Checklist for a Falling Market

Equity markets have fallen rather sharply over the last 6 weeks or so. When 4,800 on Nifty was breached on previous occasions, market “experts” were saying we’re near the bottom but this time they’re not saying so which gives an impression that price bottom may not be too far. But nobody knows. Either way, yours truly has always professed stock-specific approach which keeps you more focused in a bear market.

What’s that you should do in a falling market?

1. Do your home-work and keep ready your Buy-list of stocks with total quantity that you’d like to accumulate depending on your portfolio composition alongwith staggered price points. We are presuming that one’s already in 30-50% cash to capitalize on the fall or may be fresh position coming in.
2. In the Buy-list, avoid any highly leveraged companies or those with management/governance issues and where more than 40% of promoters’ holding is pledged.
3. Next is make a note of the price points at which you’d be willing to buy each of those stocks in small lots of say 20%, 25%, 25% and 30% of the target quantity in a falling market. To give an example, suppose you want to accumulate 100 shares of RIL and price points begin with 20 no.s at Rs 780 going to 25 at Rs 740, 25 at Rs 705 and 30 at Rs 670. If it goes below 670 you don’t do anything. If it rebounds from 700 you hold only 70 and live for another day. There may be some change in your pricing depending on actual situation at that time, cash flow etc but a broad plan has to be ready upfront as to what you want to do to your portfolio both on buy and sell side. Example of RIL was just an illustration, I have no interest in the stock.
4. Investors should be able to distinguish between a stock falling due to weakness in broader market and a stock falling due to fundamental damage. Out of the two, it’s only the former that should be bought into provided the stock was in your Buy-list in the first place.
5. Be flexible to identify good opportunities. Having a starting list does not prevent you from being open. Very often, price falls make some stocks more attractive than they originally were. What happens is that a vertical fall is generally irrational and new opportunities are unraveled very fast in the slide. Having said that, basic conviction in the stock should be there and no short-cuts in the diligence process.
6. Watch out for people advocating seemingly good stories and often enhancing them to suit their own biases while ignoring the hard facts.
7. Even after the fall is over (first gets over in index and large cap stocks), the small caps languish at beaten down levels for some more time making easy picking, but please remember #4.
8. Staying power is a must. One should be prepared for a flat to bearish phase of 12-18 months, if not longer. Oct-2008 to Mar-2009 was a very short fall time-wise and it can certainly get longer than that, and much will depend on actual signs of reversal in interest rate cycle.
9. Make sure the cash deployed does not come in the way of any personal/family goals coming up in next 2 years.

Big money can be made in falling markets amidst despondency and pessimistic news flow, and that’s one of the reasons that equity investing is so tricky.

Happy hunting!

Bajaj Electricals Ltd – An update

We discussed the stock of Bajaj Electricals Ltd (BjEL) in April 2011 here.

CMP is Rs 194 and the stock price has corrected by about 28% since April 2011.

Coming to its Q2-FY2012 results, revenue at Rs 700.80 crore increased by 19% on the back of a strong growth in lighting and consumer durables which grew by 25% and 21% respectively. E&P growth was lower at 10%.

Earnings increased slower at 7% as interest costs jumped up significantly.

Let us evaluate the key risks to our investment case:

1. Large number of unorganized and small players operating in the electrical appliances business.
2. Increasing competition from branded players including some new entrants will squeeze operating margins of BjEL.
3. Excessive dependence on certain vendors for key supplies or production.
4. Performance of E&P segment is a concern, and this could lock higher working capital debt resulting in more interest outgo.

Now we look at some of the mitigants and comforts:

1. Lighting division has some pricing power despite competition.
2. Morphy Richards brand products in the premium segment are growing well ahead of the industry average.
3. BjEL has taken steps to stop bleeding in the E&P division and cut down the number of projects handled to around 50 to improve project execution.
4. Commodity prices have softened which will benefit BjEL margins.
5. Consumer durable division will maintain its momentum given the market positioning of BjEL products.

We expect BjEL to close fiscal FY12E with topline of about Rs 3,000 crore and EPS of Rs 14. In less than 6 months from now, markets would start discounting FY13 estimates. At about 9-10 times FY13E earnings, EV/EBIDTA of 6, MCap/Sales of 0.6, ROE of 25% and decent Free Cash Flow expected in FY2013, BjEL looks quite attractively placed.

Representativeness: Does this heuristic affect your Stock-picking?

Very often, we see in investing world that a person categorizes a situation based on his/her previous experiences or notion or belief about it rather than any objective assessment. In simple terms this is how we can explain Representative Heuristic which is a cognitive bias. Well, if one makes a short-cut decision, something like a rule of thumb strategy, this can sometimes be useful when faced with uncertainty. But as a process, representative heuristic can be limiting and almost suffering from close-mindedness when we talk about stock-picking.

The Next….

Cut back to 2002, we had so many software companies claiming to be the next Infosys. A few growth years or financial parameters, and pat came the declaration from the investing community of The Next... It was representativeness without any thorough understanding of their business or management attributes. We know most of them do not exist today, and others failed to make it big.

Cut back to 2007, we had so many engineering and infrastructure companies claimed to be the next L&T. Hefty order books and growing construction work all around and even professional analysts declared arrival of The Next... Again, it was mainly representative heuristic without any objective assessment. I don’t want to name any companies in this league but those who follow the markets would have understood which ones I’m alluding to, and look how they are struggling to keep their head above the water.

Now in 2011, you’ve a urban consumption branded stock that is highly successful in something - shoes, undergarments, pizza, coffee or whatever. Here I’m talking about success of the stock, not necessarily success of the company (my saying so can put off few but I defer that discussion for some other time). Then comes another stock in similar space, through an IPO, re-listing, analyst’s discovery or restructuring. And the analysts declare it as The Next…

The Gambler's Fallacy…

This basically means that if a fair coin is tossed repeatedly and say heads comes up 6 out of 6 times, a gambler may incorrectly believe that in 7th toss the coin is “due” for a tails and the outcome of heads is less likely. When in reality, the probability remains the same 50% no matter how many times the coin is flipped. Likewise, there is a reverse gambler's fallacy where a person may instead decide that heads are more likely since run of events or fate has all this time allowed heads consistently so why change the odds. Either way, memory of past results does not statistically influence future outcome.

To some extent, this fallacy happens in investing while extrapolating the stock trends and performance. When we look at a stock which has historically traded at high PE of 20 times and due to “turn of events” came down to say 10, Investor A will buy thinking how cheap it is, without regard to change in its business dynamics. Investor B will bet that it has now lost favour of the market and sell it.

The Reversion to Mean…

Will returns generated by that evergreen stock over the next 5 years outpace the industry average the way it has done in the last 5 years? This is the moot question. Can it be taken for granted if you do a Rip Van Winkle and come back after many years? Well, mean reversion works until it doesn’t. There have got to be good reasons that it has worked or they did something better than the pack. What needs to be investigated from investment perspective is can this competitive advantage be sustained over a longer period?  Stocks that have risen too fast like flash in a pan or beaten the normal trajectory for a short while can revert to the mean faster than one expects.

Most of the Polyfilm stocks gave such an opportunity in 2010 where decent money was made given the disproportionate market demand and fewer players (yours truly also utilized the run and sold out in time), but to have expected that this would last forever was a fallacy.

Sum up

Representative heuristics affect our stock decisions all the time. Sentiment is an integral part of the market psychology. Not very long ago, you heard your friend saying that 52-week high for this stock is so and so and now it’s available at such a lucrative price. Besides the stock and its underlying, we need to track the real drivers that decide its performance - the competition catching up, the moat melting away, the size becoming an enemy, the macro policy shifting, the hitherto tight cost structures giving away and the customer preferences changing.

We need to be sure that we are looking at the right metrics. I conclude with quote from Peter Bernstein “The fundamental law of investing is the uncertainty of the future”.

Corporation Bank

Amidst headlines of Moody’s downgrading banks in Portugal, UK, Italy and at home our own SBI, isn’t it little out of place to discuss a PSU Bank as an investment idea?  Second reason that makes this looks out of place is that in current fall, it is very difficult to zero down to one banking stock when most of them are quoting at dirt cheap valuations.  But then, fundamental equity investing is more about making your bets when there is fear, uncertainty and investors are moving into “cash” (read USD) as the preferred asset class.

PSU banks seem increasingly commoditised business with very little moat and pricing power. So why prefer a Corporation Bank over another 20 banks when many of those left out have better branch network, brand recall and size. On the lower end of spectrum, you have one trading at half of IPO price, and another at half of book value, well nearly.

Nobody can be certain that we have seen the peak of interest rate cycle, with RBI’s hawkish stance continuing and policy rates again under the scanner in Second Quarter Review of Monetary Policy on October 25, 2011.  In short, we can see even lower price levels for banking stocks.

Coming to Corporation Bank, it is a well established Bank with GOI and LIC holding 58.5% and 25.5% respectively.

Financial Summary

				Amt in Rs crore
Indicator	2007-08	2008-09	2009-10	2010-11
Networth	4,228.51	4,896.51	5,774.87	7,137.81
Deposits	55,424.42	73,983.91	92,733.67	116,747.50
Advances	39,185.57	48,512.16	63,202.56	86,850.40
Total Business	94,609.99	122,496.07	155,936.23	203,597.90
Total Income	5,216.33	7,174.57	8,481.03	10,459.62
Operating Profit	1,251.14	1,796.61	2,136.73	2,622.40
Net Profit	734.99	892.77	1,170.25	1,413.27
Key Ratios
CAR %	12.09	13.66	15.00	14.11
ROA %	1.38	1.28	1.28	1.21
ROE %	17.38	18.23	20.26	20.70
EPS (Rs)	51.24	62.24	81.58	96.60
BV (Rs)	294.79	341.36	402.60	481.85
NIM %	2.71	2.26	2.07	2.52
Non int/Tot inc	13.42	17.06	17.61	12.66
Gross NPA %	1.47	1.14	1.02	0.91
Net NPA %	0.32	0.29	0.31	0.46
Dividend (Rs)	10.50	12.50	16.50	20.00

Positives:

What struck me about its balance sheet is the kind of capital utilization it has shown in building assets:

(1) Share Capital of Rs 148.13 crore and Total assets are Rs 1.43 lakh crore. Asset/Equity Ratio of 968 is phenomenal for a midcap PSU Bank, whichever way we look at it. CAR is at 14.11 % as per Basel 2, with Tier 1 capital at 8.69%.

(2) There is hardly any equity dilution in last 10 years, which means y-o-y growth in networth of Rs 7,137 crore is entirely organic.

(3) Asset quality is relatively better than most PSU banks, both at gross (0.91%) and net (0.46%) NPA levels as at 31-03-2011. Since then, there is marginal increase of 7% in gross on q-o-q basis in Q1-FY2012. The bank maintains a decent PCR of 74% as at end of June 2011.

(4) It crossed total business (deposits + advances) of Rs 2 lakh crore in FY 2011. Business has grown 8 times in last 10 years.

(5) Infrastructure accounts for about 17% of bank’s credit exposures and SMEs for 13%.

(6) CD Ratio as on 31.03.2011 stood at 73%. Advances registered a growth of 28% in FY 2011. I don’t think current FY will see such type of growth.

(7) Cost Income Ratio at 38.5% is quite decent, and likely to further reduce in this year.

Concerns:

(1) CASA at 26% is lower than some of the peer banks.

(2) NIM was at 2.5% as at end of FY 2011 but fell to 2.1% in Q1-FY2012 due to higher mobilization of term deposits and higher cost of deposits.

(3) There were some allegations/ complaints about alleged irregularities in issuance of tenders and sanction of loans which are under inquiry by CVC/CBI. We can see some press reports here. It is difficult to comment on these issues from outside but it can be reasonably expected that with change of guard (new Chairman has joined wef October 01, 2011), it should get cleaned up.

(4) Trading volume is less given the low floating stock (84% held by GOI/LIC).

Stock parameters
CMP: Rs. 405.25 (FV Rs. 10); Market Cap: Rs. 6,006 crore; 52-week high/low (NSE): Rs.814.30/ 401.90; 200 DMA: Rs. 534.

Valuation parameters

PE: 4.20; P/BV: 0.84; Dividend yield: 4.93% (based on DPS of Rs 20 for FY2011).

Outlook

Historically, it has traded at 1 time trailing P/BV.  There are quite a few catalysts that can help it re-rate from here, provided interest rate environment starts softening by Q4-FY2012. Investors who have 3-4 year kind of time horizon on this stock can reap handsome gains and dividends.

Developing a Dividend Strategy

The months of July and August are welcome for all dividend investors when credit column in their bank statements become active with receipt of dividends. Long term investors understand the importance of dividends very well, more so those who depend on equities as the main source of their income. I have seen carefully crafted portfolios with dividends as the cornerstone strategy.

Dividend investors can be broadly compared to tortoise in the tortoise and hare story. If your stock picks are rights, dividend growth can be a sure way of compounding returns over a period of time.

Returns for dividend investor = Capital gains + Dividend yield

For long term investors, growing dividends year after year are a perfect way to counter inflation. Come to think of it, what greater evidence can a small investor get than a reliable stream of dividends coming to his account year after year, it shows that the company actually generates earnings after covering all its expenses, paying the interests, taxes and other costs.

What to look for in Dividend plays?

1. Consistency & Track record – The consistency and track record in paying dividends is the foremost. Mature businesses with less need for fresh capex are more likely to declare higher dividend compared to companies in growth phase and/or those having  immediate capex plans. Before formulating a view from dividend investing perspective, check out at least 5-year track record of the company, if not more. A company showing steady rising trend in dividend pay-out is preferable to one which is showing a zig zag trend. Often, we find aberrations before IPO, other fund raising exercise or some such event. The judgment for the investor lies in making a call whether the company will be able to sustain the DPS going forward.
2. Dividend yield – Dividend yield is defined as Annual dividend per share / Stock price per share. In simple terms, if company A and B both pay Rs 10 as annual dividend, the one quoting at lower market price offers a higher dividend yield. We discussed about dividend yield being one of the valuation measures here. In effect, a high dividend yield can act as a price support for the stock when markets slide. At current index level, Nifty stocks have a dividend yield of 1.52%. With the beaten down market levels being seen at the moment, it may not be difficult to pick decent stocks with dividend yield of 4% and above.
3. Dividend pay-out ratio – How much percentage of earnings is paid out as dividend determines the payout ratio. Mature companies like established FMCGs and MNCs tend to have a higher pay-out ratio. Generally, payout ratio of 20-25% and above indicates dividend friendliness of the company.
4. Exclude special and one-time dividends – It is important that investor normalizes the dividend for determining its yield, that is, after excluding any special dividends or one-time dividends linked to a particular event. For example, recently JB Chemicals & Pharma announced a special dividend of Rs 40 after selling some of its division. Smartlink Network Systems declared a special dividend of 1500% sometime back. Such special payouts should be knocked-off while analysing the long term dividend trend of any company.
5. Understanding the business – I need not over-emphasize this while making any post on stock selection. Can you take a step forward without understanding the business dynamics and its drivers?
6. Watch equity dilution since last dividend – If there is any equity dilution, i.e. number of outstanding shares have gone up due to rights issue, bonus, QIP etc, the last dividend per share may not be maintained in next year by the company on the increased paid-up capital. In such cases, past trend of dividend pay-out ratio may be a better indicator to gauge the new likely DPS.
7. Dividend policy of the management – Most companies do not have a stated dividend policy, but you get an idea from understanding of its business, concalls of the management and of course, the historical trend of the dividends.

High Dividend yield companies

List of some high dividend paying companies can be seen here.

Well, I am not going to name or shortlist any companies as the best dividend plays. It cannot be a free advice, right?

Dividends are indicators of value and also demonstrate confidence of the management in future growth of the company. Present levels in the markets can be an excellent opportunity to accumulate some good dividend yield companies in your core portfolio.

Time to become a tortoise, and emerge a sure winner!