the investing standpoint.

I mean all “consumer facing” businesses cannot be clubbed into one large basket with skyhigh price multiples assigned. After all, they are different breeds and animals which will find their own paths over a longer period of time. Let us analyze this little deeper from view of consumption pattern:

1. Consumables vs Durables – The most obvious distinction to be made when discussing consumer businesses is consumer goods in contrast with consumer durables.  While both the segments are witnessing growth, it’s the consumer goods (FMCG) theme that keeps adding new product categories that were not present before. For instance, we see in the marketplace a host of anti-ageing creams, beauty products, differentiated food supplements, health drinks with a thrust on premiumisation not seen before. FMCG industry in India is projected to become Rs 4 lakh crore industry by the year 2020.
2. Brand stickiness – With rising per capita income and growing rural prosperity (relatively speaking), there is a structural shift in consumer demand towards brands and organized products. Brand play is more evident in consumer products that any other product category one can think of. The chances of your changing your toothpaste or soap brand every single time one purchases is very less. Generally, consumer tend to stick with their brands as they get conscious of the segments and lifestyles.
3. Repeat purchase – To put it simply, the consumables vanish after one use, necessitating repeat purchase. You need a toothpaste, soap, detergent, hair oil (ok, till you have hair on your head) pack after pack all your life. That sounds simplistic, isn’t it? But that’s a fact and the business opportunity these guys are looking at. On the other hand, in durables segment with longer shelf life there is an onslaught from the Koreans & Chinese making life difficult and margins thinner.
4. Fashion & technology trends – Consumer preferences change with the times and need for innovation is a constant. Growing youth population is very conscious of what they consume.  At the minimum, re-packaging in different SKUs and appealing advertising is a must. We have seen even some of the giant companies of yesteryears (like Kodak) getting marginalized due to not keeping pace with ever-changing technology.
5. Target User group – I include it here from the viewpoint of total addressable market and the ultimate growth. If you’re talking about shaving blade & products, half of the population (female folks) is straightaway not the market. Of the remaining, you have below 16s who don’t need to and beard-sporting who don’t prefer to shave. Come to think of it, a toothpaste or soap company has no such limitation on its addressable market – entire country is its market. So the point is, other things being equal, would you like to give a PE multiple to a razor company as high as to a toothpaste company.
6. Staple vs Discretionary – Another important distinction to be made is consumer staples vs consumer discretionary products. Demand for consumer staples doesn’t decline appreciably with seasons and cycles. With increase in inflation and pressure on disposable incomes, discretionary spends are the first to be curtailed by consumers. Jewellery is one such discretionary spend, except for marriage type of purposes. Of course, the recent spurt in jewellery stocks doesn’t seem to support my view, and these are rocketing like no tomorrow.
7. Market positioning – Leadership in market position backed by brand power ensures steady growth. The market leaders have generally the first-mover advantage in introducing new products and break-through technological processes given their superior product portfolios. It imposes high entry barriers for new players.  With competitive intensity in consumer space, market leader companies are constantly looking for volume growth, maintaining their market position and guarding that distance from their next competitor (in market share).
8. Pricing Power – Strong consumer companies are in dominant position in their respective categories and command significant pricing power. For example, tobacco & IMFL (I personally avoid both segments for reasons of socially responsible investing) companies demonstrate that kind of pricing power since their consumers are habit forming and keep coming back. Similarly, baby food is a near monopoly for Nestle that gives them pricing power.

There are a lot many factors however, in financial and management terms, and some of the determinants of PE we discussed in a previous post here and here.

In conclusion, I’d say it’s important for a retail investor to be mindful of the product characteristics of the business and consumption patterns while analyzing a business : the addressable market, the seasonality & cyclicality attached to the products, strong brand or absence of it, market positioning & pricing power, any moat that protects the premium positioning.

The Edge of Small Investors

The title of the post might raise a few frowns among equity investors. “How can a small investor have any edge?” is a natural question that comes to mind. A small investor is generally the last one to get a piece of any actionable information. You must be thinking what way a small investor is better placed over big institutional guys who are armed with all their degrees, research teams, models and analytical tools. Let’s look at the issue in a bit more detail and how a small investor has some advantages:

1. Small investors do not have any rules or binding criteria imposed on stock selection, like stock should be above a particular market cap, so much maximum to a particular sector, not to exceed 5%-7% to a particular stock etc. She is free to pick a stock that suits her the best, no artificial rules to play on.
2. Let me give a small example how this rule criteria works against an investor. I study a micro-cap with market capitalization of Rs 100 crore and am reasonably sure of its business prospects and future growth, so I Invest in it. Normally a mutual fund will not invest in companies with such a small market capitalization. Same stock grows manifold in a couple of years. Now, having grown 8 times when the same stock is not such a compelling buy, it will come on the radar of mutual funds and institutions.
3. A small investor can make all her equity allocation to just 2 of her highest conviction stocks and construct a portfolio. Can an institutional fund manager do so? I am not suggesting strategy of having a 2-stock portfolio even for a moment, but putting a point in favour of a really concentrated portfolio in case investor is really sure of the bets.
4. Returns are often made when good stocks are held for long time, notwithstanding temporary blips and periods of underperformance. Formal fund managers have to mostly mimic or outperform their benchmark index or peers quarter on quarter, and year on year. If there are long periods of underperformance against benchmarks and peers, fund manager’s bonus and incentives shall suffer and the job can be on the line. Small investors do not have any such compulsions and can decide to hold or sell as and when they please depending on their own review and conviction.
5. Size of the portfolio need not be a handicap for small investor. It is easier to find stock ideas with smaller sums of money of say half a million than say when you have a billion to invest. Generating double digit returns on such large portfolio sums is a daunting task for institutional managers.
6. It’s not just performance pressure on formal fund managers that can be a drag. There are also issues of redemption pressures just when the fund manager does not want it, that is bear phase of the markets. Many subscribers get scared of equities at the wrong time (read bear markets) and start making redemption requests when they should actually be buying. But those are the classical investing mistakes on which a fund manager has no control and the Fund has to simply redeem. On the other hand, a rational small investor can avoid such mistakes. She can add to her position at such depressed times.
7. Lastly, small investors do not have any committee to report to while making buy-sell-hold decisions. You are your own boss!

For an advantage to work in your favour, it is however, important for small investors to stay rational, control emotions and do your home-work well before making equity investments.

Happy investing!

Ramco Industries Ltd

Business

1. Ramco Industries Ltd is engaged in building products like Fibre Cement (FC) Roofing sheets, Calcium Silicate Boards (CSB), Fibre Cement Pressure Pipes and Cement Clinker Grinding (CCG).
2. Sales of FC Sheets which is the mainstay of the company increased to 5,50,026 MT in FY 2012 recording a growth of 15% over previous year. In monetary terms, turnover was higher at Rs. 492.70 crore in FY 2012 compared to Rs. 381.85 crore in previous year.
3. CSB sales turnover for FY 2012 was Rs 30.01 crore. It was marginally lower compared to previous year. Company is also in process of setting up a modern plant for manufacture of Calcium Silicate Boards with an annual capacity of 48,000 M.T. at Kotputli, Rajasthan.
4. Company also has business interests in Cotton yarn.  During FY 2012, the division produced 24.65 lakh kgs of Cotton Yarn compared to 31.12 lakh kgs produced in the previous year.
5. Windmill capacity installed by the company is 16.40 MW. During FY 2012, they generated 302 lakh units of electricity.
6. The Company also has a foreign subsidiary in Sri Lanka. Performance of the FC Sheet Plant of the subsidiary improved and it produced 1,11,888 MT during FY 2012 as against 1,06,801 MT during previous year. Net Sales were SLR 32,839 lakhs (Rs 139.90 crore) in FY 2012 as against SLR.25,492 Lakhs (Rs 103.65 crore) during the previous year.

 Management

Ramco Industries Ltd belongs to the Ramco Group. Promoter Directors are Mr P.R. Ramasubrahmaneya Rajha, Chairman and Mr P.R. Venketrama Raja, Vice-Chairman & M.D.

The promoters have bought 144221 shares from market during Q1-FY2013. Their stake has increased to 53.92% at end of June 2012 (compared to 53.75% in Mar 2012). No pledged holdings from promoters.

Factories for building products are located at Arakkonam & Gangaikonda in Tamil Nadu, Bihiya in Bihar, Karur in Karnataka, Kharagpur in West Bengal, Maksi in Madhya Pradesh, Sinugra in Gujarat, Silvassa, Union Territory of Dadra & Nagar Haveli and Vijayawada in Andhra Pradesh. Cotton yarn facility is at Rajapalayam, Tamil Nadu.

Financials

1. As per consolidated financials, total sales for FY 2012 was Rs 798 crore as compared to Rs 672 crore in previous year. There is improvement both in volumes and realizations in building products.
2. Raw material is their biggest operating expense constituting around 55-60% of sales. Chrysotile fibre and cement are the main raw materials.
3. Consolidated PAT for FY 2012 was Rs 76.88 crore as compared to Rs 60.67 crore in previous year.
4. Net cash flow from operations for FY 2012 was at Rs 50.70 crore compared to Rs 138.71 crore for previous year.  Ramco acquired fixed assets to the tune of Rs 97 crore in FY 2012 (both by way of building and plant & machinery. It therefore did not yield free cash flow.
5. Ramco’s paid up share capital is just Rs 8.68 crore and networth of Rs 446 crore as at 31-03-2012. Debt marginally increased to Rs 248 crore as at end of FY 2012 compared to last year.
6. ROE improved to around 16% level as at end of FY 2012. Operating margin at around 17% and net margin at 9.5% level.
7. Ramco’s activity can be said to have element of seasonality with Q1 and Q4 as comparatively stronger quarters. Q2 is generally a weak quarter due to monsoon effect.
8. Coming to Q1-FY 2013, company posted strong results with sales at Rs 268 crore recording growth of 45% y-o-y and 41% q-o-q.  PAT was at level of Rs 22 crore. Net Margins were down 150 bps y-o-y and 490 bps q-o-q that is attributable to decline in operating margins and higher tax rate.

Risks & Concerns

1. Profitability of the cotton yarn division is a major concern due to power cuts and related problems.
2. Seasonality of building products industry with weakness in Q2 and Q3.
3. Restrictions on chrysotile sheets in some countries due to health hazards.

Investment Thesis

Ramco is a well managed company expanding well over the years, with subsidiaries contributing to growth. We have included it here for another reason, and that is its investments in listed companies including its group companies – Madras Cements Limited , Ramco Systems Limited and Rajapalyam Mills Limited. They also have some investments in HDFC Limited, HDFC Bank, Indian Bank etc. Total market value of all these listed investments is in excess of Rs 1,000 crore and on cost basis at Rs.197.42 crore.

Company’s Market Cap is Rs 491 crore. After accounting for debt and cash, Enterprise value is at about Rs 700 crore.  EPS for FY 2012 is at Rs 8.87 and estimate for FY 2013E estimates are indicative of Rs 10.

BV for FY 2012 stood at Rs 48.

There was some market buzz that it may be looking at offloading some stake in Madras Cements to one of the international cement players. Haven’t seen any firm report though.

At CMP of Rs 56, the stock quotes at 5.5x FY 2013 and this looks promising offering good upside potential both by way of a decent core operating business and value of investments.

PS- Please do your own due diligence before any investment decisions.

Regulatory & Legal Risks in Stock Investing

Investors are generally mindful of business, management and financial risks while selecting stocks to invest. A risk that is often underestimated by common investors is the regulatory and legal risk attached to business of the company. In that sense, it’s part of the business risk evaluation, but we are far too much focused on the main business, its products/services, competition, raw material, key drivers of supply chain, business dynamics, order book and next year growth, and often do not give sufficient attention to the regulatory & legal risks faced by the company.

Regulatory risk refers to the risk to earnings, capital and reputation associated with a failure to comply with various regulatory requirements and expectations set by regulatory bodies. Legal risks are broader and could emanate from any transaction including those from change in legislations, policy norms, licenses/clearances, contract terms and commercial disputes. Without splitting the hair, we are using the term Regulatory & Legal risks as one risk category in context of stock investing.

Let us discuss a few case examples to make it little more understandable. And we are not going to look at legal risks from perspective of Tax disputes and claims here.

1. Indraprastha Gas Ltd - Oil & Gas sector, more so the PSUs, is always known to be  prone to risk of regulatory & policy action given the political sensitivity and subsidy issues. Within that space, Indraprastha Gas was one monopoly kind of business till April 09, 2012 when order from Petroleum & Natural Gas Regulatory Board (PNGRB) came regarding network tariff and compression charges. At the time of writing this post, the arguments on IGL's petition challenging PNGRB order and the regulations have concluded and Hon’ble Delhi High Court has reserved the judgment.
2. SKS Microfinance – Stock came to the bourses with lot of limelight at time of its listing and quoted at Rs 1400 in Sep-2010 and now at Rs 70. This is what regulatory risk can do to a stock!! Andhra Pradesh Microfinance Bill passed after reported suicide by small borrowers of MFI companies allegedly because of usurious rates charged by these companies and their supposedly high handed recovery tactics. This resulted in MFIs like SKS being unable to collect dues or lend fresh loans, leading to write-off losses of over Rs 1,000 crore and is to shift its base to Mumbai.
3. Hawkins Cookers Ltd – Nobody had thought that a well-established company manufacturing pressure cookers for decades will land up in problems with the Punjab Pollution control board. And that too so badly that the case will go to court affecting its actual production over a prolonged period. Judgement can be seen here. Company hopes the matter will get resolved but we all know these things can drag.
4. Telecom companies – So much has been said and written about 2G licenses, spectrum allocation, cancellation of licenses, investigations, court hearings that I almost wanted to skip it here. But the key take-away for small investors is to be vigilant about sectors and industries where regulation is in formative stage, dependent on fast changing technologies or not yet ripe enough. These are the investment calls which should be taken by a stock-picker only when there is adequate margin of safety on the side of the investor.
5. Gold loan NBFCs – Slowdown in business is seen by Mannapuram and others on account of LTV cap introduced in March 2012 by the regulator and there have been restrictions around bank lending to such NBFCs. These regulatory actions surely impact customer acquisition by Gold loan NBFCs and the resultant impact on their growth.
6.  Noida Toll Bridge  Company – Hey, why am I including this company here? It’s in simple business of collecting toll charges from anyone who uses their bridge, it doesn’t get simpler than that. Then, who said regulatory & legal risks have anything to do with simple or complex businesses. The company has provision for toll hike in the concession agreement. The toll increase is proposed based on Consumer Price Index. For assets maintenance and maintaining the quality of service levels, in February 2011 the company had proposed the hike as per the formula mentioned in the concession agreement. However, due to protests and PILs filed, it had to roll back the hike, and it can well happen in future too. So legal risks can sometimes affect pricing power of a business.
7. Banks – Fortunately, most Indian banks do not have that much problem on this front as of now. That’s not the case though with all banks worldwide. I remember having read that JP Morgan Chase has 10,000 lawsuits against them (home mortgage bonds, securities, many other stuff), and will end up facing upto USD 3 billion in litigation which means something like 8% of what they are expected to earn in 2012-2013.

What can investors do?

At IPO time, in RHPs we get detailed disclosure of pending litigations, regulatory risks and so on. But there is hardly any information in normal course. Annual Reports contain very little on these aspects unless the impact has precipitated by which time it’s too late for any action by the investor.

When regulatory & legal risks of any significant magnitude actually materialize, the PE of the stock can be de-rated quickly.

On part of investors, prudence demands to keep a tab on the policy & regulatory environment of an industry where they have interest, sectoral changes occuring and any specific legal cases faced by investee firms.  

Performance Review - Virtual Portfolio

 

We introduced Virtual stock portfolio of 10 stocks worth Rs 1 million here. While it has been a short period of just about 4 months, it is customary to evaluate the portfolio performance at the end of the financial year.

	Scrip	Buy price	CMP	Qty (No.)	Invest. Rs lakh	MV   Rs lakh	Gains %
1	Bajaj Electricals	181.00	195.95	550	1.00	1.08	8.3
2	Balmer Lawrie	537.65	533.70	185	0.99	0.98	-0.7
3	Corporation Bk	352.00	424.80	287	1.01	1.22	20.7
4	Hawkins Cooker	1,500.1	1,532.05	67	1.00	1.02	2.1
5	Hinduja Global S	321.10	325.00	310	1.00	1.01	1.2
6	IL&FS Inv Mgrs	26.75	27.00	3,740	1.00	1.00	0.9
7	JB Chm Pharma	71.95	61.00	1,390	1.00	0.84	-15.2
8	South Indian Bk	21.95	24.70	4,560	1.00	1.12	12.5
9	Tata Global Bev	88.25	112.35	1,130	1.00	1.27	27.3
10	VST Industries	1,115.2	1,455.15	90	1.00	1.30	30.5
	Total				10.00	10.88	8.8%

Sensex has returned 5.6% in the same period, so this portfolio has beaten the index comfortably.

Annualised returns of 25% is decent performance anyday, never mind if it’s virtual or notional. Having said this, we should not expect repeat of similar returns in future across periods and cycles.

Portfolio Moves

If this was my actual portfolio I’d not have made any change to it, and let it take its course. But to give the portfolio review a semblance of activity, we make just one change:

Exit VST Industries:

We are mindful that a hefty dividend will be announced in the next few months which will not hurt the returns but the stock has run up a bit, and the opportunity cost of holding it comes in the way.

Enter Unichem Laboratories:

Unichem Laboratories Limited (CMP: Rs 132.95, FV: Rs 2) is an established midcap Pharma company engaged in manufacturing of formulation products and Active Pharmaceutical Ingredients (API). Unichem has aligned its formulation segments into 7 divisions- 3 operating in Acute Therapies and 4 in Chronic Therapies. Ampoxin, Losar H, Losar, TGTOR, Olsar, Unienzyme and Telsar are some of its prominent brands in local markets. Unichem has strong focus on domestic formulations with plants at Baddi, Roha, Ghaziabad, Goa, Pithampur & Sikkim. Besides, Unichem has subsidiaries in UK, USA, Brazil and South Africa.

Consolidated sales of Rs 824.03 crore in FY11, PAT Rs 95.19 crore, EPS Rs 10.47

(Subsidiaries are incurring losses)

Standalone performance highlights of Unichem Laboratories are:

S.No	Particulars	FY 2010	FY 2011	9mon-Dec11	9mon-Dec10
1	Sales (Rs crore)	690.59	764.73	603.54	581.60
2	PAT (Rs crore)	133.62	108.71	59.22	93.65
3	EPS (Rs)	14.77	11.95	6.53	10.32
4	ROE%	21.88	16.03
5	ROCE%	26.41	19.92

Pursuant to court convened general meeting (minutes available on NSE under corporate announcements), there is a proposal to realign share capital between promoter group companies.

Performance for 9 month period ended 31-12-2011 has not been too encouraging, but company should be seen improving its performance from here.

 So now the overall portfolio looks like this:

No	Scrip	Entry price Rs	Qty (No.)	Invest. (Rs lakh)	MV (Rs lakh)
1	Bajaj Electricals	181.00	550	1.00	1.08
2	Balmer Lawrie	537.65	185	0.99	0.98
3	Corporation Bank	352.00	287	1.01	1.22
4	Hawkins Cooker	1,500.1	67	1.00	1.02
5	Hinduja Global Sol	321.10	310	1.00	1.01
6	IL&FS Inv Mngrs	26.75	3,740	1.00	1.00
7	JB Chem & Pharma	71.95	1,390	1.00	0.84
8	South Indian Bank	21.95	4,560	1.00	1.12
9	Tata Global Bev	88.25	1,130	1.00	1.27
10	Unichem Laboratories	132.95	948	1.26	1.26
	Total			10.26	10.83

After accounting for short term capital gains incurred on sale proceeds of VST Industries, we have accumulated 948 quantity in Unichem Laboratories at closing price of 30-03-2012. It’s only a coincidence that in serial order, 10^th stock is replaced by 10^th, they are still in alphabetical order. From next review onwards we will have to incorporate Portfolio IRR since transactions are on different dates.

Disclaimer: This is only for academic purpose & conceptual understanding. Nothing in this post constitutes a buy or sell recommendation. Read detailed disclaimer on the blog and do your due diligence and consult your financial advisor.