Memo to Students: Bob Hamman Video

Bob Hamman is considered to be one of the best bridge players in the world. He runs a very interesting company called SCA Promotions.

Wikipedia Page:

http://en.wikipedia.org/wiki/Bob_Hamman

Company Site:

http://www.scapromotions.com/

Warren Buffett is a fan of Bob Hamman. Buffett and Ajit Jain (the genius who runs BRK's super-catastrophe insurance operation) often do things similar to what Bob does. Here is what Buffett wrote in this connection in his 1995 letter:

"Ajit Jain is the guiding genius of our super-cat business and writes important non-cat business as well. In insurance, the term "catastrophe" is applied to an event, such as a hurricane or earthquake, that causes a great many insured losses. The other deals Ajit enters into usually cover only a single large loss. A simplified description of three transactions from last year will illustrate both what I mean and Ajit's versatility. We insured: (1) The life of Mike Tyson for a sum that is large initially and that, fight-by-fight, gradually declines to zero over the next few years; (2) Lloyd's against more than 225 of its "names" dying during the year; and (3) The launch, and a year of orbit, of two Chinese satellites. Happily, both satellites are orbiting, the Lloyd's folk avoided abnormal mortality, and if Mike Tyson looked any healthier, no one would get in the ring with him."

You can view a very interesting video of Bob in which explains what he does i.e. how he sets odds in a risky situation. You can view this video from:

http://tinyurl.com/3bfjpl

The Bob Hamman video can be seen by clicking the link titled "Risky Business"

The video may play only if you have an older version of Real Player installed on your comp. You can get an older version - the Real Player 8 from

http://tinyurl.com/nsad

Lectures 03 & 04: Risk Arbitrage, Fermat-Pascal, and Life

List of topics discussed in Tuesday's class:

1. Graham, Buffett, and Rubin suggested as role models for learning risk arb and the fermat/pascal way of probabilistic thinking.
2. Case on Arcata Corporation from the Buffett letters was discussed at length to illustrate the idea behind risk arb
3. Risk arb defined, Buffett's four questions on risk arb deal analysis (probability of deal going thru, time to consummation, chances of icing on the cake, and worst case scenario)
4. Graham's framework on special situations from the appendix of the 3rd edition of Security Analysis, Walter Schloss on that appendix, and how my own career was deeply influenced by it.
5. Robert Rubin's philosophy on risk arb (students were asked to do substantial reading on Rubin prior to class), Graham-Newman's arbitrage results over a long time, Buffett's own results in the field.
6. Extended discussion of the the GE Shipping spinoff deal, the twists and turns in that deal
7. Discussion of some old deals from my experience involving bailouts, mutual fund arbitrage, creating cheap shares in schemes of arrangements, tender offers, buybacks, going-private transactions, merger arb, dividend capture, and recapitalizations.
8. Fermat/Pascal system of thinking, the necessity of developing an expected value frame of mind (Fermat/Pascal letters can be seen from here.
   
9. Rubin's four principles of decision-making - the uncertainty principle, probabilistic thinking, decisions and actions being different (includes the ideas of preserving optionality and sometimes having to choose the least worst option), and the importance of process over outcomes.
10. Process vs. Outcome- bad process will inevitably produce bad long term outcomes, but bad short-term outcomes do not necessarily imply a bad process, importance of luck in success.
11. Frequency-Magnitude framework of expected value, how the world focuses on frequencies and not magnitudes and expected values, the jellybean experiment, how people give up an idea because they think its too tough without thinking thru the consequences of success, how long term-success almost never comes from the first idea, how conviction in oneself and cumulative learning produce good long-term outcomes even though they are improbable (you only have to get rich once), the venture cap model (low chance of success, high magnitude of success in a few cases), how someone can be wrong most of the time, and be right just a few times (Taleb's bleed strategy).
12. Preserving optionality - the deep simplicity behind black-scholes - options have value even when they are out-of-the-money because of time and volatility, the more the volatility, the more the value of the option, the importance of not making a decision i.e. deferring it, particularly in a dynamic situation, allowing new information to come in which changes the odds, Graham's idea of never converting a convertible, how risk arb teaches the benefits of keeping options open till the last possible moment ("stuff happens"), we will cross the bridge when we come to it.
13. Contrary viewpoint - when to burn bridges, when to close options and make decisions, how often big decisions in life often involve burning bridges, while generally the preserving optionality model is very useful, particularly in investing.
14. Probability Blindness, how people make big mistakes when they estimate probabilities, denominator blindness (an example of anchoring bias), the monty hall problem, believing that trends are destiny, wrong perceptions of risk because some bad event has not happened for a long time (people assume its become safe when the exact opposite is true e.g. some earthquake-prone areas which have not experienced an earthquake for a long time), conjunction fallacy, mistakes in interpreting causal chains (a chain cannot be stronger than its weakest link)
15. Why is risk arb fun apart from the money? Forces you to think rationally using expected value framework which is dynamic requiring frequent calibration of thinking in response to new information and new interpretation of old information, forces you to think about
    opportunity cost, requires multi-disciplinary thinking (e.g. probability, psychology particularly game theory, law particularly corporate and securities law, and finance), and of course the availability of un-co-related to market opportunities arising out of corporate actions, giving the arbitrageur plenty of very interesting things to do...
16. How the expected value framework, so well-taught by practicing risk arbitrage, can also be be used in regular straight value investing, Buffett's case on investing in Wells Fargo, how he estimated worst case scenario and exploited the perception-reality gap in the
    marketplace.

Memo to Students: Ben Franklin's Prudential Algebra

Benjamin Franklin wrote this to a friend in 1772:

To Joseph Priestley

Dear Sir, London Sept. 19. 1772 In the Affair of so much Importance to you, wherein you ask my Advice, I cannot for want of sufficient Premises, advise you what to determine, but if you please I will tell you how. When these difficult Cases occur, they are difficult chiefly because while we have them under Consideration all the Reasons pro and con are not present to the Mind at the same time; but sometimes one Set present themselves, and at other times another, the first being out of Sight. Hence the various Purposes or Inclinations that alternately prevail, and the Uncertainty that perplexes us. To get over this, my Way is, to divide half a Sheet of Paper by a Line into two Columns, writing over the one Pro, and over the other Con. Then during three or four Days Consideration I put down under the different Heads short Hints of the different Motives that at different Times occur to me for or against the Measure. When I have thus got them all together in one View, I endeavour to estimate their respective Weights; and where I find two, one on each side, that seem equal, I strike them both out: If I find a Reason pro equal to some two Reasons con, I strike out the three. If I judge some two Reasons con equal to some three Reasons pro, I strike out the five; and thus proceeding I find at length where the Ballance lies; and if after a Day or two of farther Consideration nothing new that is of Importance occurs on either side, I come to a Determination accordingly. And tho' the Weight of Reasons cannot be taken with the Precision of Algebraic Quantities, yet when each is thus considered separately and comparatively, and the whole lies before me, I think I can judge better, and am less likely to make a rash Step; and in fact I have found great Advantage from this kind of Equation, in what may be called Moral or Prudential Algebra. Wishing sincerely that you may determine for the best, I am ever, my dear Friend, Yours most affectionately, B Franklin

END

Note the underlying wisdom in the Franklin system of decision making. By making a list of things that would go in favor of, as well as, a list of things that would go against, a potential decision, he prevented his mind from jumping to conclusions (first conclusion bias as a subset of availability bias). This procedure also ensured that Franklin did not over-weigh any particular factor which could mis-influence his decision (availability bias). Further, his insistence on not making sudden decisions without reflecting over them for a few days ensured that he "preserved optionality" allowing new information to come in which could change the odds (Robert Rubin's idea of preserving optionality is valid here). Finally, his roughly-right system of dealing with trade-offs works way better, in my view, than the "optimization systems" you see in the modern world.

Keynes had it right when he said, "its better to be roughly right than to be precisely wrong."

Btw, I love doing "Prudential Algebra" on my mind maps...

Memo to Students: Robert Rubin as a Role Model

Hi,

The next two classes will deal with the Fermat/Pascal way of thinking.

In my view, the best way to understand Fermat/Pascal thinking style, from an investment viewpoint, is to see how risk arbitrage works. And one of the best ways to learn the dynamics of risk arb is to study the experiences of Graham, Buffett, Greenblatt, and Rubin.

As the course progresses, we will be talking about all of these experts. At this time, however, I'd like you to do some work on Robert Rubin.

Rubin learnt risk arb at Goldman Sachs. And the lessons he learnt, he says, served him very well in his life. Risk arb teaches a lot of things about life, as you are about to find out. So, please make the effort of reading/viewing the following:

1. Rubin's page at Wikipedia;
2. The first three minutes and fourteen seconds of Rubin's interview with Charlie Rose;
3. Rubin's commencement address at Harvard;
4. Rubin's interview with Carol Loomis;
5. The following pages from Rubin's book "In an Uncertain World": A note from the author, pages 7-8, Chapter 2 (A Market Education), Chapter 3 (Inside and Outside Goldman Sachs), pages 173-176, Chapter 10 (Hitting Bottom), pages 340-350, and page 382.
6. This article on Rubin in the New York Times Magazine and this letter about that article; and
   
7. This press release issued by Rubin's office when he was Treasury Secretary.
   

Just do it!

Mindmaps in Investing

As mentioned in my class yesterday, I frequently use Mindmaps for my investment thinking.

Here are two mindmaps - one is historic and one is current.

You will need mindjet viewer to be able to see the maps which you can download from here.

Lecture 02: Introduction to Mental Models & Mental Tricks- II

Topics covered in today's class:

1. Surfing as a mental model, There's a tide in the affairs of men, which taken at the flood, leads on to fortune - Shakespeare, example of Sunil Mittal who rode the GSM wave and because one of India's richest men. A lot of business fortunes are made because someone happened to be in the right place at the right time - i.e. luck.
2. Two views of the world - Bell curve world, and the Power Law world, Scalability in the Power Law World, Winner-takes-all model, importance of scale in valuation.
3. Diseconomies of scale, bureaucracy, eventual decline of all great corporations inevitable.
4. Mental Trick: Importance of using checklists in dealing with availability bias, first conclusion bias, and confirmation bias, the pleasure of exploiting other people's availability bias, examples.
5. Mental Trick: Effects have effects, Peltzman effect, Carol Loomis on The Risk that Wont Go Away, Need to think like a chess grandmaster, unintended consequences, America's futile war on drugs, Price controls, Jim Roger's Law (you can control the price, or the supply but not both), examples of Licence Raj, Ration Shops, Smuggling and Arbitraging. Need to do "second step analysis" as Buffett did in shutdown of textile operations, how price changes everything (in stock market crashes), how people respond to changes in tax policies and how markets tend to assume that tax changes are permanent, how Indian companies became more profitable and not less after opening up of Indian markets to competition in 1990, How Y2k did not end Indian IT Industry, how in cyclical businesses are influenced by effects of effects, the inability of excel to capture the power of the human sprit to fight and bounce back.
6. Mental Trick: Backward thinking, proof by contradiction, its utility in security analysis, expectations investing, how to find absurd valuations using backward thinking, the removal of need to make elaborate predictions when using backward thinking, using backward thinking in risk arbitrage and in option markets (implied volatility), the need to falsify first conclusions, negative empiricism, the asymmetry between proving something and disproving it.
7. Mental Trick: Zooming in - the need to focus on what is going on at the detailed level e.g. segment data of Microsoft and ITC reveals something very interesting which is camouflaged when one looks at overall financial performance.
8. Mental Trick: Zooming out - Need to step back and look at a situation, e.g. Buffett's decision to shutdown textile operations, need to think like an allocator of capital and not as someone married to a business.
9. Mental Trick: Be creative: use mind maps, creative whack pack, innovative whack pack - examples of creativity in investment thinking e.g. changing viewpoints, asking what if, using metaphors and Aesop's fables (e.g. the rabbit runs faster than the fox because the fox is running for his dinner but the rabbit is running for his life), the need to invert, the need to check your timing (e.g. instead of asking is this attractive at this price, asking how can I make money in this deal, corporate event etc), the need to be aware of unintended consequences, the need to be very curious about things around us, the need to see the opposite viewpoint, and the need to kill your own best loved ideas, the need to be charmed by randomness...

Lecture 01: Introduction to Mental Models & Mental Tricks

Here is a list of topics covered in my BFBV class (in which I had an opportunity of discussing Charles Munger and Charles Ponzi together!)

1. Mental models: definition, utility, Herb Simon's and Charlie Munger's idea of using checklists, the man-with-a-hammer syndrome.
2. Warren Buffett's decision to shut down textile operations of BRK (students were given his essay in his 1985 letter as pre-reading material). Dissection of Buffett's textile experience into multiple mental models - competition from microeconomics, return on capital from accounting, opportunity cost from microeconomics, prisoners' dilemma from game theory, contrast effect from psychology and bias from commitment and consistency from psychology.
3. The necessity of "jumping jurisdictional boundaries" and the futility of using a single tool like Microsoft excel to make decisions.
4. The mental model framework - the Lollapalooza effect, the need to look at extreme outcomes and working backwards to mental models and also to see how mental models work together to produce lollapalooza effects (thinking forwards).
5. Inherent contradictions between some mental models e.g. Adam Smith's invisible hand and Garrett Hardin's invisible foot.
6. Feedback loops from engineering, their application in other disciplines, positive feedback loops (spiral, runaway, vicious circles) and negative feedback loops (self correcting e.g. business cycles). Examples of bank runs and stock market crashes and successful business models with embedded positive feedback loops (e.g. Buffett's example of dominant newspapers wherein circulation and advertising feed on each other, and Wal-Mart where low-prices create high volumes, which creates scale economics for the company which are passed on to customers in the form of low prices which create high volumes....)
7. Regression to the mean from statistics - applicable in a gaussian bell curve world, Buffett on markets performance regressing to underlying business performance over time, the Graham voting machine weighing machine metaphor, mean reversion strategies, all trends are not destiny.
8. Creative Destruction by Schumpeter and its relation to extinction in evolution - Sometimes trends ARE destiny, examples of digital cameras vs analogue cameras, mobile phones vs fixed line telephony etc - fascination about observing what goes on inside the heads of entrenched player in a industry who is about to be dislodged by an upstart who has made a better mousetrap, the light at the end of the tunnel coming from an oncoming train metaphor.
9. Ponzi scheme from mathematics - importance of thinking in terms of Munger's "functional equivalents" i.e. in this case embedded ponzi schemes in RIETS, business models like Amway, venture capital, greater fool theory in IPOs, chain letters, pension funds etc.
10. As a follow up reading, students were asked to read Charlie Munger's essay on S&Ls in Wesco Financial's annual report for 1990. They were asked to analyze his marvelous decision to get out of the S&L business when he could see the threat from money market funds and Freddie Mac (oncoming train), and how not only he got out of the way of that metaphorical train, he jumped on to it and made a billion dollars for his investors in the process.

Two Nights Before...

.
My course - Behavioral Finance and Business Valuation (BFBV) starts on 9/11. Two more nights to go. Been busy preparing a revised course outline (I like to change my course every year otherwise it gets too boring to put the same slides again and again).

I will have a total of 30 contact sessions with 70-odd students. I wish I could have more contact sessions - there is so much material to cover! Soon, the students will be tormented by an avalanche of mails and assignments etc from me :-)

I have prepared a list of topics I want to add and those I want to delete. There is a list of movies to show, stories to tell, video scenes to play. There is a list of appropriate quotes to insert at the right moment. Its like writing a screenplay!

I am increasing the scope of behavioral finance component this year and hopefully students will like that. I have also incorporated many changes triggered by Nassim Taleb and his influence on my thinking. His latest book- Black Swan - is very good and I can relate what he has written to a huge number of real-cases which would be suitable for classroom discussions.

The photo at the top was taken by my wife while I was deeply engrossed with my friends i.e. my books. Two more nights and miles to go before I sleep...

My Bookshelf at Shelfari

You can see my bookshelf here which I am in the process of updating. I recommend this site to you.

Interview with Capital Ideas Online

11 June 2007

Chetan Parikh of Capital Ideas Online, who had hosted a talk for me in 2002, came to Delhi on 22 March, 2007 to interview me. The transcript of the 2002 talk can be seen from here. And the transcript of the 2007 interview can be seen from here.

Update on 8 July 2007

The full version of the 2007 interview can now be viewed from here. Uploaded with permission of CIO.

Going, Going, Gone!

Finally, I found an auditor with a sense of humor!

Here is a notice filed by a listed company with NSE today:

Madras Fertilizers Ltd has informed the Exchange that "With regard to Auditor's opinion that the Company is not a 'GOING CONCERN' but a 'GONE CONCERN', it is stated that the Company has represented to the GOI that the policy on pricing of NPK since Apr 2002 and on Urea from Apr 2003 have adversely affected its profitability. Consequently, the Company has been making huge losses. The networth has been fully eroded on 31.3.2004. The Company has been urging the GOI to make suitable corrections in the Pricing Policies. The DOF referred the Company to BRPSE. BRPSE recommended certain relief measures for revival of the Company. A Financial Restructuring package aimed at making the operations of the Company commercially viable is under the consideration of Government".

Thank you Ankur for pointing it out to me!

My Recent Investment Operations

I have uploaded a pdf file on my recent investment operations on my site which can be seen from here.

Schemes of Derangement

One of my colleagues, Ankur, brought this one to my attention.

There is this company - Shivam Autotech- which was recently listed on the stock exchanges. This company emerged out of a scheme of arrangement proposed by Munjal Auto Industries.

Here is the stock price chart of the Shivam Autotech since it listed:

As the above chart shows, the stock price has fallen significantly post-listing - this is a very common phenomenon.

Anyway, while going through the scheme of arrangement, Ankur came across the following text:

"All the equity shareholders of the transferor company shall be issued 1(one) equity share in transferee company and 1(one) equity share in transferor company in lieu and substitution of 2 (two) equity shares held by them in the transferor company as on the record date fixed by the transferor company. Those shareholders holding the Shares in physical form shall get shares in the physical form and those holding in Demat shall be credited in Demat form. Fractional entitlements arising out of the aforesaid shall be consolidated and sold through market operations and proceeds will be donated to the Prime Minister Relief Fund." [Emphasis mine]

Unbelievable, isn't it?

If you owned odd number of shares in the transferor company, the sale proceeds of your fractional entitlements ended up with India's Prime Minister. Neither did you get the shares, nor did you get the sale proceeds! A wonderful example of altruism isn't it?

I am reminded of another scheme of derangement which was implemented several years ago. Godrej Industries, with the help of very helpful lawyers (whose bread I eat, his song I sing) drafted a scheme which enabled the company to buy back shares from minority stockholders at Rs 18 per share - a rather low price in relation to underlying value, as subsequent events would prove.

The interesting thing about this scheme of derangement was that it had negative consent embedded in it - if you were a minority stockholder in Godrej Industries on record date, the company would take away your shares and send you a check for Rs 18 per share, unless you opted out of the scheme by a specified date. And if you were holidaying on date or forgot to open your mail, or opened it a bit late? Well, thats just too bad!

The Godrej Industries case went all the way to India's Supreme Court and the Court ruled that one share is one vote and if the body of shareholders has passed the scheme, then the court sees no reason for intervention. The company, backed by the Court judgment went ahead with the buyback. That same stock today quotes at Rs 976 (after adjusting for a stock split).

So much for shareholder democracy i.e. all shares are created equal. But, as these schemes of derangement show, some shares are "more equal" than other shares...

Essar Shipping's Delisting Sinks, Drowns Prisoned Stockholders

Essar Shipping's stock sank yesterday on news of the failure of the tender offer to take the company private under SEBI's Delisting Regulations.

In a cryptic-sounding message, the company informed the following to the Mumbai stock exchange:

"Essar Shipping & Logistics Ltd has informed the Company pursuant to the approval of the shareholders for delisting of equity shares of Essar Shipping Ltd ("Target Company") from Bombay stock Exchange Ltd ("BSE") pursuant to SEBI (Delisting of Securities) Guidelines, 2003, The Essar Shipping & Logistics Ltd had made a Public Announcement for making an offer to the Public Shareholders of the Target Company in terms of the Guidelines.

The Reverse Book Building Process ("RBB") closed on March 16, 2007. As the aggregate number of shares tendered by the Public Shareholders was less than the number required to reduce the public shareholding of the Target Company to fall below minimum public shareholding determined as per the provisions of the Listing Agreement, the Delisting Offer has failed in terms of the Guidelines and no securities can be acquired pursuant to such Delisting Offer.

In light of the facts and law stated above, the Target Company will continue to remain listed on BSE. The shares deposited in the Special Depository Account of the trading members during the RBB will be returned to the respective public shareholders in accordance with the Guidelines."

If you were a shareholder in Essar Shipping, your situation was analogous to that of one of the prisoners in the famous game of prisoners' dilemma. You could either sell your shares in the market, or you could tender them to the offerer.

If you tendered, then the offerer would return your shares if the total number of shares received were less than the minimum required (this is what happened in this case) or if the book-built price arrived at after the tender was over was rejected by the offerer as too high. (this is what happened in the Blue Dart case a few months ago).

Both these outcomes take place AFTER the tender offer is over, by which time its too late to sell the tendered shares in the market (in the absence of futures trading) because you don't have them with you. So, a failed offer, typically results in a crash, as the above chart depicts.

Viewed from your own perspective, the correct strategy is to sell the stock in the market rather than tendering it - the above chart shows that those investors who followed this advice would have fared well.

The problem, of course, is that if everyone follows this advice, then the tender offer must fail!

A nice little prisoners' dilemma embedded inside the SEBI's Delisting Regulations...

The Journey from "Value" to "Glamour": Two Examples

In October 2001, SRF (SRF@IN) appeared on my radar screen as a deep-value stock. At that time, the stock price of the company was Rs 14 per share. The company was deeply out of favor in the stock market for many reasons.

First, the company was in the business of making CFC gases many of which were required to be phased out under the Montreal Protocol.

Second, the company was also in the business of making Nylon Tire Cords (NTC), an input required for making cross-ply tires as opposed to radial tires. Cross-ply tires need much more NTC than radial tires. As India was expected to move from cross-ply tires towards radial tires just like other developing countries had in the past, the SRF's NTC business was perceived to be a declining one.

Third, a family whose record in matters of corporate governance was nothing to write home about, controlled the company.

Fourth, the company was highly leveraged due to over expansion with debt in the past and was perceived as risky because of this reason.

So, there were many things going against the company and the stock: sunset industries, poor management, leverage.

However, a few things intrigued me. At Rs 14 per share, the market cap of the company was Rs 910 million. Debt was Rs 3.4 billion. So the enterprise value was Rs 4.3 billion. Over the previous three years the company’s operations had generated cash of Rs 1.9 billion a year. The enterprise value was 2.3 times cash flow. Moreover, the average cash flow from operating activities (after payment of interest) over the same period was a hefty Rs 1 billion a year so the shares of the company were selling at less than one times cash flow! Simple backward thinking showed, that for this valuation to be correct, the company must go extinct very soon. How likely was that? Extremely unlikely, I figured. For many reasons.

First, the company was de-leveraging its balance sheet and the stock price was highly sensitive to debt-reduction (which is the most sensible allocation of capital decision in such cases).

Second, even though the company was in business activities perceived by markets as sunset industries, the company would continue to be around for a long long time. In my view, the markets had over-discounted the negative aspect of a declining industry and under-recognized the benefits that go with such cases (low competition, high returns on capital, plenty of free cash flow since depreciating productive capacity wont be replaced).

Third, the company had acquired a NTC plant from Du-Pont for a song. Du-Pont was exiting the business, and sold it to SRF at a ridiculously low price in relation to the amount it had spent to build that plant. Moreover, along with the low-priced plant came accumulated losses, which SRF could use for shielding its profits from taxes. And SRF could, and did, turn around the plant with little effort and expense (by changing it to make a product that was in high demand as opposed to continue to making a product for which there was little demand and for which the plant that originally been erected by Du-Pont).

Fourth, the company was receiving compensation under the Montreal Protocol, for phasing out the production of some CFC gases. Indeed, what astonished me was that the amount of money to be received was more than the then prevailing market cap of the company! Such was the negative perception of the market that it was unwilling to see how cheap the stock had become.

Fifth, at Rs 14 per share, the company was paying a dividend of Rs 2 per share. The dividend yield was an unbelievable 14%. Normally in such cases when one sees such a high historic dividend yield, the future dividend is cut. I figured that given the healthy cash flows and the low amount of cash required to maintain dividend, this was extremely unlikely to be the case. With the benefit of hindsight, I can now say I was right.

Convinced that I had identified an extremely cheap stock, I bought it in large quantities.

Fast forward to 2006. See chart below:The chart above gives a vivid description of what happens to a stock when it moves from “value” to “glamour”.

By March 2006 – less than five years after I identified it as a deep value stock – the stock price had soared to Rs 360 per share – a twenty-five bagger (ignoring dividends which would make it look even better).

I sold off my shares long before it hit Rs 360 because when it moved out of my “value” range I no longer understood it. I sold and moved on to what I thought were greener pastures.

What’s more interesting for this discussion is that by time the stock hit Rs 360 it had become a “carbon credit story” which in early 2006 was considered as “glamour”. The company was in possession of carbon credits and more were in the pipeline and the markets were seduced into putting a very high market value on these credits. As the carbon credit story melted soon after, the stock has since declined to Rs 120 indicating the risk of investing at high prices in glamour stocks as opposed to the risk of investing in deep value stocks at non-glamorous prices.

In August 2004, I added to my holdings in Heritage Foods (HTFI@IN) because the stock had declined from Rs 70 to Rs 50 level for what I thought were wrong reasons.

At Rs 50 per share the market cap of the company was Rs 500 million. Total debt was very low at Rs 230 million. The stock was yielding 5.5%, which was very attractive because in India dividends received by investors are treated as tax-free income.

Heritage makes packaged milk, a product where penetration rates are low because most of the milk in India is sold in loose form. Given that India is the largest milk producing country in the world, the potential for growth in this business is huge.

However the stock price of the company, at Rs 50, per share, did not reflect this. In effect, at that price, one was getting the future potential growth for nothing.

Over the previous 10 years, Heritage’s revenues had grown at 35% p.a. and EBITDA had grown at 36% p.a. Moreover the reported earnings of the company were real earnings, which showed up in discretionary cash instead of fixed assets, inventory, or receivables.

I also liked the management of the company, which was focused on growth without sacrificing stockholders’ interests. For example, the company had completed a stock buyback program recently.

Despite having a good business (with superb returns on capital), excellent growth prospects, a solid balance sheet (low debt in relation to cash generating ability), an owner-oriented management, a low price in relation to underlying value, the stock had declined from Rs 70 to Rs 50. The chief reason for this, in my view, was the poor recent showing of the company.

Heritage buys milk from farmers, processes it in its milk processing plants, packages and sells it under its brand. Milk procurement prices had recently increased due to shortfall of rains (less rains means less fodder which results in less milk supply) as well as intervention of state governments in fixing prices of milk to be paid to farmers. In addition, the state governments also control the retail prices of milk and they were kept low, which forced the company to absorb cost inflation. As a result, the company’s margins had fallen dramatically from their long-term average.

I thought this to be a temporary phenomenon. I have strong faith in “reversion to the mean” mental model. If you flip a coin ten times, you may easily end up with eight heads and two tails. If you flip it twenty times, the proportion of total number of heads to total flips should reduce from eighty percent. If you flip it a thousand times, the proportion of total number of heads of total flips will almost certainly revert to fifty percent, which is the probability of landing a heads if you flip a coin.

In the above example, the mean of fifty percent acts as a strong magnet pulling the average towards it.

What works in coin flips works in a whole lot of other things around us. For example stock returns are mean reverting but stock prices are not. In the case of stock returns, the magnet that pulls the returns towards it is the underlying return on equity. Hence the truism of that famous quote by Mr. Buffett: “Bull markets and bear markets can obscure mathematical laws but they cannot repeal them.”

I figured that reversion to the mean was the appropriate model to use in the case of Heritage for many reasons.

First, the company had staying power to ride out temporary adversity. A strong balance sheet and a high cash generating ability of the business indicated this staying power. Second, the rise in milk procurement prices would produce the incentives for farmers to direct more capital towards production and sale of milk. And third, the politicians had reduced the sale prices of milk in retail markets to gain some temporary political mileage, which was needed by them to win some elections.

All in all, I figured that the reversion to mean in Heritage would, in all probability, restore normal earning power of the company and deliver me with more than satisfactory returns.

Did I get those satisfactory returns? The chart below shows that I did.But, did the returns come because of the mean reversion? No, they did not. Over the next two years, even though the company’s revenues grew significantly, the margins did not grow. Then what caused the stock to rise from Rs 50 in August 2004 to Rs 440 in February 2007 – a nine bagger in just two and half years?

The company announced its intentions to go into real-estate development. Since the company was in possession of some real estate, and real estate was “glamorous” in late 2006 and early 2007, the markets became excited and lifted the valuation of the company in a very short while. By the time the stock hit Rs 440, the company was more of a real-estate company, which also sold milk, rather than the other way round!

I had long ago sold my holdings before the stock hit Rs 440. As was the case with SRF, when the stock went above Rs 170, I could not understand it anymore. It was no longer a value stock but was about to become a glamour stock. (The stock has since fallen to Rs 225 as markets have become a bit more sanguine towards the real estate sector).

I can give you more examples of similar transformation of value stocks into a glamour stocks. But that would be unnecessary I think. What I want to do here is to list out the similarities in such situations.

Almost certainly, the near-term outlook in such cases looks horrible. And markets assume that recent trend is destiny. More often than not, markets are proven wrong. So, betting against the market in such cases is likely to be a winning strategy.

In a famous academic paper, the authors De Bondt and Thaler explained that investors tend to extrapolate past earnings growth too far into the future, assume a trend in stock prices, over-react to good or bad news, or simply equate a good investment with a well-run company regardless of price.

For any or all of these reasons, some investors get over-excited about stocks that have done very well in the past and they buy them and then these “glamour” stocks become over-priced.

Similarly, many investors over-react to stocks that have done very badly, and they become excessively pessimistic about them and sell them at lower and lower prices and as a result these out-of-favor stocks become under-priced.

According to De Bondt and Thaler, contrarian investment strategies work because contrarian investors invest disproportionately in stocks that are under-priced, and under-invest in stocks that are over-priced.

My own experience shows that De Bondt and Thaler were right. When you buy a value stock, lots of good things can happen to you- things, which will deliver you more than satisfactory returns. Even though your original thesis of buying into a value situation may prove to be somewhat inaccurate, the chance that more good things are likely to happen to you than bad things becomes a real friend. In contrast, when you buy a glamour stock, you run major risk of a permanent and sudden loss of capital because by its very nature glamour is a fair-weather friend – here today, gone tomorrow!

My Course, My Mac, and Some Recent Investments

My course at MDI is over for the year! What a relief!

Here is a presentation, made on my new Mac (If you don't have one, then get one - if you have a windows PC, then switch - its easy), on some of my recent investments (many of which were discussed as cases in the class):

http://www.sanjaybakshi.net/Recent_Investments.zip

You will need Apple's Quicktime to view it. Get it from:

http://www.apple.com/quicktime/download/win.html

Arjya @ MDI

On a cold Sunday morning, Arjya Chattoraj, an ex-student who is presently Senior Manager at SBI Mutual Fund, delivered an excellent talk to 20 students at MDI . The talk was titled "10 Things I Wish I Knew Before I Entered The Equity Markets".

You can see Arjya delivering the talk from here.

The presentation can be downloaded from here.

Hips don't Lie

Dear Sir,

This is with reference to the ‘Hips Don’t Lie’ lecture. There are a few doubts I have about this…

Firstly, this is what I understand about the two approaches (please correct me where I’m wrong):

An investment is ‘good’ if the present value of future cash-flows is greater than the price paid for it (the basic economic concept). Since future cash-flows have to be estimated, there is a risk that we may overestimate these cash-flows. To deal with this risk, we keep a margin of safety in the price that we are willing to pay for an investment. These points are common for both ‘value’ and ‘growth’ approaches.

Now, on the one hand, in the value approach, we keep a margin of safety by mainly relying on the current economic value of the firm’s assets and not so much on its future growth. We mainly try to value the existing assets of the firm and see if we can get an ‘interest’ in them at a cheap price. Graham’s 10 rules of return and risk largely point in this direction.

On the other hand, in the growth approach, we keep a margin of safety by mainly relying on the future growth prospects of the firm and not so much on current economic value of its assets. We try to estimate the future cash-flows of the firm based on our strong expectations of growth and see if we can get an ‘interest’ in these cash-flows at a cheap price.

The ‘value’ approach relies on cash-flow value of assets while the ‘growth’ approach relies on the cash-flow value of growth. Therefore, in using Graham’s approach, the nature or quality of a company’s business is not of critical importance but the quality of its assets is. On the other hand, using Fisher’s approach, the nature and quality of the business (including the management) is of prime importance and not the quality of its assets.

Now my question: when you say that the two approaches are ‘joined at the hip’, do you mean that they CAN be integrated into a better investment philosophy or they SHOULD be integrated to have any sort of philosophy at all?

To my mind, the two approaches are separate and can be effectively used separately. Even if someone is able to integrate them, at some point of time, there would have to be tradeoffs between the two approaches. When I say this, I’m thinking similar to Michael Porter’s model of basic strategic orientation of firms: Low Cost OR Differentiation. A firm cannot be both: a low-cost operator as well as a differentiator, at the same time. It has to make a trade-off and focus on one approach as a provider of ‘sustainable competitive advantage’ this is because the two approaches are mutually exclusive. This does not mean that a low cost operator should completely ignore differentiation and vice-versa. What it only means that in the end, a firm can focus on only one approach from which to derive its competitive advantage.

Similarly, can an investor, psychologically and intellectually, handle the diverse demands of the ‘growth’ approach and the ‘value’ approach? Will he not have to eventually make trade-offs, in his investment philosophy, towards one approach, at the expense of the other? The expertise required to pick a good value stock and a good growth stock are probably very different. Should one try to achieve both? It is certainly desirable to be able to do both.

But is it feasible?

Sincerely yours,

K.K

_____________________________________________________________________________________

Dear K.K,

I think it is feasible to have your cake and eat it too :-)

You made some excellent points.

Graham's approach - often called the value approach was based on “protection” instead of “prediction”. He was never a believer in forecasting financial statements beyond a year or two. Rather, he focused on getting something that was cheap today based either on asset valuation, or on earning power valuation, WITHOUT making optimistic growth projections about that future earning power.

The key thing to remember is that Graham never really valued a business or a stock. Rather he insisted on a large margin of safety i.e. proof that the price was he was paying was much less than the value that he was receiving, whatever that value may be. Moreover, his extreme diversification took care of mistakes of commission.

In the modern context, many Grahamites, including me, have evolved Graham's approach to incorporate growth expectations in our investment process. Basically, we are so spoilt by Graham that we like getting free lunches and having our cakes and eating them too :-)

Seriously, we DON'T pay for growth. We are aware that some businesses have a great growth potential but we don't want to PAY for that growth. So we like to buy growth stocks at prices which imply low or negative earnings growth.

Read the following very interesting document which will hopefully resolve your questions. If not, please revert.

http://tinyurl.com/y9h252


SB

___________________________________________________________________________________


Dear Sir,

The speech you sent does indeed explain the ‘have your cake and eat it too’ approach. In essence what you and Mr. Nygren are saying is: take Graham’s value approach and apply another ‘filter’ of growth to these value stocks. The ones which emerge out of this double selection criterion are good stocks for investment.

So the approach is essentially value investing with an additional safety buffer called growth. You are not looking for high-growth stocks and buying them almost regardless of the price because the high internal rate of return will make up for a steep valuation today, given sufficient time.

So, I’m probably beginning to understand the idea behind value and growth approaches being ‘joined at the hip’.


K.K

Are CFO's Men with Hammers?

The following is the text of an article I wrote recently for a publication meant for CFOs. The article was withdrawn before publication.

Are CFO's Men with Hammers?

I often ask my students the following question:

You are the CFO of a textile company which makes commodity yarn. The industry in which you operate is extremely competitive beset with excess capacity.

A leading textile machinery manufacturer’s marketing agent approaches you with a proposal to sell you a new loom which is more efficient than any other loom available in the market. He informs you that the new invention is far more efficient and that it will save your company a substantial sum of money every year, so that it will pay for itself in a very short span of time. To justify his claims, he presents you with the following figures: (1) Cost of machine: $100 million.; (2) expected life = 10 years; (3) annual savings in operating costs for the next 10 years = $25 million. p.a.; (4) expected residual value of the machine = $10 million.

You have verified the numbers presented to you and find them to be accurate. Your company’s pre-tax hurdle rate is 15% p.a.

Should your company place orders to buy these looms?

Using their newly-acquired skills in DCF analysis, the students quickly determine the NPV, which is large and positive, and conclude that the loom should be purchased and installed as soon as possible.

The main problem with this approach is that it often leads to wrong conclusions arising out of over-use of the DCF model in finance and ignorance of appropriate models from other disciplines such as microeconomics, game theory, and psychology.

Warren Buffett, the world’s most respected investor and Chairman of Berkshire Hathaway Inc., and his partner, Charlie Munger, call this “the man with a hammer syndrome”: To a man with a hammer everything looks like a nail. If all you have is one tool, you’re going to end up overusing it.

How can one deal with the man with a hammer syndrome? Well, the best way, according to Mr. Munger, is to train oneself to “jump jurisdictional boundaries” and grab the most appropriate models from multiple disciplines that best solve the problem at hand.

The present problem requires a two-step analysis drawing on models from multiple disciplines before drawing any conclusions.

The first step involves using DCF analysis, which my students have no problem with. That part of the analysis has already been done and described above.

It’s the second part of the analysis which they miss. They miss it because they are not yet trained to think in a multi-disciplinary manner.

That second part of the analysis requires them to answer the following question: How much of the cost savings that the new loom will deliver be kept by the company and how much of it will be passed on to the company’s customers?

Ah ha! Now it gets a bit tricky, doesn’t it? It gets tricky because to answer that question one has to grab models from microeconomics – such as the model of competition. And, of course, when you look at it from that angle, its obvious, that given the nature of textile industry’s competitive nature, arising out of surplus capacity and commodity attributes of the product, most of the cost-savings from the new loom will go to the customers of the company, and not to its owners.

This will happen because once a textile company acquires the new loom and achieves the promised cost savings, it will tend to either lower its prices to gain market share, or keep prices unchanged to earn higher margins.

Sooner or later either of these two actions would get noticed by the company’s competitors and they would naturally rush to make the same investments in new, efficient looms, in order to regain lost market share or to earn higher margins. Ironically, the very salesman who sold the loom to your textile company will rush to sell it to your second competitor and then the third one and so on, citing your own cost saving experience as reason for your competitors to buy his company’s new invention. After all, he is not in the business to make your production process more efficient. He is in the business of making money for his company (“Whose bread I eat, his song I sing”).

In our problem, competition i.e. the absence of a cartel will ensure that almost all of the efficiency gains end up in the pockets of the buyers of textiles, and not in the pockets of the owners of the textile companies.

Another irony arises out of the fact that this tragic outcome would occur even though all of the promised efficiency gains materialized. It’s not that the new looms aren’t any good. In fact they are so good that any advantage for the early buyers will prove to be a temporary illusion because sooner or later everyone has to have one or risk being perished.

Such is the nature of certain businesses where you have to keep on putting more and more money in just to stay where you are. (It's like running up on an escalator which is moving down - lots of investment, zero progress). You keep on investing money in projects which have positive NPVs and high IRRs and still end up earning substandard returns on capital that destroy shareholder value.

On the other hand, if we were dealing with India's largest tobacco company like ITC, a virtual monopoly where the buyers of its cigarettes are price-insensitive addicts – if someone sold it a more efficient machine to make its cigarettes - then the cost savings from this new wonderful invention will not be passed on to the customers. Rather, much of the post-tax cost savings would accrue to the benefit of ITC’s shareholders.

So, without jumping over the jurisdictional boundary of finance where DCF resides, into the jurisdictional boundary of microeconomics where the model of competition resides, you cannot solve the problem at hand in a satisfactory manner.

In early 1980s, Mr. Buffett faced a similar dilemma in the management of the unprofitable textile business of Berkshire Hathaway. He knew that the US textile industry was going to become increasingly uncompetitive, primarily due to its high, and impossible to reduce, labor costs. He also knew that he had other opportunities in which he could invest capital where the prospects of earning superior returns were excellent, given the fundamental economics of those businesses then available.

Long before most capitalists would even consider the possibility, in 1985, Mr. Buffett decided to shut down the textile operations of Berkshire and redeploy the capital in great businesses. It proved to be one of the best business decisions he ever made. In a letter written to the shareholders of Berkshire in 1985, Mr. Buffett reasoned:

“The promised benefits from these textile investments were illusory. Many of our competitors, both domestic and foreign, were stepping up to the same kind of expenditures and, once enough companies did so, their reduced costs became the baseline for reduced prices industry wide. Viewed individually, each company’s capital investment decision appeared cost effective and rational; viewed collectively; the decisions neutralized each other and were irrational (just as happens when each person watching a parade decides he can see a little better if he stands on tiptoes). After each round of investment, all the players had more money in the game and returns remained anemic.”

Mr. Buffett utilized the metaphor of a parade to illustrate a well-known problem in game theory called “Prisoner’s Dilemma.”

Prisoner’s dilemma involves two suspects, A and B, who have been arrested by the police. The police have insufficient evidence for a conviction, and, after separated both prisoners, offer each the same deal: if one testifies for the prosecution against the other and the other remains silent, the betrayer goes free and the silent accomplice receives the full 10-year sentence. If both stay silent, the police can sentence both prisoners to only six months in jail for a minor charge. If each betrays the other, each will receive a two-year sentence. Each prisoner must make the choice of whether to betray the other or to remain silent. However, neither prisoner knows for sure what choice the other prisoner will make. So the question this dilemma poses is: What will happen? How will the prisoners act? The dilemma is summarized in the following table:

The dilemma arises when one assumes that both prisoners only care about minimizing their own jail terms. Each prisoner has two options: to cooperate with his accomplice and stay quiet, or to defect from their implied pact and betray his accomplice in return for a lighter sentence. The outcome of each choice depends on the choice of the accomplice, but the player must choose without knowing what their accomplice has chosen to do.

Let's assume prisoner A is working out his best move. If his partner stays quiet, his best move is to betray as he then walks free instead of receiving the minor sentence. If his partner betrays, his best move is still to betray, as by doing it he receives a relatively lesser sentence than staying silent. At the same time, the other prisoner's thinking would also have arrived at the same conclusion and would therefore also betray.

If reasoned from the perspective of the optimal outcome for the group (of two prisoners), the correct choice would be for both prisoners to cooperate with each other, as this would reduce the total jail time served by the group to one year total. Any other decision would be worse for the two prisoners considered together. When the prisoners both betray each other, each prisoner achieves a worse outcome than if they had cooperated.

In other words, actions that appear to be rational from an individual’s perspective sometimes become foolish, when viewed from a group’s perspective. The functional equivalent of the prisoner’s dilemma in our problem creates miserable choices but would we have discovered that unless we had jumped over into the jurisdictional boundary of game theory? I think not.

So, we grabbed DCF from finance, and then jumped over its jurisdictional boundary into the territory called microeconomics, where we grabbed competition. Then we jumped over the fence again and grabbed prisoner’s dilemma from game theory.

We need one more jump into the jurisdiction of psychology. And then we can stop jumping around and solve the problem.

One model we will grab from psychology is what Mr. Munger calls “bias from commitment and consistency.” When you have already made prior commitments to pet projects, you may find it hard, even impossible, to reverse your position and change course. If old reasons are no longer valid to support the original decision, new ones shall be invented. Man, after all, is not a rational animal, but a rationalizing one.

Another model we will grab from psychology is called the “contrast effect”. One version of the contrast effect makes small, incremental escalations in commitments go un-noticed, particularly when these escalations are carried out over a long period of time.

It works in Chinese brainwashing techniques. It also contributes to foolish business decisions.

If you’ve already sunk in $1oo million in a bad capital investment project, an additional investment of $10 million will look very small in contrast to the much bigger total commitment already made and will therefore tend to go un-noticed.

This version of contrast effect is also called the "boiling frog syndrome": If you put a frog in boiling hot water, it will jump out instantly, but if you put a frog in room-temperature water and then slowly heat it, it will boil and die.

The story about the boiling frog isn’t true. That metaphor, however, is highly appropriate because the human equivalent of the boiling frog is there in all of us.

Mr. Buffett could see that bias from commitment and consistency and the boiling frog syndrome from psychology often combine with the prisoners’ dilemma model from game theory, making many a businessman take foolish decisions by continuing to sink more and more money in a lousy business instead of taking money out and re-deploying it more productively elsewhere. He realized that in some industries the chief problem is that if you continue to remain in the game then “you can’t be a lot smarter than your dumbest competitor”.

And, so, Mr. Buffett wisely refused to play this game and withdrew his capital from the textile business and re-invested the proceeds in businesses with much better fundamental economics like Coke, Gillette, Capital Cities, See’s Candies, and Nebraska Furniture Mart. Over time, his decisions to shut down the textile operations of Berkshire and to re-allocate the released capital elsewhere have made its shareholders richer by tens of billions of dollars.

Mr. Buffett’s multi-disciplinary mind helped him solve a complex business problem. I see no reason why CFOs cannot apply the same thinking style in solving complex business problems they face.

Otherwise, they are destined to remain as “men with hammers”.

Project Libra Revealed

In 2001, I and one of my great friends Nalin, were working on a secret project. We decided to call it "Project Libra". The Project involved exploring ideas for unlocking value from a company which I thought was highly undervalued.

While preparing for a lecture today, I came across the transcript of a chat I had with Nalin on Project Libra. This chat took place on 19 May, 2001. I reproduce here the transcript of that chat. I decided not to edit anything out or make any corrections whatsoever.

At the end of the transcript, I have placed a stock price chart of the company from around the time of that chat till recently. It became a 35-bagger. The company's name is Lakshmi Machine Works.


Chat
Date: May 19 2001 - 11:58am


Sanjay says:
Hi Nalin, will try to send Libra comments thru MSN

Nalin says:
Okay - send

Waiting for Nalin to accept the file "Libra Comments.htm" (4 Kb, less than 1 minute with a 28.8 modem). Please wait for a response or Cancel (Alt+Q) the file transfer.

Transfer of file "Libra Comments.htm" has been accepted by Nalin. Starting transfer...

Transfer of "Libra Comments.htm" is complete.

Nalin says:
Okay got it. Tell me when you send the Libra stuff. Bye
Sanjay says:
Wait
Nalin says:
waiting
Sanjay says:
is the file legible. it may not be i am sending a text version
Nalin says:
okay send

Waiting for Nalin to accept the file "Libra comments.txt" (4 Kb, less than 1 minute with a 28.8 modem). Please wait for a response or Cancel (Alt+Q) the file transfer.

Transfer of file "Libra comments.txt" has been accepted by Nalin. Starting transfer...

Transfer of "Libra comments.txt" is complete.

Sanjay says:
will SMS u when ready with Taurus comments
Nalin says:
Got it thanx. Actually I don't remember myself if Rieter was under hostile takeover. Remember I told you in Delhi about a Swiss activist investor. Do you remember which company he was trying to acquire - why is Rieter or some other ?
Sanjay says:
That guy sold stake a pharma co to another pharma co
Nalin says:
Okay - anyway I had already deleted the hostile takeover reference.
Sanjay says:
OK spend a couple of minuts reading my note. I'm waiting
Nalin says:
Okay
Nalin says:
I'm still reading it - but I have one question - maybe you can answer while I continue reading - why should normal dep be 50% of dep charged ?
Nalin says:
Also, on the financial engineering thing - if you took out Rs 100 Crore from the company (by replacing it with debt) it won't earn 45 Cr of discretionary profit a year.
Nalin says:
I agree, in general, that financial engineering can add value. But only when cash earnings. (They may already be stable - but we're not sure of that yet). Also, financial engineering in India is a very difficult task - and an acquirer would not want to pay now for benefits of financial engineering which he'll do post acquisition.
Sanjay says:
Take a look at the gross block and the accumulated depreciation. Gross block is 603 cr and acc dep is 407 cr. They are definitely overproviding depreciation. The amount of money that would be required to replace this gross block is definitely a lot more than the net block figure of 196 cr
Nalin says:
Sorry I missed a work in that message. I meant to say "But only when cash earnings are stable"
Nalin says:
If you feel that they are overproviding dep, then that is an additional upside which we will find out in detailed due diligence (if we are ever allowed to do that ) - at this stage its just a guess - we can't expect someone to pay top dollar for a guess.
Nalin says:
For all we know their assets might need a major revamp - which they have been delaying. Also in cash earnings we must deduct their increasing need for working capital
Sanjay says:
I am quite confident of the overprovision. Take a look at all the cash they have squandered away thru stupid diversification over all these years. THow did they finance it? not from new issue of shares, but from debt and internal accruals. Basically they had too much cash and insteadd of returning it to stockholders they simply threw it away
Nalin says:
You are right they might have overprovided depreciation. Do you want to base our presentation on that premise. Are you sure enough to make it a KEY assumption ?
Nalin says:
I'd rather just make it an additional upside
Sanjay says:
Not at all. What I want is to inform our investor group that this is classic case of massive misallocation of cash generated from operations. And that a rational person in control will have an opportunity to correct that misallocation and create value
Sanjay says:
Fine, you'can make it an additional upside but I should be in the document
Nalin says:
Okay - so we make that an upside that an acquirer gets - when he gains control. But I don't think we should ask him to pay for an upside - that we have no way of proving at this stage.
Nalin says:
Then the strategy remains more or less unchanged ?
Sanjay says:
Please also notice that my additional debt of Rs 100 cr requires an annual interest outgo of only Rs 15 cr and I have assumed c discretionary cash earnings of 45 cr p.a. at least until TUF benefits are available for the next three years. Even if the discretionary earnigns come to less than 45 cr, I can still pay a Rs 100 cr dividend financed out of from borrowed funds because the company is hugely
Sanjay says:
underleveraged.
Sanjay says:
Therefor I can bring my effecive cost of acqusition to Rs 18 cr for a 40% stake
Nalin says:
Like I said earlier - financial engineering is not something an acquirer will pay for up front
Sanjay says:
Why not? I would if I was certain of the benefits. If we get more info on the company's cash generating abilites then I would very gladly pay for financial engerring value
Nalin says:
In some cases it makes sense to go to the hilt in paying. In this case it makes sense to pay as little as possible - and not factor in too many upsides
Nalin says:
How do you get certain of the benefits ?
Sanjay says:
I agree with the conservatinve approach u are taking but putting a value equal to 100% of adjusted book value is too conservative, I feel.
Sanjay says:
We go to Coimbatore on a fact finding mission. we can control costs by travelling by train
Nalin says:
Its conservative - but in this case, paying more doesn't achieve much additional advantage - it disproportionately increases our downside risk. If we stick to market price in our bids - we have almost zero risk of loss - and a considerable upside.
Nalin says:
Even getting control of this company is very difficult - with labour, politics etc involved. Also, it probably has liabilities we haven't even dreamed off - such as corp guarantees for the steel project. Its a mess we don't want.
Sanjay says:
Ok think of it this way. Suppose, the amount of cash that can be taken out of this company without hurting it is only Rs 35 cr p.a. for the next three years and we are use a discolunt rate of 20% p.a. Then the present value of the next three year cash flows alone comes to Rs 650 per share.
Nalin says:
Its pure GM - with controlled downside risks
Sanjay says:
Nalin how can we do a successful GM when we are delaing with promoters who are not cash rich? I thought u did that cash rich promoters
Nalin says:
Listen - the way the industry is going - the company may need to get cash negative - to be able to emerge a strong player
Sanjay says:
But we'll be out well before that happens
Nalin says:
How do you get out ?
Sanjay says:
Leveraged recap can esnure that our cost is negligible. Then whatever we sell the company for is profit
Nalin says:
You can't do a leveraged re-cap if we fear uncertain cash flows - because of a recession + competition. Depending only on the TDF is not enough.
Sanjay says:
To quote u, "I agree to disagree!"
Nalin says:
But what strategy do we put in the book
Sanjay says:
I guess it would be best if we were to fix the meeting for wednesday and I come to mumbai on Monday and we spend 2 days on it
Sanjay says:
Im ust tell u that I am enjoying working with u
Nalin says:
Thats good.
Nalin says:
Lets give one last attempt at coming to consensus now.
Nalin says:
Tell me why is my strategy flawed. Let me defend it for a change.
Sanjay says:
It all comes down to valuation. You are being unlta conservative in valuing this company. A company that produces a cash profit of 70 cr cannot be worth less than the book value of 117 cr. This is true even if a large part of those earnings are not discretionary.
Nalin says:
I'm not saying its not worth more - I'm just saying we shouldn't pay more - what's wrong with sticking to a low price ?
Sanjay says:
Your views on valuation in the presentation are so pessimistic that the whole project will turn off investors
Sanjay says:
and I thought u were an investment banker!
Nalin says:
I WAS an investment banker. Now I think more like a value investor.
Nalin says:
My views on valuation were given on the next page - where I said that it could be worth Rs 1800
Nalin says:
Did you get the presentation ?
Sanjay says:
LOL! i agree we sohuld pay less if we can get away with it but how to achieve it is the issue here. We cannot do this deal unless we convince investors that this is a sitting duck
Nalin says:
But did you get the presentation - I hope you aren't refering only to my initial note
Sanjay says:
That 1800 is based on relative valuation with peers, something that may be difficut to sell to our investors.
Nalin says:
Before I proceed I need to know if you got the presentation
Sanjay says:
I got the presentation. Also, our strategy shoudl reflect the illiquidity of the stock for exit. We cannot sell a deal to investor on the basis that one of the exit routes will be thru the market when dailty volume is 15 shares. We cannot also tell them to hold it as a value stock. Our investors want to make a quick buck.
Nalin says:
I mentioned exit through the market only when the deal is on (and only to a very limited extent). I mentioned illiquidity when I said only 32,000 shares were traded last year.
Nalin says:
Holding on to the stock is a worst case scenario. I think we shouldn't proceed unless we have an investor who is willing to take that risk. Because its a real risk. I can think of no other approach which has a lower risk.
Sanjay says:
The stock is so illiquid that mkt operations after Public Annoucement will not be feasible. under such circumstances, why not have a conditional two-tiered tender offer which guarantees either control or exit thru tender in their counter offer?
Nalin says:
Let me think about this for a minute ?
Sanjay says:
Say a 7% toehold at 850, a 21% offer at 1500 subject to minumum level of acceptance of 20% with a lower offer price of 850 if shares tendered are less than 21%
Nalin says:
I think the problem again will be return on investment. We did this exercise in Taurus. The return on investment was just too low
Nalin says:
What should be the offer size ?
Sanjay says:
The toehold will cost only Rs 7 cr. A 21% offer will cost 38 cr., 50% of which or 19 cr will be cash escrow
Nalin says:
You are saying a 21% conditional offer, with 20% minimum acceptance ?
Sanjay says:
yes
Nalin says:
But in terms of risk - how is this different from what I said. You still run the risk of getting stuck with acceptances in your offer at Rs 850 ? But the downside is that return on investment goes for a toss. It was bad enough under my option at only 50% annualised.
Nalin says:
You also run the risk of actually getting 21% at Rs 1500
Nalin says:
Are you saying the only problem with my plan is that we won't get an investor willing to take the risk of a residuary holding at Rs 850 ?
Sanjay says:
I am unable to explain. Either we have to meet or I have prepare a note on bidding strategy explaining why I think that a conditional offer may make sense. The main reason is that a conditional offer is a hedge. But it imposes an ban on market purchases. But mkt purchases are not going to happen in any case in this stock/
Nalin says:
Okay - we'll discuss conditional offers later. Lets go back to why my plan is flawed ?
Sanjay says:
Look at pg 18. What if they don't buy us out? What if they go to instutions and get them to not tender to us because of lack of significant premium to market offer fro us. There are 100 shares. 13+21+33 (rieter,promoter,instutions) or 67 will not come. 20 shares are are missing. therefore 87 will not come. we already have say 7%. so we'll get only 6% if institutions do not tender.
Sanjay says:
they can simply ignore us and just get institutions to not tender.
Sanjay says:
so we end up with 13% at 850 and no control just apin in their necks
Sanjay says:
in order to get the institutions to tender we have to offer a significant premium to market otherwise they will have an excuse for not tendering. I saw this in Gesco case
Sanjay says:
If institutions do not tender and they don't make a counter offer we are fucked
Nalin says:
There is only a small chance that FIs will pre-agree not to tender. I think FIs will keep quiet about their intentions - therefore LIBRA will be forced to act. Also Rieter may want to ext. I don't think Libra will ignore us because they will not want to take any chances of losing control.
Nalin says:
But assuming this happens (its only a 2% chance) then our max downside is we are stuck with a 15% stake at 850. In other options there are worse risks.
Sanjay says:
In case of Gesco, the institutions made it very clear that they will not tender unless they got book value. In Gesco the book value was 54 and return on equity was less than 5%. So we told them that the stock is not worth book value because ROI is so poor. Thay told us to fuck off and come back with a 54 offer.
Sanjay says:
In LIBRA book value is 2000 even though a lot of it is water, but it does give a huge excuse to institutions to not tender. Also there is a history of this stock which at one tiem sold for Rs 10,000
Nalin says:
FIs will certainly want to put pressure on LIbra to give a better counter offer. They won't want to give them guaranteed comfort - and suggest they don't need to counter offer. Rieter will also want a higher counter offer - so there won't be any guarantees from that end eithre
Nalin says:
Anyway - we are talking about the same flaw - the chance (in my opinion small) of a residuary stake at Rs 850 ? Is there any other flaw ?
Sanjay says:
Precisely the point. In order to put this company in play we have to make institutions the sellers. Once we do that with our offer then our offer is the minimum they would get and they would demand higher from promoters or Rieter.
Sanjay says:
Unless we induce instutions to sell, we cannot succeed. becasue in any proxy contrest tyhey would side with management
Nalin says:
Okay - but we have to be careful not to introduce higher risks just to eliminate that risk - also be careful not to dilute returns too much. If you can come up with such a plan good. If we can't - we scrap this project.
Sanjay says:
My basic difference with you on this is that u are approaching it as a GM operation, whereas I am appraoching it as an acqusition prior to a leveraged recap, but which could also become a GM operation.
Sanjay says:
Hopefully it will be the later
Nalin says:
I strongly feel that we should not acquire this company - but stick to GM
Sanjay says:
But even if it turns out to be the former, I can do a recap to get my cost to negligible levels
Nalin says:
Do you want to discuss GM vs acquisition a little more ?
Sanjay says:
OK
Sanjay says:
Let's talk about promoters. GM is done with cash rich guys not poor ones
Sanjay says:
thesze guys are leveraging to creep up. OK, chola may be a white knight in which case our probability of GM is that much higher
Nalin says:
Overgeneralisations are dangerous. Every situation is different. In this case, we keep the cash required to buy us out low - so that they can actually buy us out - therefore a low bid
Sanjay says:
u do have a point there
Nalin says:
If Cholamandalam is appears as a white knight and gives a counter offer without buying us out - we lose - but hopefully without a loss.
Nalin says:
Also please note if we start a bidding match, Cholamandalam can still come in - in that case our losses would be even higher
Sanjay says:
now u're making sense
Sanjay says:
what 2 do?
Sanjay says:
OK, here;s a plan, we go with your presentation with John and ASit and see how they feel about it. Do u want to talk to Asit about Libra?
Sanjay says:
On pg 19 of your presentation u mention, "If promoters do not give counter offer - we become largest shareholder". I don't agree with this because we will not have significant tenders at a low price offer if institutions are not participating
Nalin says:
Listen I don't want to steamroll you into this. So you keep thinking. I'll keep working on the presentation. Overall, I think we should give both plans to Asit and John, just to show that we have more ideas where Taurus came from. On whether the plan is good or not - we can decide tomorrow
Nalin says:
Okay - I'll take care of that
Sanjay says:
Just think about this aspct
Nalin says:
Yes - this requires a lot of thinking - I agree
Nalin says:
Earlier when I said we should give both plans to Asit _ I meant both projects not both plans
Nalin says:
Someone has just sent me an email from gescocorp. Should I check and see ?
Sanjay says:
WHATTT????
Nalin says:
Wait I'm checking
Nalin says:
A friend of mine has just joined Gesco Corp. He's coming to visit tomorrow. How wierd.
Sanjay says:
Don't tell him about me!
Nalin says:
I have this feeling that destiny is just a game played for God's perverse amusement
Nalin says:
I won't.
Sanjay says:
I wanna live
Nalin says:
Okay.
Sanjay says:
ask him what's happening in the company
Nalin says:
Any more detailed comments on Libra - such as page 19 ?
Nalin says:
I'll work on another draft of the presentation and send it to you - in the meantime you think strategy. But hurry up with Taurus. Because I need to print the presentation today
Sanjay says:
OK Give me 2 hours on Taurus. I agree with most of your work there, just a few points I want to add/amend
Nalin says:
Okay talk to you later then ?
Sanjay says:
In libra disagreement is on valuation, and accoringly on strategy, but i see your point that a alow priced offer will enable the promoters to buy us out at a lower cost
Sanjay says:
Bye?
Nalin says:
It was a stimulating discussion anyway. Bye.
Sanjay says:
bye

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