Vantage Point: 8 Points of View For Evaluating a Stock

The following is the transcript of a talk I gave to students of IIM Lucknow on March 17, 2011:

Today, I am going to tell you a story. Its a detective story with eight witnesses — each with a different point of view.

How many of you have seen the movie, “Vantage Point?”

In any case, let us watch the trailer.

Wikipedia describes the movie as “a 2008 American political action thriller which focuses on an assassination attempt on the President of the United States as seen from a different set of vantage points through the eyes of eight strangers…Displayed with eight differing viewpoints, an assassination attempt on the president occurs, relayed in a time span of 23 minutes. Each time the events unfold from the beginning, a new vantage point is shown revealing additional details, which ultimately completes the story of what actually took place during the incident and who was involved in the conspiracy.”

I got the idea about today’s talk from this movie. And so, I am going to introduce to you eight witnesses in this story. Each has a different point of view.

We are going to take one company — whose name shall soon be revealed — and then we are going to look at this company from the vantage point of each of these eight witnesses. The basic idea borrowed from the movie is that we get closer to the truth when we have multiple vantage points.

As we move from one vantage point to the next, you will get a piece of the puzzle. When you have seen all the eight vantage points, you will have all the pieces of the puzzle. You will get closer to the truth.

During this mystery—solving exercise, you will also recognize a few academic financial ideas and beliefs. You will see them crumble in the face of evidence.

In the end, you will see a more clearer picture of reality than would have been possible otherwise.

Vantage Point # 1: Business Analyst

Our first witness is a business analyst. He is not trying to value the company. Rather, his job is to evaluate whether this is a great business or not. How would he do this?

First, he would look at the company’s balance sheet, an extract of which is reproduced below. Notice, you don’t know the name of the company yet, and you won’t for a while. Let’s keep the suspense on.

What do you see? Let me tell you what I see and while I see this stuff, some questions will arise, to which I would like to know the answers in due course. That’s part of the puzzle we are trying to solve, right?

I see a company which, as of end of March 2011, employed Rs 247 cr of assets. Out of these, Rs 139 cr was deployed in net fixed assets.

The first question that comes to my mind is whether the company is fixed capital intensive? Well, I don’t know the answer to that question until I get to compare the amount of fixed assets employed with annual revenues of the company. That’s what capital intensity (or fixed asset turnover) means — number of rupees of fixed assets required to produce a rupee of revenue. So, I don’t know yet if this business is fixed capital intensive or not. But I soon will. Lets move forward.

What else do I see? I see the company is sitting on investments worth Rs 190 cr. I have a whole lot of questions about that. What are these investments?  Are they marketable securities? (Yes) Are they money parked in debt mutual funds? (Yes). Are they surplus to the needs of the business? (Yes).

What else that is important do I see on the face of the balance sheet? I see a negative working capital of 95 cr. Many questions arise. Why is working capital negative? Is this is a company which is running out of cash and is therefore, distressed?

Hmmm. I know the answer to that one and the answer is no.

How did I arrive at that conclusion? Think about this for a moment.

Let me tell you how I arrived at that conclusion. One piece of evidence is the presence of Rs 190 cr. of investments. As I look deeper in the investment schedule of the balance sheet, I find that almost all of this money is parked in money market mutual funds and therefore, is as good as cash. If this company was financially distressed, it won’t be sitting on so much of cash, would it?

The second piece of evidence that supports my hunch that this is not a financially troubled company, is to do with something that is missing on the balance sheet. Can you guess?

Take a look at the balance sheet again. What do you don’t see?

Debt! There is no debt!

If this company was financially troubled, you should have seen a lot of debt on the balance sheet. But there is no debt! The absence of debt proves that this company is not in distress.

You see, sometimes what you don’t see is terribly important. That’s a useful principle to keep in mind. Most people overweigh what they see and underweigh what they don’t see. But you’re not going be like most people, now, are you?

If the company has negative working capital, and is not in any distress because its debt-free and has substantial cash, then what could cause the working capital to become negative? Think about this for a moment…

Working capital can only be negative if current liabilities exceed current assets. So what part of current liabilities contributes towards negative working capital. Let’s take a look at the current liabilities schedule.

Notice that the company has sundry creditors of Rs 161 crores which, when compared with the total of inventories, receivables and cash on the current assets (see the balance sheet) would still result in a positive working capital. However, there is one item pertaining to Advances from Customers of Rs 92 cr in the above schedule which explains why  working capital is negative.

What does this figure tell us about the quality of the business model of this company? Notice, we haven’t even looked at the income statement, or the cash flow statement yet. Those will come later. But without even looking at those statements, we can conclude that this company has a solid business model, enabling it to demand its customers to pay for its products in advance — thats what advance from customers means isn’t it? In an ordinary business, customers buy first, and pay later. In extraordinary businesses, customers pay first, and receive what they bought later. (In this case, the company’s customers are not end consumers but the distributors of its products who are willing to give it advances first and lift inventory later.)

So it appears that this company has an extraordinary business which is supported by our earlier two discoveries: the presence of substantial surplus cash held as investments, and the absence of debt.

Great businesses are much more likely to have the winning combination of: (1) being debt-free; (2) being cash rich; and (3) with a negative working capital. For example take a look at the balance sheet of two great businesses – Colgate  and Hindustan Unilever- and you will find the same pieces of evidence.

So what have we discovered so far when we put ourselves in the shoes of a business analyst? We have discovered that this company is well financed and probably has a solid business model. Let’s move forward with our analysis.

By looking at the equity schedule we find that company has 1.54 cr shares of Rs 10 face value. Since there is no debt, we can take the total assets of Rs 247 cr and divide by 1.54 cr shares to arrive at the per-share book value of Rs 160.

Next, as business analysts, we want to determine the average capital employed in the company’s operations over the last few years. For that we need to look at figures given in the tables below for fixed assets as well as working capital.

Using the figures in the above table, we calculate average fixed assets employed in the business over the last six years. This comes to Rs 109 cr. Similarly, we calculate the average working capital employed over this period. This comes to a negative Rs 83 cr. Deducting Rs 83 cr from Rs 109 cr, we find that on average the company employed only Rs 26 of assets over the last six years.

Next, let’s take a look at the income statement which is given below:

The first thing that catches my attention is the total revenues of Rs 1,125 cr.

“My god!” I am thinking. This company employs, on average, only Rs 26 cr in assets but has revenues of more than Rs 1,000 cr! Wow! So, now we have the answer to the question I had asked in the beginning: Is this company capital intensive? The answer, of course, is no.

But wait a second. I also notice that of the revenues of 1,125 cr, Rs 653 cr — or 58% of revenues- goes to the government as excise duty! Wow! Thats big isn’t it? It makes me think: “Hey this company is in the business of making money for the government. And the government must depend on it.”

Can you guess what this business could be?

Let me fix my earlier error. I should compare net revenues after excise duty with capital employed to determine capital intensity. Net revenues of Rs 472 cr were produced by employing, on average, only Rs 26 cr of assets. So even after fixing my error, our conclusion that this business is not capital intensive is still valid. The capital turnover ratio of 18 times (472 cr/26 cr) implies very low capital intensity.

What other conclusion can we draw from this analysis? When capital turnover ratio is high, the company can afford to have a low margin, and still deliver an exceptional return on capital. That’s basic “du-pont analysis” you have read about elsewhere. That analysis, you will recall, involves splitting Return on Invested Capital (Profit/Capital) into two components: (1) Margin (Profit/Revenues); and (2) Turnover (Revenues/Capital).

In case of our company, we already know that Capital Turnover is 18. So, even if the company operates at a 5% margin, it can earn a 90% return on capital! Not bad at all.

The big lesson here is that not all low margin businesses are necessarily bad. So next time, you meet someone who tells you that his business has very low margins, ask him or her about its capital turnover ratio, before making any judgments about the quality of the business.

The next step for us is to see what’s the margin earned by our company. Take a look at the income statement again. From the Rs 98 cr of total profit before taxation and exceptional item, lets deduct other income of Rs 33 cr. which pertains to treasury assets. We are left with an operating profit of Rs 65 cr, which on net revenues of Rs 472 cr, translates into a profit margin of about 14%.

Wow! When we combine a 14% margin with a capital turnover of 18 times, we get a pretax return on capital employed of a staggering 250%! We can double check by directly comparing the pretax operating profit of Rs 65 cr with Rs 26 cr of average capital employed to get the same answer.

This is one hell-of-a-business isn’t it?

Two more questions come to mind: (1) Are the reported earnings real; and (2) if they are real, then what’s causing this company to be insanely profitable?

To answer the first question we need to look at the company’s cash flow statement, which is given below:

Recall that from the income statement, we found that the company earned an operating profit of Rs 65 cr in FY 2010. This figure was arrived at after accounting for depreciation. The cash flow statement above shows that cash generated from operations was Rs 81 cr and if we adjust this for the depreciation of Rs 18 cr, we arrive at Rs 63 cr. So, the cash flow statement is consistent with the earnings statement for FY 10. We can do the same analysis for the earlier years and we arrive at the same conclusion.

An extract from the cash flow statement for the last six years is given below:

Total cash flow from operations for these six years comes to Rs 567 cr and annual average cash flow comes to Rs 94 cr. However, since the FY 10’s number was less than the average, lets assume that number of Rs 81 cr to be our estimate of sustainable cash flow going forward. This Rs 81 cr of sustainable cash flow is an important number I want you to keep in mind.

When we compare sustainable cash flow of Rs 81 cr a year with average capital employed of Rs 26 cr, we find that the company earns a cash flow return on capital of 319%, which brings us to the second question I asked earlier: What makes this business insanely profitable?

It is now time to reveal the name of the company to you. Ladies and Gentlemen, the company we are examining is called VST Industries, the Hyderabad-based cigarette manufacturer which owns the “Charms” brand.

I think now you will begin to understand why is this company so profitable, isn’t it? Its because its in the business of selling nicotine to addicts who are brand loyal and price insensitive.

Just how insensitive have these addicts been? We can learn more about that by extracting some useful information from the annual reports of the company. Take a look at the following table:

Notice also that the number of cigarettes sold by the company in FY10 were less than the number sold in FY06. And yet, earnings have grown instead of shrinking as can be seen from the table below:

The reason for rise in revenues and profits despite lower business volume is pricing power. Price per cigarette stick has increased at an annual average rate of 13.9% a year. Every time the government increased excise duties on tobacco products, the company simply passes it on to its addicted customers.

That’s pricing power, which is one the most important attributes of a great business.

The next question that comes to mind is how sustainable are future cash flows of Rs 81 cr a year going to be?. To answer that question, we have to think about the likelihood of people giving up smoking. I think, we all agree, that’s not going to happen.

We als have to think about the possibility of a ban on tobacco consumption, imposed by the government. Now, take a look at just how dependent the government is on VST by looking at excise duties paid by the company over the years from the table below:

The table shows that over the last six years, VST has paid about Rs 3,000 cr as excise duty to government. Now, you tell me how likely is it that the government will kill this golden goose?

Combine this with the direct taxes paid by the company and we can easily conclude that the vice of tobacco has a very good friend in the form of India’s government and so its very unlikely to ban the product. This is a major assumption we are making, however – one that we will look at later on but for the moment lets assume that there is unlikely to be any significant threat to this company’s ability to continue to sell tobacco products to a large population of nicotine addicts.

Vantage Point # 2: Prudent Banker

Now lets shift focus from a business analyst’s vantage point to that of a prudent banker.

Imagine that you are an old-fashioned, prudent banker who believes in the banking dictum that one must lend money to only those borrowers who don’t need it.

How much money would you lend to VST against the security of its business (not counting the surplus cash on the balance sheet?)

What are the key factors that prudent bankers think about before deciding how much to lend to a borrower?

Three factors are critical: size, cyclicality, and interest cover. Other things remaining unchanged, its prudent to lend to large companies whose businesses are not cyclical. If a business is cyclical, then a prudent banker would not depend on peak earnings. Rather, he would compute average past earnings and then ask for a higher interest cover on those earnings than would have been the case if those earnings were not cyclical.

In the case of VST, we already know that the company is both large and not cyclical. Tobacco is one of the least cyclical businesses in the world, after all.

So how much you, the prudent banker, would lend to VST?

Let’s assume that you’d rely on the work done earlier by the business analyst. Let’s also assume that the prudent banker is happy to assume that VST is quite capable of delivering a sustainable cash flow of Rs 81 cr. a year. Let’s further assume that you, the prudent banker, would still insist upon a minimum interest cover of 3 times on the total debt of VST.

Divide 81 cr by 3 and we get Rs 27 cr. This is the maximum amount of interest that VST’s business can easily afford, says you the prudent banker. Given that current interest rates for high-quality borrower are 9% p.a. at present, this means that the maximum amount of debt that you the prudent banker will be pleased to give to VST comes to Rs 300 cr. (Rs 27 cr/9%). In other words, if you give a loan of Rs 300 cr to VST, then the interest on that loan at 9% a year would come to Rs 27 cr a year which would be one-third of its sustainable annual cash flow of Rs 81 cr. So there would be a huge margin of safety on your loan because before your loan is in jeopardy, the earnings of VST must collapse by 67% which is extremely unlikely given the stable nature of the business the company is into.

Paradoxically, the dangerous habit of smoking translates into safety for the prudent banker’s loan to the company.

We have now arrived at an important number of Rs 300 cr as the debt capacity of VST’s operating business. Notice this debt capacity has been arrived at without considering the surplus cash of Rs 190 cr in possession of the company. This Rs 300 cr, is the amount of loan that you, the prudent banker, would happily lend against the collateral of VST’s operating assets and their cash flow.

Vantage Point # 3: Ben Graham, Smart Value Investor

Now let’s put ourselves in the shoes of a smart value investor — someone like Ben Graham who wrote the book on Security Analysis. How would Ben think about this?

This is how he would think:

“Well, the business analyst has done some useful work and determined that VST is capable of delivering a cash flow of Rs 81 cr a year, and the prudent banker has determined the debt capacity of VST’s operating business to be Rs 300 cr. What if, instead of lending money to this business, I could buy the whole business, or parts of the business called shares, at less than debt capacity?”

After all it was Ben Graham, who wrote in his book “Intelligent Investor”:

“An equity share representing the entire business cannot be less safe and less valuable than bonds having a claim to only a part thereof.”

And, in his book, “Security Analysis” Ben wrote:

“There are instances where an equity share may be considered sound because it enjoys a margin of safety as large as that of a good bond. This will occur, for example, when a company has outstanding only equity shares that under depression conditions are selling for less than the amount of the bonds that could safely be issued against its property and earning power. In such instances the investor can obtain the margin of safety associated with a bond, plus all the chances of larger income and principal appreciation inherent in an equity share.”

When it comes to VST, Ben is thinking:

The prudent banker will lend Rs 300 cr to VST. The business delivers Rs 81 cr of cash flow a year. Interest on that loan would be Rs 27 cr. So the prudent banker, by virtue of his loan, would have a claim on only ONE -THIRD of its cash flow. What if, I could buy into VST, a debt-free company, and acquire a claim on ALL of its cash flow for less than 300 cr? After all, if the prudent banker’s claim on only ONE-THIRD of its cash flow alone is worth Rs 300 cr, then my claim on ALL of its cash flow must be worth a lot more than Rs 300 cr.”

Ben would visualize that “hidden inside the stock of debt-free VST, is a bond component, which I can independently value and that value comes to Rs 300 cr. If I can buy the whole business for less than 300 cr, then something good should happen to me.”

And so, Ben would take the debt-capacity of VST’s operating business (Rs 300 cr) determined by the prudent banker. Then he would add the surplus cash of Rs 190 cr on the company’s balance sheet and arrive at Rs 490 cr. He would then divide this number by 1.54 cr shares outstanding which comes to Rs 318 per share.

Ben Graham, the smart value investor, would be pleased to buy VST’s stock at less than Rs 318 per share.

Did the stock fall below Ben Graham’s desired acquisition price? Take a look at the chart below:

In the bear market of 2008-09, VST’s stock price did fall to below the level of its debt-capacity per share, estimated by Ben to be Rs 318. At that price, the stock was a bargain.

Notice that the smart value investor Ben Graham never valued VST. All he did was to determine a price at which it was a bargain. He thought along the following lines: “I don’t know how much its worth. But I do know, it CAN’T be worth less than what a prudent banker would lend to it.”

There is an important lesson here. Smart value investors don’t always value stocks or businesses. Rather they seek a margin of safety. They know that the question ,”How is much its worth,” is tougher than the question, “Is this likely to be worth a lot more than my price?” Smart value investors keep away from making elaborate predictions. Instead, they focus on protection in the form of a margin of safety.

Vantage Point # 4: Bond Fund Manager

How would a bond fund manager think about VST? Well, we know one thing about him. He certainly won’t think out of the box like Ben Graham did.

If VST did have bonds worth Rs 300 cr outstanding, the bond fund manager would happily invest in those bonds. But if Ben Graham approached him and said: “Hey look at debt-free VST. If it had bonds of Rs 300 cr outstanding, you’d gladly buy them because they would be safe. This safety would come from a large size business, very stable cash flows, and an interest-cover of 3 times. But, you would have a claim on only one-third of its cash flows. You’d value that claim at Rs 300 cr. Why not buy the equity of this debt-free company instead for an effective price of less than the same Rs 300 cr, and get a claim on all of its cash flow?”

The bond fund manager would be aghast! He will politely tell Ben that he is not allowed to buy equities and that he is only a bond fund manager. Then Ben will tell him:“You know there is a hidden bond component inside the stock of VST, and that alone is worth Rs 300 cr, so how can the stock be worth less than that?”

Such an argument, which to me is very persuasive, won’t be so to our bond fund manager for he thinks in terms of silos. He goes by titles (like “bonds” and “stocks”) and not by economic substance.

Vantage Point # 5: Henry Kravis, LBO Artist

You are Henry Kravis, who virtually invented the leverage buyout. How would you think about VST?

Imagine its March 2009. The world is apparently ending, and VST’s stock price has crashed to Rs 220 per share. With 1.54 cr shares outstanding, the market cap is Rs 338 cr.

You have done your homework. You know that the company’s business can generate a sustainable cash flow of Rs 81 cr a year. You also know that the company has Rs 190 cr of surplus cash. Relying on the work done by the business analyst and Ben Graham, you know that the minimum value of the stock is Rs 318 per share. That’s puts a minimum value of Rs 490 cr on the company.

It’s time to act. Very quickly, you incorporate a company. Let’s call it “Acquirer.” You, Henry Kravis, inject Rs 490 cr into that company, of which you borrow 90% or Rs 441 cr. The balance Rs 49 cr is your money.

What do you do with the Rs 490 cr in this new company? Well, you use it to make a tender offer to all the shareholders of VST at Rs 318 per share. Since the stock is quoting at 220, your offer price is 45% above the stock price.

Imagine that all shareholders of VST tender their shares to the “Acquirer.” What does the balance sheet of “Acquirer” look like after the acquisition? The cash on the asset side is replaced by a 100% ownership of VST’s shares. On the liability side, there is debt of Rs 441 cr, and equity of Rs 49 cr.

VST is now a 100% subsidiary of “Acquirer.” The entire operating business of VST plus its surplus cash would now belong to “Acquirer.” You would immediately make VST borrow Rs 300 cr from the prudent banker. The cash on VST’s balance sheet would now become Rs 490 cr.

You then merge VST into “Acquirer.” What would be the net result of this merger? The cash of Rs 490 cr, the operating business, and VST’s debt of Rs 300 cr will become part of  the balance sheet of “Acquirer.”

The Acquirer’s balance sheet would now have cash of Rs 490 cr. and debt of Rs 441 cr + Rs 300 cr or a total debt of Rs 741 cr. You would immediately use all the cash to retire debt. As a result, the balance sheet of “Acquirer” would now consist of debt of Rs 251 cr (Rs 741 cr — Rs 490 cr). It would have no surplus cash, but would own 100% of VST’s operating business.

You, Henry Kravis, would then change the name of “Acquirer” to “VST Industries.”

What have you accomplished? Well, you have used the un-utilized debt-capacity of VST along with its surplus cash to acquire it, by putting up only Rs 49 cr of your own money! Granted that the balance sheet has Rs 251 cr of debt, but we already know that this level of debt can easily be serviced from the operating cash flow of Rs 81 cr a year. You can dedicate all surplus cash flow towards debt reduction and pay it all off in just six years, as the table below shows:

In six years you, Henry Kravis, would own 100% of VST, which would now be debt free. You would have bought the company from its stockholders by paying them 45% more than what the stock market was valuing the company for. And yet, your own investment for this acquisition was just Rs 49 cr!

In other words, in just six years, by putting up only Rs 49 cr, you would end up owning a 100% stake in a business capable of delivering Rs 81 cr of unleveraged cash flow a year. And you’ve have accomplished this by buying out the business at a 45% premium to its prevailing market price!

Not bad at all!

And, so much for market efficiency!

There is an important lesson here: Control value investors don’t worry about macro events that cause prices of great, stable, debt-free, cash rich businesses to drop to below the levels of their debt capacities. When such businesses become available at those bargain prices, they act fast. They do not allow the environment of uncertainty and fear prevailing at the time to shift their focus from what really matters — the fundamentals. They go by Warren Buffett’s advice, who famously wrote: “Fear is a foe of the faddist, but a friend of the fundamentalist.”

Vantage Point # 6: Modigliani & Miller, Finance Academics, Nobel Laureates

If you look at what Henry Kravis did to VST, from the vantage point of Modigliani & Miller (MM), you would say its impossible for one of MM’s famous theorem was on the “irrelevance of capital structure.”

According to MM’s proposition on capital structure, under certain assumptions, the value of a firm is independent of its capital structure. One of the assumptions is that the markets are efficient. If the markets were efficient, then there is no difference between price and value and there are no bargains. There can be no Ben Graham, and no Henry Kravis either.

MM’s proposition on capital structure means that in March 2009, when VST’s stock price was Rs 220 per share and its total market value was Rs 338 cr, then that value was “correct” because the “market is always right.”

The MM proposition on capital structure states, that if you make VST borrow Rs 300 cr the value of the firm will rise from Rs 338 cr to Rs 638 cr, comprised of debt of Rs 300 cr and equity of Rs 338 cr. The total cash with the company would now stand at Rs 490 cr. (Rs 190 cr + Rs 300 cr).

Then, MM proposition on Capital Structure states, that if you were to withdraw this cash of Rs 490 cr from VST, which is exactly what Henry Kravis did, then the value of the equity will simply drop from Rs 638 cr to Rs 148 cr.

Recall that the business generates Rs 81 cr of annual average cash flow and the first year’s interest at 9% on total debt of Rs 300 cr, would come to Rs 27 cr. MM on Capital Structure says that VST’s shares after the LBO, will be worth Rs 148 cr even though the business would have earned Rs 54 cr of cash flow after interest in that year!

Isn’t this baloney? Well, I certainly think it is.

People like Henry Kravis laugh at academics who concocted theories like MM on Capital Structure, a theory that all of you have read and I guess, so far assumed it to be correct. Well my advice to you is to dump MM and to pick up lessons from Ben Graham and Henry Kravis instead…

Vantage Point # 7: Value-Oriented Manager

Imagine that you are a value-oriented manager who runs VST and its March 2009 and the company’s stock is languishing at Rs 220. You know that your company’s business is capable of delivering an annual average cash flow of Rs 81 cr. You also derive comfort from absence of debt and presence of Rs 190 cr as surplus cash on the balance sheet. And yet your company is being valued by the market at only Rs 338 cr.

What can you do about this? Well, you can do many things but lets just talk about three of them.

Special Dividend

You make VST borrow Rs 300 cr. Add to this the existing surplus cash of Rs 190 cr, and you now have a total of Rs 490 cr. That’s Rs 318 per share. Then, you simply declare a special one-time dividend of Rs 318 per share! Remember, the stock price is Rs 220 per share!

WTF?

What about MM on Dividend?

Recall from your earlier work in this MBA program that MM also had a famous proposition on dividends. According to this proposition, under certain conditions (the primary one being the assumption of market efficiency), the value of a firm is independent of its dividend policy. The proposition states – and all finance textbooks swear by this as if its the holy grail of finance – that if a company pays a dividend then on ex-dividend date its value will simply fall by the amount of the dividend paid. The theory further states that investors should be indifferent between dividends and capital gains because what they get by way of dividends, they will lose by way a decline in the market value of their shares. And if a firm does not pay a dividend, they will have equivalent capital gains on the stock.

Well, let’s apply this “theory” to VST. If VST’s stock price before the dividend announcement was Rs 220 per share, then after the payment of Rs 318 per share of dividend, its stock price should become negative Rs 98! Is that possible? Can stock prices be negative? Of course not. Ok, lets grant MM this. Let’s say since the price can’t be negative, but because MM on dividends is holy grail, we have to grant to MM that the stock price of VST post dividend of Rs 318 will go to zero!

WTF?

How can this be? Let’s just do the math again.

Recall that what the company paid out as dividend consisted of its surplus cash (which, by definition it does not need to generate its annual average cash flow of Rs 81 cr) and Rs 300 cr borrowed. This Rs 300 cr borrowed can easily be serviced the operating business. We already know this from the work done by the business analyst earlier. We also know that the first year’s interest expense at 9% interest rate on Rs 300 cr of debt will be Rs 27 cr, leaving the company with cash flow for equity of Rs 54 cr. (Rs 81 cr gross cash flow less Rs 27 cr of interest). How can a business that earns Rs 54 cr of cash flow after meeting interest requirement be worthless?

This is an example of proof by contradiction, something you read about when you were in school. Well, its a trick, I advice you to use more often in much of everything you do.

We can never really prove anything. Nassim Taleb says if you want to prove the propositions that “all swans are white” then you can’t prove it by looking for white swans. If, for example, you see  thousand swans and all of them are white, that does not prove the proposition that all swans are white. You can see a million — a billion swans — and if all of them are white that does not prove that all swans are white. But a single sighting of a black swan disproves the notion that all swans are white. So, you just have to learn this trick of disproving much-loved but wrong ideas in finance and other fields by looking for contradictions.

The example of VST’s special dividend is the functional equivalent of the black swan. It’s a contradiction that kills the MM Proposition on dividends, isn’t it?

Share Buyback

You have Rs 190 cr of surplus cash plus you have debt capacity of Rs 300 cr which you utilize and now you have Rs 490 cr. You want to teach the stock market a lesson by valuing your company for only Rs 338 cr.

You are feeling angry at the market and you are feeling bold. You know your company’s stock is worth a lot more than its current price of Rs 220. You announce a buyback at Rs 500 per share!

WTF? Are you crazy?

Lets find out by doing the math. How many shares of the company can be retired at Rs 500 per share by using all of the cash of Rs 490 cr. Divide Rs 490 cr by Rs 500 per share and you get 0.98 cr shares, which out of the total existing 1.54 cr shares amount to 64% of the equity.

Let’s imagine that you go and implement this bold buyback plan and assume that its executed successfully. What will be the consequences?

The company would be left with only 0.56 cr shares. All the cash would be gone. There would be a debt of Rs 300 cr. But the company would still possess the operating business capable of delivering annual average operating cash flow of Rs 81 cr. Reduce first years interest of Rs 27 cr on the debt, and we are left with Rs 54 cr of cash flow for equity. Divide that by the remaining 0.56 cr shares outstanding, and you get cash flow of Rs 96 per share!

If MM is correct, then post buyback the value of the firm should simply fall by Rs 500 cr used for the buyback. The value of the firm before buyback was Rs 338 cr. Then it took Rs 300 cr of debt and the value rose to Rs 638 cr. Now, post buyback, according to MM, the value of the firm should fall to Rs 148 cr. But since there is debt of Rs 300 cr, according to MM, the stock price should become negative and since thats impossible, then it will surely go to zero.

Will the markets really value a stock capable of delivering a cash flow per share of Rs 96 at zero? So, perhaps, a buyback at 500 – at more than double the prevailing stock price, won’t have been as crazy as it looked, after all…

Bonus Debentures

You have Rs 190 cr of surplus cash. You can borrow Rs 300 cr but you don’t do that. Instead of actually borrowing the money, you go and create bonus debentures worth Rs 300 cr and allot them proportionately to your stockholders!

WTF?

Let me explain. We already know that the company can easily service Rs 300 cr of debt. But we dont need the company to actually borrow money. We can simply create a debt instrument out of thin air and distribute it to our stockholders. Let’s say the face value of every debenture we create is Rs 100. So there will be a total of 3 cr debentures. Let’s say the interest rate VST will pay on these debentures is 9% a year.

The company has 1.54 cr shares outstanding. These shareholders will receive 3 cr debentures. This means that for every one share, 1.948 debentures would be simply be given to the stockholders as bonus debentures.

If a stockholder owns 1,000 shares, their market value before the bonus debentures was Rs 2.2 lacs. Now this stockholder will receive a total of 1,948 debentures. How would the bond market value these debentures?

Since these debentures have a face value of Rs 100, a coupon of 9% a year which is the going rate of interest, and since the company would be very credit worthy even after these debentures were created, we can safely say that these debentures would be priced by the bond market at Rs 100 each. The aggregate market value of these debentures in the bond market will be Rs 300 cr.

The stockholder who owns 1,000 shares in VST worth Rs 2.2 lacs would receive 1,948 debentures, which would have an independent market value of Rs 1.95lacs, and he would still own all the shares!

The value-oriented manager did not change anything on the asset side of VST’s balance sheet. All he did was to create a prior claim and transfer it on a piece of paper called “debenture.” This debenture would be valued by the bond market independently. The bond market would correctly value 1,948 debentures at Rs 1.95 lacs and all of the 3 cr debentures at an aggregate value of Rs 300 cr.

If you were to believe MM on Capital Structure, however, the value of the investor’s 1,000 share would drop by Rs 1.95 lacs, from Rs 2.20 lacs to Rs 0.25 lacs and end up selling for Rs 25 per share.

The stock would drop to Rs 25, says MM, because there was no change on the asset side of the balance sheet! There was no new cash coming into VST or going out of VST.

MM on Capital Structure says that if the total value is to remain unchanged, and if we create debentures out of thin air, then the value of the equity shares must simply shrink by the exact amount of the value of the debentures. If MM is right, then the creation and distribution of 3 cr bonds worth Rs 100 each, should result in the drop in the value of the equity by exactly Rs 300 cr – that value would drop from Rs 338 cr to Rs 38 cr or Rs 25 per share.

And yet,this Rs 38 cr market cap company would be capable of earning cash flow for equity of Rs 54 cr. (see our computations in “Special Dividend” section above).

Do you really think that the market would value a firm capable of earning Rs 54 cr a year for Rs 38 cr?

How can the bond market value a claim on only ONE-THIRD of cash flow for Rs 300 cr, but the stock market value a claim on ALL of the cash flow for only Rs 338 cr, which still having surplus cash on balance sheet of Rs 190 cr?

Don’t you see the contradiction here?

Either the bond market is right, or the stock market is right. Both of them can’t be right! That would be impossible isn’t it?

Sherlock Holmes said: “When you have eliminated the impossible, whatever remains, however improbable, must be the truth”

Improbable as it may sound, ladies and gentleman, our method of analysis shows that its the bond market was right by valuing a small part of VST at Rs 300 cr and that stock market was wrong by valuing the whole of the company at Rs 338 cr, not evening counting Rs 190 cr of cash!

The important lesson from the three examples of special dividend, buyback, and bonus debentures is this: A value oriented manager can always do these things to force the stock market to correct its valuation mistake. Moreover, one does not need a Henry Kravis to take VST private using an LBO and enjoy all subsequent benefits for himself. The value oriented manager can achieve the same objective using bonus debentures, allowing the company’s stockholders to benefit from the creation of leverage on VST’s balance sheet.

Recall also that Ben Graham’s abstract idea of a “hidden bond component inside the stock of VST.” Well, the value oriented manager can literally use that idea to deliver to his company’s stockholders an actual bond instrument having an independent market value, thereby forcing the market to correct its valuation error.

Vantage Point # 8: The Civilization

We have come quite far in our investigations. But there is still one vantage point left — that of civilization.

None of the witnesses we have met so far have looked at the company from the civilization’s viewpoint by incorporating what Charlie Munger calls “virtue and vice” effects.

I said earlier, that you’ll get closer to the truth by having access to several vantage points. So let’s examine this last vantage point. Zoom out a bit and look at what’s really happening here. How does VST make money? What do you see?

I will tell you what I see. I see that VST makes money essentially by selling something that kills people. I know its legal to do it, otherwise VST would not be in the business of selling tobacco. But that does not change reality does it? Consider this: If tobacco was discovered today, and the world knew about its horrible effect on the health of smokers, would it be legal to sell it?

Of course not.

You see, things carry on, because they have carried on. The tobacco business is legal because its been around for so long and societies have this status-quo bias, this inertia which prevents them from change. Moreover, the tobacco lobbyists, who don’t want this change, are very powerful. Plus, of course, the government depends on the tax revenues.

What are the real costs of tobacco? I think we all agree that the real cost of tobacco is hardly in the cigarettes sticks. The real cost comes the form of disease and misery caused to smokers and their loved ones when they die from cancer. That real cost is borne not by the tobacco manufacturers, but by society.

Privatized benefits and socialized costs is what makes VST prosper.

How long will this last? I can’t say.

Will you buy the stock? I don’t know. It’s really up to you.

If you see this from the vantage point of a Ben Graham or a Henry Kravis, then maybe, at a price, you will. If you see it from another vantage point, perhaps, you won’t – at any price.

The choice really is up to you. Moreover, you can rationalize whatever you choose. Man, after all, is not a rational animal. Rather he is a rationalizing one.

I do know, however, that you get closer to the truth by having multiple vantage points.

Having just one vantage point in a detective story is not good enough.Having eight is rather cool.

Isn’t it?

Thank you for inviting me!

Note: An abridged version of this post will be published in the next issue of Outlook Profit.

The Grand Strategy of Ajay Piramal

Even if you put zero value on Ajay Piramal, as the stock market is doing right now, you’d have to agree that he’s beaten the hell out of that insanely crazy market.

Since 1988, when he took charge over what is now called Piramal Healthcare, and may soon be called by another name — Ajay Piramal has made his long-term investors not just rich. He’s made them fabulously rich.

Ajay Piramal

Ajay Piramal’s Track Record Speaks for Itself

Consider this: Over the last 23 years, investors in Ajay Piramal’s flagship company have compounded their money at an average annual rate of 28%. In contrast, Sensex compounded at only 17% a year. The difference between compounding money at 17% a year and at 28% a year becomes truly staggering over time. While Rs 100 became Rs 3,700 with Mr. Sensex in 23 years, they became Rs 29,230 with Mr. Piramal instead.

Ajay Piramal’s track record becomes even more impressive if one considers that the 28% a year return delivered by him was computed by using the currently undervalued stock price of Piramal Healthcare.

As I write this, the company has 20.9 crore shares outstanding selling at Rs 479. By the time you read this, however, the company would have bought back and extinguished 4.2 crore shares (20% of the total) at Rs 600 each.

An indication of the price at which the remaining 16.7 crore shares may be valued by the market after the buyback, one can look at the April 2011 futures price now quoting at Rs 450 per share. In effect, post buyback, the stock market is valuing Piramal Healthcare at about Rs 7,500 cr.

When Ajay Piramal bought Nicholas Laboratories from its foreign parent in 1988, the company’s market value was only Rs 6 cr. This launch pad into the drug space enabled him to ride on the wave of huge subsequent growth of the Indian pharma industry. After several brilliant acquisitions, mergers, spinoffs, and other corporate restructuring transactions orchestrated by him over the next 23 years, the company morphed into what became known as Piramal Healthcare.

Then, in May 2010, he stunned the business world by announcing that he has sold part of Piramal Healthcare’s business, constituting about half the company’s revenues, for a staggering $3.8 billion, or about Rs 17,140 crores, to Abbott Labs of USA. Two months later, he sold the company’s diagnostic business to Super Religare for Rs 600 crores.

These two deals, having an aggregate value of Rs 17,740 crores delivered an upfront cash of about Rs 10,200 crores to the company. The balance Rs 7,540 crores — almost all of it due from Abbott — would be received over the next 42 months. Having an insignificant credit risk, these future receipts, which are not conditional upon the achievement of any milestones, have an estimated present value of Rs 6,300 crores, assuming a discount rate of 10% a year.

India’s Largest Cash Bargain

The value of cash already received (Rs 10,200 crores) plus the present value of receivables (Rs 6,300 crores) comes to Rs 16,500 crores. From this, if we deduct taxes paid amounting to Rs 3,700 crores on the huge profits made on these disposals, Rs 2,500 crores utilized for the buyback, debt of Rs 793 crores, and two minor items relating to the payment of a non-compete fee and charity, we are left with net cash and cash equivalents of about Rs 8,700 crores as of now.

On a per share basis (post buyback), this comes to Rs 517.This is the number I want you to focus on because it exceeds the stock price of Rs 450 per share.

If Piramal Healthcare were to be liquidated today for just the cash and its equivalents, with no value received from the sale of its three operating businesses which Ajay Piramal decided not to sell, the stockholders would get about Rs 517 per share. The stock market, it its own “wisdom,” is valuing the whole company at Rs 450 per share.

In other words, if you were to believe the stock market, this company is worth more dead than alive.

For long-term investors, however, this is a great opportunity to partner with one of India’s great wealth creators on very favorable terms.

Given that the current market value of the company is less than cash assets alone, the stock market is putting no value at all on the three operating businesses which appear on its balance sheet. Then, of course, there is Ajay Piramal, who does not appear on the company’s balance sheet but, nevertheless, is its most important asset. He comes free too.

How often do you get a combination of: (1) a company with a large market capitalization; (2) cash in excess of its market value; (3) other assets having substantial future value; and (4) a brilliant and ethical owner-manager who has a demonstrated track record of enormous wealth creation for his long-term partners? Not very often, in fact, its very rare.

Ajay Piramal is a rare occurrence and his story is worth telling you about. But the real story of the man is not just about how remarkably he sold the formulations business to Abbott. Nor is it only about the numerous smart acquisitions he has done although that has grabbed most of the media’s attention over the years.

Ajay Piramal’s story is also about a man who has a contrarian bend of mind, who ceaselessly explores multiple ways of creating value, and who has a very long-term orientation about wealth creation.

A Wealth Creation Machine

Take a look at the following table, taken from a presentation available from the company’s website.

A Snapshot of Long Term Operating Performance

The stunning growth depicted in the table is the result of both organic and inorganic growth. That’s another very rare combination. Being successful in M&A transactions is rare enough (about 70% of acquisitions fail to create value). Being successful in M&A and in operating several businesses in multiple countries is very rare indeed.

One test of long-term managerial performance I use, and which is favored by Warren Buffett, is an “earnings-retention test.” The test measures how every rupee earned, and not paid out as dividends, by a company gets reflected in incremental market value over a five—year rolling period basis.

For companies that destroy value, every rupee of earnings retained is, over the long run, expected to translate into less than one rupee of incremental market value. For value creators, the equation is opposite. Every rupee retained should become much more than one rupee of incremental market value.

Going back to 1990, I applied this test to Ajay Piramal’s flagship company. Even if we ignore that the company’s stock is undervalued (which severely penalizes the results of this test), here is the report card: From 1990 to date: 5.8 times (that is, every Rupee 1 retained became Rs 5.80 in incremental market value); From 1995 to date: 5.5 times; From 2000 to date: 5.1 times; and From 2005 to date: 4.7 times.

Any way you look at it, Piramal Healthcare has been a consistent wealth creating machine, one which has been only partially recognized by the stock market. Had the market given full value to the cash, the three operating businesses, and Ajay Piramal at the company’s helm, the above results would look even more impressive.

Even with one hand tied behind his back, Ajay Piramal has been a champion jockey. Why, then, is the market treating him like an also-ran?

Meeting Ajay Piramal

To find out the answer to that question, and many others, I met Ajay Piramal at his office in Mumbai last August. I met him again today (25 March).

Ajay Piramal

Before meeting him, I studied every acquisition done by him since 1988 including Nicholas Laboratories in 1988, Roche Products in 1993, Boehringer Mannhiem in 1996, Hoechst Research Center in 1998, Rhone Poulenc in 2000, and ICI Pharma in 2002.

As I went through each of these deals, and as I studied his track record of managing the business over 23 years, a pattern emerged.

A Contrarian Mind

In deal after deal, it emerged that Ajay Piramal is a contrarian. Over and over again, he seems to watch what the crowd is doing, and then he goes and does the exact opposite.

Back in 1990s, when MNC pharma were participating in a kind of a “Quit India Movement,” Ajay Piramal bought them out one by one at distressed prices. Now, when MNC pharma is desperate to be a part of the “Indian pharma growth story,” he has sold out to Abbott.

His vision to expand the formulations business which focused on India, while other Indian pharma companies were focusing on exporting generics to the west, was another superb contrarian decision.

Ajay Piramal enjoys taking the road less travelled by. And it certainly has made all the difference.

A Value Investor

Another pattern that emerges is that like any good value investor, he simply does not overpay for assets and he often finds value where there is a distressed seller.

When I asked Ajay Piramal about his acquisition strategy, he listed his three acquisition principles.

“One, there has to be a strategic fit and you have to be honest when you evaluate that. I have seen that there are many investment bankers and consultants who want the deal to happen and so they convince you that there is a strategic fit.”

“Two, M&A is a very heady thing to do for a CEO. At least for the first few weeks, everybody puts your photo in the newspapers and talk about you and so there is this tendency to over pay. And, as you know, 70% of M&A deals don’t create value. So whatever the value you have set out, you should not exceed that. We don’t believe that you can get value out of overpayment.”

Ajay Piramal

 

“Three, never look for a perfect asset. If you are going to acquire a perfect asset then the whole world is going to bid for it and its a very easy calculation to understand value and then you have to keep outbidding the next bidder. So there has to be some chink.That asymmetry which you can recognize that is there today — an inefficiency perhaps, or something wrong which you can correct — that is where the value is created.”

“In every acquisition of ours there was something that other bidders found wrong and that’s why they didn’t do it.Take the classic case of Nicholas Laboratories in 1988. That company was a small multinational and for two or three years they was struggling and they wanted to exit. Another multinational had the offered to buy them out, they had gone through with it in terms of value. Everything was agreed because it was another UK company.”

“But the reason they did not do it, and this is what one of their directors later told me, is because they realized there was some contingent liability relating to some excise duty matter. And you know in many corporations nobody is willing to take the final decision. You need clearance from accounts, you need clearance from legal and so on.”

“If you asked a legal person if there is a risk? Yes there is a risk. But you have to evaluate the risk.Is it really going to materialize and if it does what could be the consequences. In multinationals nobody is willing to take the chance. Instead, they always say, we can’t do it. And that’s how we entered the pharma industry.”

“Or take a look at the Roche and Rhone Poulenc deals. In both these transactions, there was something which was wrong and thats why I tell people when they do M&A deals within our group that if you find everything right, then please understand you have to pay top dollar plus.”

“In the case of Rhone Poulenc, when we acquired it, we realized there was a manufacturing plant in Mumbai. A plant in Mumbai that does manufacturing is a cost. It is a value destroyer because the costs are high. And there are issues of union etc. To most people, that’s a negative. For us, that was a positive because we knew that we can deal with unions and that we can realize value from that asset by developing it.”

One metric commonly used in the pharma M&A deals is price-to-revenue. The highest Ajay Piramal ever paid was 3 times revenues for ipill, the popular oral contraceptive brand he bought from Cipla in March 2010). More typically, he paid less than one times revenue for most of his acquisitions.

When it came to the sale of formulations business to Abbott, however, he was able to obtain a stunningly rich price of 9 times revenues. In contrast, Ranbaxy sold out to Daiichi in June 2008 for 5 times revenues. Indeed, the sale of the formulations business to Abbott, is one of the most richly-priced pharma deals ever.

Seamless Web of Deserved Trust

A big part of the reason why he got such a rich price, is to do with a “seamless web of deserved trust” Piramal has created with big pharma over the years.

When I mentioned this idea to him — an idea that was first articulated by Charlie Munger, Warren Buffett’s partner — he smiled at me. He knew what I was getting at. After all, Ajay Piramal is a Buffett and Munger fan and often goes to attend Berkshire Hathaway meetings in Omaha.

Charlie Munger attributes Berkshire Hathaway’s enormous success to this idea. “When you get a seamless web of deserved trust,” he once said, “you get enormous efficiencies. It’s what the Japanese did to beat our brains out in manufacturing: suppliers, employers, the purchasing company, management – all created a seamless web of deserved trust. It’s the same with good football teams. We are trying to live in a seamless web of deserved trust. It has worked for us, and it is the ideal way to live. How can Berkshire Hathaway work with only 15 people at headquarters? Nobody can operate this way. But we do.”

Now that we were warming up, Piramal wanted to tell me more about the creation of his own “seamless web of deserved trust” over 23 years.

“This web of trust extends to our dealings with everyone including those from whom we have bought businesses and those to whom we have sold. In almost every acquisition that we have done, there was somebody who was willing to pay higher — from Nicholas Laboratories, Roche, Rhone Poulenc, to ICI — there were higher bidders but we ended up acquiring these businesses. Why did this happen? The only reason why it happened every time is because of the trust we have.”

“Why did we get this valuation from Abbott? It is because of this trust. Seeing what other transactions in the environment before us (he is talking about Ranbaxy—Daiichi deal), they could have gotten another asset at much lower price. So why did they come to us? Because there was this level of trust and understanding.

Ajay Piramal

 

“Having a “web of trust” is our philosophy. I am comfortable with it. We don’t have a single legal case. Why? Why did we not go into patent challenges? Because you can’t have a relationship where you keep fighting.”

Ajay Piramal wants you to know that by refraining from fighting big MNC pharma companies on their turf (as many Indian pharma companies have done), he was able to get a much better value for the formulations business from them on his turf. Can this advantage be replicated? I think so. How could it be otherwise?

Take for example the CRAMS business about which he is optimistic and has a long term vision. This is a small business at present but Piramal expects it to grow. Pfizer (the world’s largest drug company) is a customer of Piramal Healthcare in its customs manufacturing business.The act of letting someone else handle your intellectual property by big innovative pharma companies, requires a very high degree of trust in the manufacturing partner. By leveraging his web of trust, Piramal expects to become a “partner of choice” for big pharma companies.

Of course this requires a very long term vision, which is another element of the pattern that emerges by studying his track record.

Long Term Vision

He tells me “I don’t take much cognizance of the stock market which focuses on the short term. I will do what’s right for the business and the shareholders.Frankly, I don’t owe my job to an analyst. So, therefore, I can afford to take a long term view.”

For instance, he decided to go into drug discovery business very early. This business requires very long term thinking, ability to take risks, and to be prepared for failures, for the success rate is very low. Moreover, there is hardly any earnings visibility — something that most analysts abhor. But if you get lucky, then the sky is the limit.

If you step back a bit and see what is happening to the big pharma companies in USA and Europe, you will see that there is this big wave coming. Its a wave of shift of innovation from west to the east. Its a small wave right now. But Ajay Piramal can see it becoming a tidal wave in a few years.

Through Piramal Life (the unit was spun off from Piramal healthcare in 2007), Ajay Piramal has positioned himself just ahead of this approaching tidal wave. Shakespeare, who wrote “There is a tide in the affairs of men, which taken at the flood, leads on to fortune,” would have approved.

Grand Strategy # 1: Drug Discovery

A big part of Ajay Piramal’s grand strategy is to retain Piramal Life. But why did he spin it off in the first place and what will he do with it now?

He tells me that Piramal Life was spun off from Piramal Healthcare in 2007 because it had a very different risk profile. By its very nature, the drug discovery business is a highly speculative business. Mixing it with the formulations business did not make sense, hence the spin off.

To many, Piramal Life’s spin off may have appeared as an attempt to correct a past mistake of going into the drug discovery business in the first place. After all, spin offs are often used to get rid of troublesome businesses created by overoptimistic and overconfident men. This, most definitely, was not the case here.

Both Ajay Piramal, as well as his highly qualified and accomplished spouse, Swati Piramal, who runs the company, are very optimistic about the long—term potential for the drug discovery business in India. In many ways, their contrarian traits can be seen from the way Piramal Life has been managed.

For example, if you run a drug discovery company, one way to de-risk the business is to out-license your molecules to a big, and more prosperous pharma company who will then put its financial, technical, and political strength behind its development and approval by regulators such as the FDA. Of course, they would do that in return for a big part of the upside. This is how drug discovery model has worked for decades.

Well, that’s not how contrarians Swati and Ajay would like to make it work for them. Piramal Life has 14 molecules under development, and has no intention, (at least, as of now) to out—license any of those molecules. The reason is simple: They don’t want to give away the upside. If they decide to out-license now, I won’t be surprised that they would be able to negotiate and obtain upfront, and subsequent payments several times the current market value of the company (current market cap at Rs 108 per share is Rs 274 crores). But that is not how they think. They think in terms of not years, but decades. They think in terms of not maximizing near term reported earnings, but maximizing eventual net worth.

Both of them share a dream of leading the first Indian company which goes from discovery of a molecule to the global launch of a drug. Can they do it?

Let me ask you the question another way. Given the resources — technical, human, financial, and their excellent relationships with big pharma — they now have, is there anyone else in India who can do it? And if they do it, can you imagine the financial consequences?

Sometimes in life, exposure to low—probability—high—positive—impact situations (positive black swans) can massively improve the financial results of that lifetime if you get lucky, for you only have to get lucky once in a big way to make it worth your while. And the best way to get lucky is to organize for good luck to come to you.

Louis Pasteur was right when he wrote: “Luck favors the prepared mind.” The minds of Swati and Ajay Piramal are prepared and they have positioned Piramal Life to have a chance for the “best shot at the goal” in the drug discovery business.

There are two more interesting aspects about Piramal Life worth noting here. One, the company has negligible revenues, is highly leveraged (at least when measured against debt service ratios), and has large accumulated losses. Typically, this implies a large bankruptcy risk.

However, the way I see it, the day Piramal Healthcare sold the formulations business to Abbott, the bankruptcy risk in Piramal Life disappeared because a very rich, committed, and long—term oriented parent now stood behind it.

Two, the large accumulated losses in Piramal Life alone would be quite useful to highly profitable and tax paying Piramal Healthcare. That’s because in a merger, they could be used as a tax shield. Back-of-the-envelope calculations show that these accumulated losses alone, are worth about Rs 60 per Piramal Life share, to Piramal Healthcare.

For these strategic and financial reasons, it makes imminent sense for Piramal Life to return to its very rich parent although there is no certainty by which this would happen.

Grand Strategy # 2: Expansion of CRAMS, Critical Care, and OTC

Another part of Ajay Piramal’s grand strategy is to expand the three businesses that he did not sell. These are Custom Research and Manufacturing (CRAMS), Critical Care, and Over-the-counter (OTC) business. These businesses are small right now, but should grow in size as well as profitability over the next few years. Keep in mind that the growth-oriented Piramal is always on the lookout of cheap inorganic growth and it wouldn’t surprise me if he made a few very smart acquisitions in these businesses over the next few years.

The key thing, when you have cash, is to also have discipline. Famous fund manager Peter Lynch once wrote about the “bladder theory of corporate finance,” according to which the more the cash that builds up in the treasury, the more the pressure to piss it away. While this principle is largely followed by many companies and men who have suddenly come into cash, is it likely that Ajay Piramal is such a man?

I doubt it very much. His track record of demonstrated discipline in acquisitions speaks for itself. And recently, when Paras Pharma was being auctioned, while he had an interest in acquiring the company, he walked away because the asking price was too high. He agrees with Warren Buffett, who once said that the smarter side to take in a bidding war is often the losing side.

The key thing to remember here is that, given the current market value of the company, all of these businesses come free to the buyer of the stock at the current price. These include some of the most well recognized brands in the OTC business including ipill, Lacto Calamine, and Saridon.

Do you remember the jingle, “Sirf ek Saridon aur sardard se aaram. Na rahe pida na rahe dard. Bas ek, sirf ek, sirf ek Saridon?”). I’ve been humming it all day! (see this video: http://vimeo.com/20980858)

Well, if you own the stock at the current price, then among many other OTC products, ipill, Lacto Calamine, and Saridon come free (the brands, not the pills or the lotion).

Grand Strategy #3: Diversification

Since the sale to Abbott, the media has been chasing Ajay Piramal about his plans for the cash. In response, he has consistently said three things.

One, he will reward shareholders. This is already done through the buyback. Two, he will expand the remaining three businesses he did not sell. And three, he will diversify into one or more new businesses.

This last statement has spooked the markets. Anytime a company announces a plan to diversify into a new business, the markets tend to dislike it. Usually the market is correct in this assessment because companies do tend to waste cash through diversification. However, my view is that you cannot paint everyone with the same brush.

Just as the market’s skepticism for Ajay Pirmal’s grand strategy of growth though acquisitions was wrong, its skepticism for his decision to diversify is also likely to be wrong. The market forgets that his original decision to move into the pharma business in 1988 was also a decision to diversify away from the textile business.

Nevertheless, the investment community is skeptical about what he will do with the money. Will he go into real estate? (He has denied this.) How about insurance? Or Retail?

My question about this is: Does it matter? Should one not focus on the man’s track record of wealth creation instead of worrying about whether he will go into real estate? And if he does go into real estate business, so what? Of all the people in India, he has one of the best experiences in the business. He was behind Peninsula Land, he was behind India REIT, he was behind India’s first retail mall (Crossroads) and he is behind Sunteck Realty.

Indeed, if Ajay Piramal were to announce that he will diversify into real estate, investors should rejoice for two reasons. One, the man has experience and track record of having done exceptionally well in that space. Two, the space is full of opportunities where he can create value by buying into distressed situations prevalent in the real estate space at present.

Then there is talk about his acquiring Hindustan Dorr—Oliver. So I asked him, not whether he would diversify into the real estate business in Piramal Healthcare, or whether he is going to buy Hindustan Dorr—Oliver. Instead, I asked him, what are the things he seeks when he wants to buy into a new business. He simply repeated his three acquisition principles mentioned earlier. How consistent! He did, however, mention, that he would expand overseas in both related, as well as unrelated ares.

Valuation of Piramal Healthcare (Or Why DCF Sucks)

One of the paradoxes about Ajay Piramal is that while he has a disdain for elaborate excel models of DCF valuation taught at business schools, it is the very same DCF (or rather the absence of the possibility of using it) which is a key reason for the street’s neglect for the stock.

When I asked him about how does he, when he buys into “less than perfect” assets, go about valuing them, and whether he uses formal DCF models or a more simple back-of-the-envelope calculations, this is what he told me:

“Management students may not like this. I am also a management student and both my kids are but let me tell you that management schools are doing a disservice by (overusing) DCF. There is nobody in the world who can predict what’s going to happen in 10 years. And I was a student, so I know how to “create value” — you change the terminal value and instead of 0.5% you will make it 2% growth and suddenly the value increases. So I don’t believe in this. I really do believe you have to get the back-of-the-envelope calculations right.”

“Who can predict what the market growth is going to be. If you tell me anybody who had predicted that the markets will grow like they have in India today. I don’t think so. If anybody could predict to me what is going to happen to the exchange rate which is another big variable? I don’t think so. Nobody can predict what happened to interest rates. So everything is variable and yet on that basis we make a fixed 10 year projection and do the DCF? I don’t believe in this and in my entire life I have never done it.”

So here is the paradox: Ajay Piramal has not made his money by relying on elaborate DCF modeling. On the other hand, sell-side analysts and many investment professionals make their living by DCF modeling. Pick virtually any research report on any stock and turn to the pages in the end and you will see what I mean. There will be projections about the future (many of which will turn out to be wrong), based on which there will projections of future cash flows, which would have been brought back to present value using more projections about cost of capital. This “false precision” is yet another form of “physics envy,” practiced by men (mostly) who forget that its better to be roughly right, than to be precisely wrong.

The trouble with doing DCF on Piramal Healthcare is this: How do you make the projections about a company, which is largely sitting on cash, and has plans to deploy that cash in some new businesses but at this time, even the owner—manager does not know which businesses the company will enter into? So, the analyst is thinking: “How can I even begin to apply DCF on Piramal Healthcare.”

“To a man with a hammer, everything looks like a nail.” The analyst, who only knows DCF, is like that man. He has just one tool — DCF — and he tries to use it on Piramal Healthcare and he fails, so he tries again by beseeching Ajay Piramal to tell him where will he put the company’s money, just so that he can make a model, but Ajay Piramal says: “I don’t know yet.”

After several failures, the analyst gives up.

My advice to the analyst is that he needs another tool, one which he will find if he reads the influential paper “Investing in the Unknown and the Unknowable (http://www.hks.harvard.edu/fs/rzeckhau/unknown_unknowable_PUP.pdf), by Harvard Professor and a, much admired by Charlie Munger, champion bridge player, Richard Zeckhauser.

The World of uU investing.

In his paper, Prof Zeckhauser states, “Most investors – whose training, if any, fits a world where states and probabilities are assumed known – have little idea of how to deal with the unknowable. When they recognize its presence, they tend to steer clear… However, unknowable situations have been and will be associated with remarkably powerful investment returns… Indeed, I would speculate that the major fortunes in finance, have been made by people who are effective in dealing with the unknown and unknowable. This will probably be truer still in the future.”

When it comes to valuing Piramal Healthcare, yes there is uncertainty. There is no visibility. But is this “uncertainty” the same as “risk?”

“Risk,” advices Warren Buffett, should be thought of as the probability of permanent loss of capital. While most uncertain situations are also risky (e.g. new startup ventures), this doesn’t mean that every uncertain situation is also risky.

I ask you to carefully think about this. Given what you now know about Ajay Piramal, given his past track record, and given the asking price for becoming his partner (free), how likely is it that if you do become his partner, and if you have a long—term view, you will suffer a permanent loss of capital?

While the street steers clear from Piramal Healthcare, India’s largest cash bargain, because “the outlook is uncertain and there is no clear visibility and that makes it too risky” does that have to mean that you should steer clear too?

That’s a question I will leave for you to answer. As for me, I have to tell you that I own shares in Piramal Healthcare, and I have to tell you that Ajay Piramal bought shares in the company in November 2010 at around Rs 460 per share, and that the company has just completed a buyback at Rs 600 per share. The stock is selling for 450. The cash per share is 517. Everything else is free.

The author is a Professor at MDI, Gurgaon where he teaches Behavioral Finance and Business Valuation. A condensed version of this post, will appear in the forthcoming issue of Outlook Profit.

How Ben Graham’s Framework Helped Me Earn 36% p.a.

In Chapter 5 titled “Classification of Securities” in his masterpiece “Security Analysis,” the author and my teacher Benjamin Graham rejected the conventional classification of securities into bonds, preferred stocks, and common stocks. Instead, he advised readers to focus not on titles but on economic substance of the security being examined. Graham suggested the following framework:

Classification of Securities: Ben Graham's Framework

This is an incredibly useful framework for practical security analysis for it teaches you to focus on the underlying reality and not on legal claims and titles and names. For instance:

1. When is a stock not a stock but more like a bond? Imagine a stock which pays a dividend of Rs 6 per share, and earns Rs 12 per share, but sells in the market at Rs 60. Imagine further that such a stock is capable of continuing to earn Rs 12 and pay Rs 6 as dividend indefinitely. Under these circumstances, can one not think of the dividend stream of Rs 6 per annum as if they were “bond coupons” on a perpetual bond. If so, what would be the value of this stream of “bond coupons?” Well, if the current rate of interest is 10% p.a., then a perpetuity of Rs 6 per annum is worth Rs 60 today. So the “stock” which sells at Rs 60 can be thought having a “bond component” embedded inside it which has a claim to only half the company’s earnings and yet it alone is worth the current stock price. In other words, using Graham’s framework, one can “see” the “hidden bond component” inside dividend paying stocks having high dividend covers.
2. When is a bond not a bond but more like a stock? Imagine a convertible bond issued at 100 carries a coupon of 10% p.a. (the going rate of interest in India), to be redeemed at Rs 100 in 5 years but which is convertible at any time in its 5th year into 2 equity shares of the issuer. Imagine that 4 years in the life of the bond are over and now the stock sells at Rs 200. Since the conversion value of this bond is Rs 400 which is four times its face value, such a bond is a bond in name only. It will behave in the market like the stock of the company. According to Graham, such a convertible bond, should be treated like a stock and bought only after careful equity analysis.

I think its terribly important for fundamental investors to incorporate Graham’s framework while analyzing securities.

I find one class of securities under Graham’s framework as very interesting. These are Type II (A): Senior Securities of variable value type: Well-protected issues with profit possibilities. These are fixed income securities where there is a very good chance of earning an yield to maturity which is significantly higher than one offered by the promised coupon on the instrument. The example below will illustrate.

In July of 2008, Ankur, my colleague (who worked on this idea) and I started buying compulsorily redeemable preference shares (CRPS) of Sakuma Exports at about Rs 60 per share. This security issued by this commodity trader (risky business model), had features of Graham’s Type IIA: Well Protected Issues with Profit Possibilities. This wasn’t a plain vanilla high grade debt security. Had that been the case, it would have been classified as a Type I security.

Instead, this was a case of Type II A security because it was worthy of a high credit rating, so far as credit quality was concerned, and yet it was selling at an abnormally low price of Rs 60 levels in July 2008. The promised redemption price was Rs 100 in Feb 2011. In addition we were promised dividends of Rs 5 per share every year. If, and it was a big if, the company would honor its promise related to the CRPS, the yield to maturity was excellent.

How did we analyze the credit risk? It was easy. While this company was conducting a risky business of commodity trading, it had zero debt and had cash on its balance sheet in excess of the value of equity and CRPS combined. The total funds required for the promised redemption were already in possession of the company. We started buying.

Two subsequent events re-inforced our belief that the credit risk was negligible and that the market was wrong in pricing this instrument at such a low price. These were (1) the company’s decision to skip its dividend on common stock in order to “build reserves to redeem preference shares by 2011″; and (2) insider buying of CRPS by the promoters.

There is an apparent paradox in (1). When a company skips its dividend, markets assume the worst. While skipping dividends may be bad news for the minority owners of a firm, its good news for its lenders because every rupee not paid out as dividend is a rupee available for debt service.

Point (2) was terribly important to us because we asked this question: “Why would promoters buy the CRPS from the market if the company was going to default on redemption?”

Ankur and I felt that the insider buying was very solid confirmation of our investment thesis and we started buying aggressively. Indeed there were several days when the entire traded volume was shared between the buying being done by the promoters and us. See chart below which shows the price movement of the security over time.

Sakuma Exports CRPS

We stopped buying at Rs 85 in December 2009. As per our expectations, the company never defaulted on the promised dividends and we collected three dividends of Rs 5 each, and one dividend of Rs 4.58 for the period 1 April 2010 to 28 February, 2011. This final dividend, along with the redemption money of Rs 100 per CRPS came in yesterday.

Since dividends are tax free in the hands of the investors, these should be grossed up in order to accurately calculate the pre-tax IRR earned on this operation, which, according to my calculations comes to 36% p.a – all from a fixed income security with profit possibilities mistreated by the market as if it was junk bond with a very high default risk.

Quick Quiz: What’s the Mistake in this Document?

Question: ICICI Securities recently issued a strong buy recommendation on Tata Motors stock. Take a look at this document. Now tell me what’s the biggest mistake in it?

Request to my colleagues: Since you already know the answer, please don’t give it here!

BFBV Examination Question on Risk Arbitrage

Study the following exhibit:

Then study the document at the link below:

Public Announcement: Ispat Industries

Now examine the following three exhibits:

Ispat Industries Stock Price

0.01% Cumulative Redeemable Preference Share

Ispat Industries February 2011 Futures

Based on the above, answer the following questions:

1. Identify the risk arbitrage (special situation) opportunity here. Explain it in detail by reproducing extracts from the documents provided to you. (20 marks)
2. Would you borrow money to do this arbitrage? Why or why not? (10 marks)
3. If you were a stockholder in Ispat Industries and wanted to continue to hold your shares because you felt that the future of this company is bright after JSW’s acquisition of its control, why would it still make sense to still sell them? What is the better alternative? Explain in detail. (10 marks)
4. If you own shares in the company and do not wish to continue owning them, why does it not make sense to tender them in the open offer, assuming the offer was open today? What is the better alternative? (10 marks)

Story@BFBV: Watch Your Language!

What do you really mean when you say you are 90% sure about something? Are you really sure about what it means to be 90% sure? Probably not, according to several studies which show people are consistently overconfident about their beliefs, pretty much like the cat in the picture below:

One trick that makes it easier to visualize what a confidence level of 90% really means requires converting that confidence into a bet involving money. Here’s how.

Let’s say you are 90% sure that the stock market will close higher in 2010 than it did in 2009. If that is really the case i.e. if you are really 90% sure about your prediction, then you should be willing to win $1 in a bet but accept a loss of $9 if you lose. Why?

We already know that either you are right or you are wrong about your prediction. In fact, you are going to be right 90% of the time according to you. Thats what being 90% sure means. If that turns out to be the case, then the expected value of your winning is 90% of $1. That comes to +$0.90

You are going to be wrong 10% of the time according to you. That’s what being 90% sure means – that you will have an error rate of only 10%. If that turns out to be the case, then the expected value of your loss is 10% of $9. That comes to -$0.90.

Therefore, if you are 90% confident that the market will close higher in 2010 than in 2009, then this is a fair bet because it involves an equal exchange.

Put in those words, you may balk at the prospect of losing $9 versus winning only $1. But that is exactly what 90% confidence level means.

When your beliefs are framed in the form of money bets instead of confidence levels, you have a better chance of understanding the odds implied by your beliefs. Keep that in mind when you express confidence in your predictive abilities.

Watch your language!

Story@BFBV: The 12 Angry Men Story

The jury system has been designed to be a great system of decision making.

So what happens in a jury system? Watch 12 Angry Men. Its a great movie to observe psychological models at work.

12 not so angry men (or women) who are honorable and have no connection with the case are required to sit in a room and listen. They are not allowed to talk – the talking is done by the lawyers and the witnesses and the judge. The jury members are required to keep them minds open and their mouths shut and hear the proceedings of the case including the arguments brought forward by both sides. They are required to NOT DECIDE AT THIS POINT. No jumping to conclusions allowed. No first conclusion bias here. No confirmation bias either.

Then they are asked to go sit in a room and NOT COME OUT until they have a UNANIMOUS (or majority in some countries) decision. To arrive at the decision, they need to debate, discuss, look at different points of view, and only AFTER this has been done are they required to DECIDE.

This is a WONDERFUL system of decision making because it forces objectivity, removes first conclusion bias, and confirmation bias – IF IT WORKS. In reality, psychologically astute lawyers will use all the tricks in the trade to manipulate jury members – but at least in theory the jury system is a fabulous system – and strongly advice you to adopt it in your own decision making process.

Remember this: The decision to not decide now on a matter is also a decision. There is wisdom in the Chinese proverb: “My indecision is final.”

Story@BFBV: The Scott Fitzgerald Story

Fitzgerald was right. Almost always there is a reason to not to do something that you have decided to do.

People hate contradictions. They make you uncomfortable. You own a stock which is ridiculously cheap. The market, however, is not cheap. What should you do? Do you ignore the market or do you focus on the market and ignore the opportunity? Is there a way out of this contradiction?

Ben Franklin created a way to deal with contradictions. He called it Prudential Algebra. He described it in a letter he wrote to a friend in 1772:

“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 of 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 balance 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 though 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 – Ben Franklin”

Story@BFBV: The Swan Story

You can never really prove the proposition that “all swans are white” even if you spot a million of them and all of them turn out to be white. But you can certainly disprove the proposition that “all swans are white” by sighting a single black swan. Nassim Taleb’s explains Karl Popper’s powerful idea of falsification in his book, “The Black Swan.”

Evidence that confirms your exiting beliefs is not as powerful as evidence that disconfirms those beliefs.

Great scientists like Richard Feynman agree. He once said, “If you’re doing an experiment, you should report everything that you think might make it invalid — not only what you think is right about it. Details that could throw doubt on your interpretation must be given, if you know them. The exception tests the rule. Or, put another way, the exception proves that the rule is wrong. That is the principle of science. If there is an exception to any rule, and if it can be proved by observation, that rule is wrong.”

Learn to recognize and respect disconfirming evidence if you want to make good judgements. Most people do just the opposite. They seek out evidence that proves them right and ignore or discard evidence that proves them wrong.

Don’t fall in love with your ideas.

 

Story@BFBV: “I Have Too Much Invested in This” Story

If you have spent a month researching an idea, it does not become more attractive than a no-brainer flash you get which you are in the shower. The attractiveness of a stock comes from the difference between its intrinsic value and its market price, and the probability of the two converging. It does not come from the effort you have put into researching it.

Remember the experience you acquire by spending a month researching an idea which turns out to be not so good an idea after all counts towards the 10,000 hours of of experience you need to have to qualify as an expert.

Great scientists know the importance of this principle. Thomas Edison once said, “I have not failed. I’ve just found 10,000 ways that won’t work.”

Likewise, past actions don’t become worth continuing simply because you have too much invested into them. Many a bad marriage is continued because of this fallacy.

You are going to make mistakes. Recognize them, correct them, and move on. Don’t perpetuate your errors by rationalizing that “I have too much invested into this, and I can’t just write it off and start again.

Sunk costs (financial and emotional) are irrelevant for future decisions.