Hunting for value in stocks

Published in The Hindu - Sunday Magazine on May 24, 2009

A back of the envelope technique to spot gems during the current downturn

It is that time of the year when the CXO daddy’s and mommy’s prepare for their annual exam…ironically at a time when the kids are enjoying the holidays. Yup! I am of course talking about the annual earnings season for the Apr08 – Mar 09 financial year. CEOs and CFOs sincerely do their homework and probably even a dress rehearsal or two – first for putting on a good show at the board meeting, second for the dreaded 5 minute interview on CNBC. That’s understandable; the CNBC guys can be brutal in their grading! But for all practical purposes, their analysis is useless - especially for investors (it makes good mid-day entertainment though). The two key metrics, which they use for the scorecard– namely ‘sales growth’ and ‘profit growth’ offers a very shortsighted view and perhaps even a wrong one. The worst part is comparing the above metrics to analysts’ ‘target’ for the year. These are companies for god’s sake, not racehorses.

The first flaw with the CNBC view, something that my regular readers would have guessed by now, is that mere earnings (net profit) growth is not an indicator of stellar performance by a company. Even a totally dormant savings or fixed deposit account will produce steadily rising interest earnings each year because of compounding. The appropriate measure of managerial performance would be ‘return on capital’. The second flaw is the short-term approach, which severely penalizes even companies with a long track record of high return on capital, just because of one bad year (sometimes a bad quarter is sufficient). The combination of the two flaws results in share prices of good companies falling below their intrinsic value sometimes.

That’s great! I say. Let’s buy shares of great companies at cheap prices. Long live the stupidity and irrationality of herds (I find it hard to understand how economists actually assume that all humans are ‘rational’).

Nobody is going to let you buy shares of a ‘star’ company, right after its best innings, for cheap. Just wait for one bad year when the earnings or the growth falls below expectations (mostly for no fault of the company per se) and the same stock would virtually be available for a song.

What most people don’t understand is that good companies (i.e > 20% return on capital track record) have deep ‘moats’ to survive temporary slumps caused by external factors and can emerge back in shape. Buy their shares cheap, when there is a dip in performance and you can earn above average returns.

The Recipe

In my previous article, I discussed the ‘cheapness indicator’ for companies with high return on capital track record. Many readers asked for a step-by-step guide to use this formula, along with an example. So I have tried to provide a breakdown of the methodology along with an experiment to figure out if the stock of a leading paint company, ‘Kansai Nerolac’ (formerly ‘Goodlass Nerolac’), is worth acquiring.

• Step 1: Download company’s Annual reports for the last five years (usually available on the company website). Go to the ‘Consolidated’ Balance Sheet and Profit & Loss account (usually available in the section titled ‘Consolidated statements’ towards the end of the Annual report). A warning for those using third party sources such as Moneycontrol: the figures reported there are for ‘Standalone Company’ and hence not appropriate.

• Step 2: Calculate Return on capital for the company over last five years and take an average (Refer my article dated April 12, 2009 for the return-on-capital formula). Is the average greater than 20 per cent? If yes, proceed. For Kansai Nerolac, the average return on capital from financial year 2005 to 2009 is 23 per cent.

• Step 3: Calculate the company’s total capital at end of previous financial year (from consolidated balance sheet). Is debt capital divided by total capital less than 25%? If yes, proceed.

For Kansai Nerolac, the consolidated total capital of company, as on Mar ’08 (since balance sheet for financial year 2009 is not yet released) is 737.5 crores (Equity capital = 612.7 cr, Debt capital = 124.8 cr). Debt capital/Total capital = 17 per cent

• Step 4: Compute Total capital of company * (1+ average return on capital over previous 5-10 years)^5
For Kansai Nerolac, 737.5 *(1+ 23 per cent) ^5 = 737.5 * 2.8 = 2065 crores

• Step 5: Calculate the market capitalisation of the company (i.e share price multiplied by total number of shares). Don’t fail to add the value of unlisted preference shares if there are any (you can look this up from the Balance Sheet under Equity capital section)
For Kansai Nerolac, market capitalisation (based on Monday’s closing share price of Rs 468) is Rs 1261 crores and the company has no preference shares outstanding.

• Step 6: Compute Enterprise value = Market capitalisation + value of preference shares if any + Debt capital
For Kansai Nerolac, Enterprise value = 1261 cr + 124.8 cr = 1385.8 crores (significantly less than the five-year breakeven value of 2065 crores and hence fulfils our ‘cheapness indicator’)

The fact that the ‘Enterprise Value’ of Kansai Nerolac is at a 33 per cent discount to the benchmark on the right hand side of the ‘cheapness indicator’ formula gives us a comfortable ‘margin of safety’ to acquire the stock. Typically, companies with share prices that obey our formula are also cheap in terms of price to earnings ratio (P/E). For example, Kansai Nerolac has a P/E ratio of 12, extremely low and attractive.

The same company’s share price at its peak last year touched Rs 900, but now it is going for half the value. Why is the company trading so cheap? The only reason I can find is that they have reported a 20 per cent drop in profits. This is a clear example of the shortsightedness caused due to herd mentality of investors and analysts who are oblivious to the fact that Nerolac is a 80-year-old company and the second largest paint manufacturer in India with a 20 per cent + average return on capital over the last 15 years. If you dig a little deeper, you’ll notice that the company derives half its revenues from home paints and half from industrial and auto sector — unfortunately both sectors are experiencing a cyclical slowdown. But does it mean that the company will go bust in the next few years (reading from the share price) — something that has not happened over the last 80 odd years? Happy value hunting!