Learning from Security Analysis - Part 1

I have started re-reading Security Analysis, 6th edition, (also will add on things from the 5th ed). I have been putting it on the backburner for sometime, but since the last time I read this was about 14 years back, decided that I have changed too much not to re-read this once more. Hoping to learn a lot more the second time around.

From the preface to the 6th edition by Seth Klarman

Value investing is not a paint-by-numbers exercise. Skepticism and judgment are always required. For one thing, not all elements affecting value are captured in a company’s financial statements—inventories can grow obsolete and receivables uncollectable; liabilities are sometimes unrecorded and property values over - or understated. Second, valuation is an art, not a science. Because the value of a business depends on numerous variables, it can typically be assessed only within a range. Third, the outcomes of all investments depend to some extent on the future, which cannot be predicted with certainty; for this reason, even some carefully analyzed investments fail to achieve profitable outcomes.

It is not enough just to number crunch. A business participates in a complex adaptive system, which is continuously in a flux. We need to be able to understand businesses and their operating environments; political, economic and social environments are also important to be understood.

While bargains still occasionally hide in plain sight, securities today are most likely to become mispriced when they are either accidentally overlooked or deliberately avoided. 

Before buying, it is important to ask the question, why is this cheap?

When bargains are scarce, value investors must be patient; compromising standards is a slippery slope to disaster. New opportunities will emerge, even if we don’t know when or where. In the absence of compelling opportunity, holding at least a portion of one’s portfolio in cash equivalents (for example, U.S. Treasury bills) awaiting future deployment will sometimes be the most sensible option. -- This is a difficult thing to do emotionally, especially in a rising market.

Like Klarman says, this is a very very difficult thing to practice. In a rising market, most value investors get out too early, which in itself is not a bad thing, but tests ones patience and fortitude immensely, to see ones friends keep making money when one is out of the market, sitting on cash.

Even in an expensive market, value investors must keep analyzing securities and assessing businesses, gaining knowledge and experience that will be useful in the future. 

Keep sharpening your saw or as Peter Lynch has said, keep turning over as many rocks as possible. I think it is important to study business in a pattern to get the most benefit. I like to look at a particular industry and multiple stocks within it.

Selling is more difficult because it involves securities that are closer to fully priced. As with buying, investors need a discipline for selling. **First, sell targets, once set, should be regularly adjusted to reflect all currently available information.** Second, individual investors must consider tax consequences. Third, whether or not an investor is fully invested may influence the urgency of raising cash from a stockholding as it approaches full valuation. The availability of better bargains might also make one a more eager seller. Finally, value investors should completely exit a security by the time it reaches full value; owning overvalued securities is the realm of speculators. 

For stocks which are compounding machines, we need to keep updating the intrinsic value, so that we do not get out of them too early. On the other hand, a sense of what a stock is worth is a must at all times for all stocks in one's portfolio.

Aarti Industries - Good Chemistry

Business Overview
• Aarti Industries (AIL) has 3 divisions –
    o Specialty chemicals - Polymer & additives, Agrochemicals & intermediates, Dyes, Pigments, Paints & Printing Inks, Pharma Intermediates, Fuel Additives, Rubber chemicals, Resins, Fertilizer & Nutrients
    o Pharmaceuticals – APIs, Intermediates for Innovators & Generic Companies
    o Home & Personal Care - Non-ionic Surfactants, Concentrates for shampoo, hand wash & dishwash
• One of the leading supplier to global manufacturers of Dyes, Pigments, Agrochemicals, Pharmaceuticals & rubber chemicals.
• Manufacturing units (16):
    o Specialty chemicals - 10
    o APIs - 4
    o home & personal care chemicals – 2

Specialty Chemicals
• Largest nitro-chlorobenzene producer of India with a capacity of 60,000 TPA
• Amongst the largest producers of Benzene based basic and intermediate chemicals in India
• Lowest cost producer of Benzene in the world
• Exports account for 51% of specialty chemicals division with 90% of exports USD denominated
• Offers 100+ products to MNCs globally; has "strategic supplier" status with many
• Globally ranks at 1st – 4th position for 75% of its portfolio
• Works on a cost+ model. Increase in cost of benzene will increase working capital requirement funded by short term debt. Decrease may lead to inventory losses and revenue reduction
• Benzene accounts for ~60% of the company’s revenues, while aniline and sulphuric acid compounds contribute ~12% to revenues.
• With start of the Dahej facility of 30,000 TPA capacity in Q1FY18, AIL will also enter toluene chemistry.
• Exports contribute ~50% to revenue with incremental capex planned to enhance standing in the export market.
• Co supplies products to more than 500 domestic customers and over 150 international customers from 50 countries with a major presence in USA, Europe, China, Japan and India. The customer list comprises marquee brands like BASF, Bayer, Clariant, Dow, DuPont, Flint Ink, Hunstman, Makhteshim Agan, Micro Inks, Solvay, Sudarshan, Sun Chemicals, Syngenta, Teijin, Ticona, Toray, UPL Limited

Pharma
• Pharma business has broken even in FY12 and can aid in growth
• Company has two USFDA facilities one for API and another for Intermediates.
• Comprises of about 15% of total revenues
• 48 commercial APIs with 33 EDMF, 28 USDMF and 16 CEP. 12 new APIs under development

Home & Personal Care Chemicals
• Low margin business
• Expected to grow on the back of larger consumption of hygiene and personal care products. Increasing consumption is driving the demand for range of cosmetic chemicals, health care products and hygiene products using performance chemicals, polymers and oleo chemicals.
• Comprises of about 5% of total revenues

Industry Overview
• Indian specialty chemicals industry is around $25 bn (FY13-14 FICCI report)
• India contributes about 3% of global specialty chemicals industry, which leaves a very large opportunity size.
• Global chemical companies are de-risking the supply chain for their raw-material by diversifying from China to India
• The most impactful regulation from an Indian perspective has been the European Union’s REACH (Registration, Evaluation, Authorization and Restriction of Chemicals), which went into effect in June 2007. This legislation addresses the production and use of chemicals and their potential impact on human health and environment. The substantial impact of REACH will come into play following the implementation of Phase 3 from June 2018 that will regulate any chemical supplied to EU at quantities of 1 tonne per annum or more. Aarti has been REACH-complaint since 2011.

Competitive Landscape
• Chlorination (ranked among the top three globally)
• Nitration (ranked among top four globally)
• Ammonolysis (ranked among the top two globally) Hydrogenation (ranked among the
top two globally), and
• Halex Chemistry (only player in India).

Risks & Concerns

• Co operates in an environmentally sensitive sector and is open to regulatory risk. Government can put in place stringent environmental guidelines which may make their products uncompetitive internationally.
• Fire and accident hazards during operations causing major disruptions cannot be ruled out.
• Issues with US FDA / cGMP on pharma APIs
• Co has exposure to foreign currency fluctuations
• Debt is high
• Though co works on a cost plus basis model in its speciality chemical segment, any significant increase in benzene prices will increase the working capital requirement for the business funded by short term debt, leading to increase in interest outgo and decline in profitability.

Management
• Management compensation aggregates to 10.25cr and is especially high amongst the Gogri family members.
• Management has maintained a dividend payout of over 25% for the last 10 years
• Management is paying out full tax

Financials
• Net debt / Equity is 1.9 at the consolidated level, which is on the higher side. Interest coverage ratio is 4.89 which is healthy.
• Co has maintained strong operating cash flow / net profit ratio, which means they have been able to generate cash successfully over a long period of time.

Piotroski's F-score Analysis

Co fairs well in the Piotroski’s F-score with a score of 6 (out of 9). The 3 points where it did not get a score were very near misses.

Dupont Analysis

• Majority of the ROE is being derived from the financial leverage. The co is slowly improving its margin profile and can maintain its ROE at the current level, even if they reduce debt. At the same level of leverage, ROE can be improved by better margins.
• With a large part of the capex already done, specially for the toluene plant, asset turnover is likely to improve, thus improving ROE further.
• The co is consistently improving its ROE over the last 5 years

Key Assumptions & Key Monitorables
• Growth led by capacity addition will continue
• Debt-Equity levels will not rise further
• Margins will be on an upward trend based on better product mix
• No issues with US FDA or any other regulatory compliance
• Toluene and ethylation plants get onstream with good capacity utilization

Valuation

Stock Update: Century Ply

Q3 FY17 investor presentation and concall summary -

• Hoshiarpur plant for MDF is to start in Mar 2017
• Sainik sold 11,819 CBM (cubic meter) vs 12,037 cbm last year. This is despite impact of demonetization
• Ply sales have been strong in January 2017 as well
• There are around 3,300 plywood units in the country and out of 3,300 units, 2,500 are totally exempted, the turnover is less than Rs1.5 crore, 700 units are under the partial exemption their turnover is Rs1.5-5 crore and only 100 units are there which are in the full duty paying
• MDF: Co 600 CBM/ day capacity MDF plant is expected to come on stream by April, 2017. It entails an investment of 380 cr with 207 cr spent till Q3FY17. 
• The company would also use the MDF produce to make value added products like doors, pre-laminated boards. While it would also produce high density fibreboard (HDF) for manufacturing wooden flooring
• Market share: The company looked to maintain market share in difficult times post demonetisation. Hence, it gave dealers some discounts which led to a margin contraction. However, going forward, the management has indicated that they would reduce these discounts over the time
• Demonetisation impact: The management believes that demonetisation impact is over as the company witnessed ~5% growth in January, 2017. Though the unorganised sector is still witnessing problems, the company believes that it has a great opportunity to capture market share from unorganised players post demonetisation
• Pre-lam particle board plant: Currently, the company has a capacity of producing 1000 boards/day at its pre-lam unit and it would augment its capacity to 3000 boards/day by commissioning one more unit in next 3-4 months
• Commercial veneer: The realisations of commercial veneer increased sharply during the quarter as company sold premium veneer. It expects to maintain such realizations, going forward
• Pricing changes: The company has not taken any price hikes post demonetisation. It would benefit from softening raw material prices and so would look to maintain prices, going forward before the final rate of GST is known. Further, the unorganised players have already take price hikes of ~5% post demonetisation and could also take further price hikes. This would lead to contraction in price differential between organised and un-organised products which would help the company gain market share from unorganised players
• Winding up furniture business: The company has decided to completely wind up its furniture business which it started in 2012. Over the years, the division has accumulated losses of ~25 crore
• Laminates capacity expansion: The company is planning to rampup its laminates capacity by 50% to 7.2 mn sheets
• GST rate: The management expects a GST rate of either 18% against the current incidence of ~27-29%. Post GST implementation, a level playing field would be established and organised players are set to benefit

Near term triggers
• GST implementation is likely to migrate unorganised to organised sector
• Pre-lam is expected to give good growth
• MDF, new facility, is expected to give good growth - FY18 revenue is expected to be around 400cr; At full utilization it can generate 600 cr

Learnings from Buffett's 2017 Annual Letter

This year Buffett dealt with a few important points. I found his lengthy discourse on the superiority of index funds intriguing - but not really applicable for the Indian markets as here, maybe unlike in the US, there is significant outperformance by good funds over the index.

On being in the market

The years ahead will occasionally deliver major market declines – even panics – that will affect virtually all stocks. No one can tell you when these traumas will occur – not me, not Charlie, not economists, not the media. Meg McConnell of the New York Fed aptly described the reality of panics: “We spend a lot of time looking for systemic risk; in truth, however, it tends to find us.” During such scary periods, you should never forget two things: First, widespread fear is your friend as an investor, because it serves up bargain purchases. Second, personal fear is your enemy. It will also be unwarranted. Investors who avoid high and unnecessary costs and simply sit for an extended period with a collection of large, conservatively-financed American businesses will almost  certainly do well.

Having a portfolio of good businesses, without being leveraged and not needing to pull out of the market when there is a downturn, can produce good results over a long period of time.

On share repurchases

It is important to remember that there are two occasions in which repurchases should not take place, even if the company’s shares are underpriced. One is when a business both needs all its available money to protect or expand its own operations and is also uncomfortable adding further debt. Here, the internal need for funds should take priority. This exception assumes, of course, that the business has a decent future awaiting it after the needed expenditures are made. The second exception, less common, materializes when a business acquisition (or some other investment opportunity) offers far greater value than do the undervalued shares of the potential repurchaser.

Here, I think, the Indian tax laws on dividend distribution has skewed the investor giveback so that companies are looking at share repurchases as an alternate mode of returning cash to shareholders. But, in general, the principle outlined by Buffett holds true.

On insurance operations

A sound insurance operation needs to adhere to four disciplines. It must (1) understand all exposures that might cause a policy to incur losses; (2) conservatively assess the likelihood of any exposure actually causing a loss and the probable cost if it does; (3) set a premium that, on average, will deliver a profit after both prospective loss costs and operating expenses are covered; and (4) be willing to walk away if the appropriate premium can’t be obtained. Many insurers pass the first three tests and flunk the fourth. They simply can’t turn their back on business that is being eagerly written by their competitors. That old line, “The other guy is doing it, so we must as well,” spells trouble in any business, but in none more so than insurance.

This is important bit of wisdom to be kept in mind, since we are seeing listed companies in this space now in India. Insurance is a long gestation business which has the potential to create significant wealth for shareholders.

My takeaways from Howard Marks' presentation

My notes from Howard Marks' presentation on 2-Mar-17:

• Definition of "great" companies is dubious. Very difficult to identify great companies over a very long period
 
• Investing is not a matter of buying good things, but buying things well (buying assets which are out of favour)
 
• Forecasting is not possible as the future is not knowable. Try to know the knowable. Focus on specific sectors, industries, companies
 
• The main decision to make at any point in time - whether to play defensive or offensive. You cannot play both at the same time.

• Low purchase price is more important than anything else (including quality of company)
 
• Have to think differently (variant perception) and better - need to have some knowledge different from everyone else
 
• Most investors behave pro-cyclically
 
• You need to have a philosophy and process that you can stick to even in most trying of times
 
• Most corrosive of emotions is to sit up and watch others make money
 
• Plan to survive the "worst day" in the market without having to sell. The challenge is we don't know what the "worst day" will look like, but can get an idea from the past.

• Hubris, ego, over-confidence are enemies of an investor
 
• Your approach needs to be consistent with your personality
 
• Turn cycles to your advantage
 
• Look at E/P and compare with interest rates to get a sense of overall market valuations

Overall, it was a great presentation with some very good Q&A. Thanks to Prof Bakshi for inviting me and hosting such a fabulous and memorable event.

Building the Right Investment Temperament - Excerpts from Howard Marks - Part 6

Finding bargains
• Investment is the discipline of relative selection
• Our goal isn't to find good assets, but good buys. Thus, it's not what you buy; it's what you pay for it.   
• The necessary condition for the existence of bargains is that perception has to be considerably worse than reality.

Ultimately, we are all looking to make money from stocks. So, even though HUL is a great business, it is unlikely to make to really wealthy. A good business is not always a good stock and vice versa.

Patient Opportunism
• Sometimes we maximize contribution by being discerning and relatively inactive. Patient opportunism - waiting for bargains - is often your best strategy.

Patience and being emotionally able to sit tight on a position or with cash is critical, although one of the toughest things to do. This is where the right investing temperament is required. As Jesse Livermore said famously and is also oft repeated by Charlie Munger, "Throughout all my years of investing I've found that the big money was never made in the buying or the selling. The big money was made in the waiting."

Having a sense of where we stand
• Most people strive to adjust their portfolios based in what they think lies ahead. At the same time, however, most people would admit forward visibility just isn't that great. That's why I make the case for responding to the current realities and their implications, as opposed to expecting the future to be made clear.

Move beyond "hope trades" to discerning what is going on in the markets today and calibrate your actions based on that.

Investing defensively
• If we avoid the losers, the winners will take care of themselves.
• Investing scared, requiring good value and a substantial margin for error, and being conscious of what you don't knowand can't control are hallmarks of the best investors I know.
• Worry about the possibility of loss. Worry that there's something you don't know. Worry that you can make high quality decisions but still be hit by bad luck or surprise events. Investing scared will prevent hubris; will keep your guard up and your mental adrenaline flowing; will make you insist on adequate margin of safety; and will increase the chances that your portfolio is prepared for things going wrong. And if nothing goes wrong, surely the winners will take care of themselves.

Avoiding Pitfalls
• The success of your investment actions shouldn't be highly dependent on normal outcomes prevailing; instead , you must allow for outliers.
• Loss of confidence and resolve can cause investors to sell at the bottom, converting downward fluctuations into permanent losses and preventing them from participating fully in the subsequent recovery.

Shit happens. Be prepared, atleast mentally to deal with it. Don't put all your eggs in one basket no matter how good and insulated the basket is!!

Reasonable Expectations
 • Investment expectations must be reasonable. Anything else will get you into trouble, usually through the acceptance of greater risk that is perceived.

Don't try to overreach. Having an unreal and unjustified return expectation is the beginning to investment mistakes. Don't pick a return (like 25% or 30% or 40%) out of thin air and hope to make that every year. It will necessarily make you do things which will eventually lead you to losses.

---

This concludes the learning and musings from Howard marks' The Most Important Thing Illuminated.

You can read the previous posts in order:
Part 1
Part 2
Part 3
Part 4
Part 5
Part 6

Building the Right Investment Temperament - Excerpts from Howard Marks - Part 5

Being attentive to cycles
• Just about everything is cyclical. Cycles always prevail eventually. Nothing goes in one direction forever.
Awareness of the pendulum
• There are a few things of which we can be sure, and this is one: extreme market behaviour will reverse. Those who believe that the pendulum will move in one direction forever - or reside at an extreme forever - will eventually lose huge sums. Those who understand the pendulum's behaviour can benefit enormously.

This is one of my core beliefs. In sports, we call this by "law of averages" or "rub of the green". Mean reversion works, but in some cases, you may need to have a suitable long term time frame to judge its impact.

Combating negative influences
• Many people will reach similar cognitive conclusions from their analysis, but what they do with those conclusions varies all over the lot because psychology influences them differently. The biggest investing errors come not from factors that are informational or analytical, but from those that are psychological.
• From time to time greed drives investors to throw in their lot with the crowd in pursuit of profit, and eventually they pay the price. We must constantly be on the lookout for things that can't work in real life. In short, the process of investing requires a strong dose of disbelief. Inadequate skepticism contributes to investment losses.

Again, something very very core to my belief system. Temperament is what differentiates the good investor from the bad. And the ability to say "No" to things or stories that don't make sense regardless of who is saying it.

Contrarianism
• You must do things not just because they are the opposite of what the crowd is doing, but because you know why the crowd is wrong.
• Establishing and maintaining an unconventional investment profile requires acceptance of uncomfortable idiosyncratic portfolios, which frequently appear imprudent in the eyes of conventional wisdom.
• Only a skeptic can separate the things that sound good and are from the things that sound good and aren't. The best investors I know exemplify this trait. Skepticism and pessimism aren't synonymous. Skepticism calls for pessimism when optimism is excessive. But it also calls for optimism when pessimism is excessive.

Taking a view that is different from the majority is a psychologically difficult thing to do. But the best results are obtained by people who are able to stand apart from the crowd.