WHAT ONE SHOULD LOOK AT WHILE INVESTING IN AN AUTO STOCK?

FINTERESTING SERIES

WHAT ONE SHOULD LOOK AT WHILE INVESTING IN AN AUTO STOCK?

VOLUME GROWTH

This is very important measure for any auto company. Ultimately the sale of automobiles determines their top line (i.e. Revenues)

EBIDTA

This measure gives you an indication of the operating profit of the company. One can determine cost efficiencies by this measure. If the raw material costs haven’t changed and Sale price is steady but the margins (Sale Price – Cost Price) have improved, this is an indication of probable improved cost efficiencies within a company.

PBT (PROFIT BEFORE TAX)

The relevance of PBT can be diluted if it has a significant portion from the sale of assets or investments or subsidiaries income. The bottom-line only has relevance if majority of the profit has come from the operations of the company and not through sale of assets. One should always discount the extraordinary or exceptional items from this factor.

PAT (PROFIT AFTER TAX)

Again the earnings indicator, it dictates a lot of investment decisions. But it might be irrelevant if the company operations element is smaller. One should be wary of the reason for sharp increases and decreases in net profits of the company. Each activity other than operational activity would have a different tax treatment.

CAPACITY UTILIZATION/ PRODUCTION

It is one important criterion to determine how efficiently the company is running its plant. If the company is running at low capacities, it means the company is running at less than expected capacities. Idle capacities incur high fixed costs. However since capacity additions happen in anticipation of future volume growth one has to consider the guided volume growth by the company versus actual volume growth. Under capacities work negatively for the company as it represents that company had failed to recognize the prospective growth.

INVENTORY

This measure can tell you about the demand supply dynamics of the market. A high inventory level should typically show a downward sales trend for automobile companies. Unsold vehicles typically take a lot of storage space and increase company’s costs.

DEBT

One of the major reasons why stock investors stayed away from Tata motors for a long time was the huge debt in its books after jaguar acquisition. A high level of debt can be comfortably serviced if there is a high growth in the sector. Else debt can be a major straggler for profitability.

ORDER BOOK

The size of order booking can help one gauge the level of interest consumers have on the automobile. At-least it provides the feeler on short term prospects of the specific models. However waiting period might not be the best measure to gauge the consumer interest.

PRODUCTION SOPS/ TAX HOLIDAYS

Usually the automobile expand to areas which offer excise duty SOPs/Tax holidays (SEZ). These benefit the manufacturer as they are able to improve their margins. The companies which enjoy high level of these SOPs are better positioned to outperform than peers.

EXPORTS

What proportion of total sales does exports constitute? Which continents it exports the autos to? One has to determine the economic scenario and demand growth, order book size at these parts of the world where the autos are exported. One also has to discount the currency movement leading to pressure on margins for the auto player. A weakening foreign currency will negatively impact the revenues. Exports can also be an important determinant of how portfolio has been diversified across different geographies.One should also analyze whether prohibitive tax / quality restrictions may be imposed in any of those exported geographies.

CURRENT MARKET SHARE

An increasing market share is a huge positive for a company whereas a declining market share should ring alarm bells for an investor. But these comparisons need to be done on segment based (Economy/ Premium / Luxury etc.) as contribution per vehicle depends on its ticket size. There can be further classification depending on which auto stock is under consideration.

PRODUCT PORTFOLIO

A wide array of offerings across segments induces customer loyalty. It helps company retain its customer base when the customers seek to either upgrade or switch the segment. However a slight negative to it is cannibalization within its product portfolio.

ADVERTISING

The more eyeballs the company captures through advertisements, the more sales it can expect. Innovative advertisement increases re-call value and create brand imagery. The use of brand ambassadors to promote the product typically helps positioning and creates aspiration brands. However there are proponents who believe Word-of-mouth is the most essential factor in purchase of an automobile. They claim Word-of-mouth essentially drives people to make the final decision. The advise of existing users, product review on web-forums super-cede the ad campaign influence.

EXPECTED NEW LAUNCHES

New launches can be big spoilers for the existing dominant player. All new launches give the consumer to rethink his choice for the established player for the same price. All new launches come with new features and design. The economics of snob effect plays in, as many are induced to make the new model purchase. One has to discount the impact of these new launches before one makes the investment decision.

COMPETITION

Very high level of competition leads to industry consolidation eventually, however it has been observed in the short term it impacts margins as many try to decrease prices to gain market share. Expected intense competition should alert investor about the prospects of the auto stock in focus.

RESERVES

A company with high level of reserves can sustain price competition for a longer time. It can also make timely acquisition without over-leveraging their balance sheets.

MANAGEMENT

It is very important to note the management of the company. What their credentials are and whether they stand to benefit the company you are investing into.

LABOUR UNION

The Indian auto industry more often than not has been plagued by labour union issues. One has to look at whether simmering tensions between management and union and if this tension of pull the production off-track.

CAPEX PLANS

It would give one a perspective on how the company expects to utilize the free cash flows it generates. Cap-ex plans are very important, it indicates company’s outlook on the current industry and scope of new operations it wants to enter into. Money into R&D and strategic acquisitions might work positively for the company.

BRAND VALUE/ RESALE VALUE AND DISTRIBUTION NETWORK

Distribution network is very important if an automobile company needs to register consistent growth. Brand value is important as it influences the consumer decisions and Re-sale value gives buyer the level of comfort make a switch faster in the future.

EMISSION / SAFETY NORMS

Emission and safety Control costs could also adversely impact auto companies. Any upgrade in technology increases cost. If the company is unable to meet the Emission & safety norms, its sales take a direct hit as the sale is restricted of such vehicles.

Raw materials like platinum and palladium which are part of catalytic converters will increases the costs for auto-companies trying to meet up the emission norms. The emission norms also imply increased cost of up-gradation of parts and processes.

RAW MATERIAL COSTS

The movement of raw material costs in case of any industry. In case of automobile industries one of the main components is Steel and rubber. The Steel and rubber price movement may positively or adversely impact the automobile prices. To be a little quicker to realize the price hikes one should track the iron ore prices. Aluminum price influence the engine prices. Copper is extensively used in wirings, bearings and radiators of the automobile.

AVAILABILITY OF FINANCE

Most of the automobile purchases done by consumers happen through auto loans. Auto loan rates have a negative correlation to auto sales. As the Banks start to increase interest rate, the auto stocks are generally seen under pressure.

INFRASTRUCTURE

Most of us are bullish on India growth story. But we are highly dependent on infrastructure development for the story to actually fructify. Better infrastructure would entail greater trade and higher GDP growth. Improvements in roads, highways should logically increase the demand for automobile as it would become a better alternative vis-à-vis other modes of transport.

MONSOON

India being a agrarian society still and the agriculture still highly dependent on monsoon, the incomes of rural households and their paying capacities are dependent on it.

FESTIVITIES

Pre-festival time (Post Monsoon), is one the better times to play the auto stock. Usually an Indian consumer buys the stock during the festival time (Sept- Mar). It is also considered auspicious time for big –ticket purchases.

OUTSOURCING

Outsourcing has been a BIG story since the turn of this decade. Outsourcing is a cheaper alternate to a critical/ non-critical work done at Developed nations. Setting up manufacturing bases in India for the export market leads to improvement in R&D work/ technology in India. This can bring down costs of production by adoption of world class standards by Indian companies (Auto ancillaries included). This can also boost the credibility of Indian auto company’s products (MADE IN INDIA) across the Globe.

ROYALTY / JVs/ TECHNOLOGY TRANSFER CONTRACTS

One has to discount the royalty payment (as in the case of Maruti Suzuki) and technology available. JVs might bring in advanced technology sharing agreements and company benefitting from the synergies of the two entities. One should evaluate how the JV might benefit the auto you propose to invest in. A limited period renewable contract technology transfer might negatively impact the auto stock closer to the contract renewal.

AUTO FUEL PRICES

One should constantly monitor the petrol and diesel prices. Any substantial rise in auto fuel rise may discourage consumers from buying automobiles. As the costs of maintaining the vehicle increase, people would look at other cheaper modes of transport instead of owning a vehicle. Also there is an indirect link. As the fuel price increases, Inflation increases. Most likely the interest rate would be hiked to contain inflation. This would result in high cost of financing hence low auto sales.

GOVT POLICIES

Some of the govt. scheme might benefit an auto company in specific or the auto sector in general. Schemes such as farm waiver, helps farmers purchase tractors and show them as on agriculture loans. NREGA scheme for instance provides money at the hands of rural units increasing spending power of the rural population and hence their consumption levels. Sixth pay commission and pay revision for Bank and Insurance employees might also boost sales as the arrears received by most of the employees might get diverted to discretionary spending needs. Increase in MSP (Minimum support prices) of crops also contributes to high rural income levels.

MACRO-ECONOMY INDICATORS

GDP estimates, Inflation, IIP numbers, the penetration levels of autos in the country, the per capita income of households, Unemployment rates might be taken into account for an overall perspective on the industry over a longer term.

FINANCIAL RATIOS

If one seeks to be the number crunching enthusiast then one should look at the following ratios, compare it with peers before making a decision to invest into automobile companies.

Earnings per share, P/E ( Price to Earnings) , P/S ( Price to sales),

P/BV ( Price to Book value), EV/EBIDTA ( Enterprise Value/ Operating Profit)

EV/Sales ( Enterprise Value / Sales )

EBIDTA ( Operating Profit), ROE ( Return on Equity)

ROCE ( Return on Capital Employed), D/E ( Debt to equity ratio)

Annual Sales Growth.

For the Fin-Wizards they can make their own DCF model with relevant assumptions.

The G-Crisis

What exactly is the G- Crisis?

There used to a person named George in Europe. He used to work at an investment banking firm. He was among the talented lot in the investment world. A few years later, a few of the investment bankers came together to form a “Association of Investment Managers” which came to be regarded as an ELITE investment managers club. Given his reputation in the market he was offered to join the ELITE club given he fulfills certain requirements.

George was very excited about this offer. He however knew he wouldn’t qualify as a member as he did not completely comply with all disclosure requirements. Being aggressive, he had taken larger exposure in the leveraged securities (securities bought from borrowed money) which was the roadblock of his becoming the member of the group. He had short term liabilities coming up which he had to put up with. But the desperation to become a member of the ELITE club made him fudge the disclosure data.

He asks his long time friend Gore Sam in US to help with how the disclosure should be presented so that he gets the membership. His friend suggests that he hide the leverage by issuing a long term loan in US dollar. He can then swap his loan at a favorable fake exchange rate. This would help him realize more money (less debt) in the accounts and reduce his short term liabilities. (To give a more complex understanding, Gore Sam asked him raise a loan of a Million USD in the US. This converted as 5 million GHX (the local currency) at existing exchange rates (1 USD: 5 GHX). He suggested he should undertake a simultaneous currency swap on the loan at an exchange rate of 1 USD: 3 GHX on the same loan. This way he could show that his debt obligations are low and he could repay his short term liabilities. However Gore Sam asked him for a Commission to arrange for the “off market” favorable exchange rate swap. Even the commission was agreed to be loaned to George by Gore Sam so that he doesn’t face any immediate liquidity crunch and which he could pay over a few months). George was confident of making amends in his accounts after he realizes the returns from his leveraged position in securities. He followed the advice and made it to the ELITE club.

A few months later, the investment decision he had taken on leveraged securities back-fired. Now he had lenders asking him to pay up their money. Under tremendous pressure of an eminent default he yields before the Club members disclosing the crisis. The Club members are baffled at his admission of manipulation. Some of them decline to help George. However since the reputation of the club is at stake they agree to help. They however impose extensive restrictions on George.

1. He is asked to curtail down his living expenses.
2. He is asked to work overtime so that he can earn more.
3. He may increase his fees he charges from his clients.

It is decided only at an eventuality of default would the fund be provided which would be based on every club members individual paying capacity.

Credits
George – Greece
ELITE club- European Union
Gore Sam – Goldman Sachs

The Economics of Money supply

Money supply is one of the most important topics in economics. Monetarists believe half of world problems can be resolved by having an efficient monetary policy.

So let me try making the whole thing easier. What do you think is money supply? How can we increase or decrease it? What are the various interest rates we need to be aware of viz Cash Reserve Ratio, Statutory liquidity ratio, Repo rate and Reverse Repo rate?

Let us relate money supply to the salary we receive on a monthly basis.

Case 1: The salary is your monthly dose of money supply. When you have an increment you are flush with more money. When you have a decrement you have less money to spend.

Corollary 1: When RBI (central bank) starts printing more money the money supply in the economy increases. When it stops printing and starts to purchase the same from the market, the money supply decreases.

Case 2: Your bank tells you to have a Minimum Balance in your salary account. This entails lesser money at the hands of the individual as one has to necessarily maintain this minimum balance to avoid penalty. If the minimum balance amount increases an individual would have lesser money spend.

Corollary 2: RBI asks all commercial banks to hold a certain portion of their deposits in the form of cash. This is called “Cash reserve ratio (CRR)”. If CRR is hiked the banks would have lesser money to lend.

Case 3: The bank wealth management team suggests that you manage your wealth by investing 25% of salary in Gold, Equity funds and a life insurance policy on a monthly basis. This further reduces the cash available for spending. If the ratio increases to 50% you would be left with a niggling amount to spend.

Corollary 3: RBI asks all commercial banks to hold a certain portion of their net demand and time liabilities (i.e. savings and term deposits) in the form of cash, gold and Government securities. This is called the “Statutory liquidity ratio (SLR)”. If the SLR gets hiked, the banks would have to hold further amount in the form of cash, gold or G-secs.

Case 4: On one particular month you realize you have a liquidity crunch (No cash). You approach the bank for short term (30 day) loan. The bank asks you to deposit gold (or LIC policy) as collateral and lends you the money at a rate of interest of 6%. You repay the money after 30 days and the bank gives you back your block of gold. This can be thought of a repurchase agreement, where you offer to repurchase the block of gold from the bank after 30 days by paying the principal and interest amount on the loan. If the bank increases the interest rate, your interest expenses would increase resulting in lower cash to spend.

Corollary 4: When banks have a liquidity crunch they go to RBI and ask for money. In turn they offer G-secs as collateral to RBI. The RBI offers to pay lend them money by charging interest on the invested amount. This interest is known a Repo rate. (Repo doesn’t mean repository but repurchase agreement as discussed in case 4). When repo increases the banks pay higher interest to RBI hence they increase their lending rates. When lending rates increase there is lower incentive for people to borrow. Hence money supply decreases in the economy.

Case 5: On another month you realize you have surplus cash. You approach the bank for 30 day term deposit. The bank tells you it would pay 5% interest on the deposit. If the bank increases the interest rate you would be more inclined to save money than spend it. Thus reducing your money-spend supply.

Corollary 5: When banks have extra cash they park the surplus with RBI. The RBI takes the money and assures them an interest. This interest is known a Reverse Repo rate. However the slight difference between the case and corollary is that RBI gives off G-sec against the money deposited by banks with an agreement to buy them back in future. Our bank offers us no collateral in case it defaults on its commitment. When reverse repo rate increases banks have a disincentive to lend as RBI offers them a higher rate at almost zero risk. Banks would therefore demand for higher returns on their investment thereby increasing interest rate and thus reducing money supply.

Investing in stock markets

Most of us get excited & worried at the same time on the talk of Investing in Stock Market

Frequently the question asked is:

1. Which Scrip?
2. What time is the "RIGHT TIME"?
3. How much return would it fetch?

I would try making it simpler to understand in the coming days. Before I begin I would like to raise one question.

What do we see before buying a car?

I guess every Indian broadly considers the following
1. The segment (small car/ SUV/ large car etc)
2. The price of the car
3. The average fuel efficiency
4. The specs/ features of the car (luxury, value –buy, etc)
5. The Market share and distribution/ service network.
6. The resale value of the car

a.The segment can be compared to which industry-stock you would like to have in your portfolio.

b.The price of the car can be compared with the price of the stock. The market price of the car is determined by the stakeholders (the car company) similarly the market price of the stock is determined by its shareholders.

c.The fuel efficiency can be compared with what is the yearly dividend payout (Earnings growth) the company gives out to shareholders every year on an average.

d.The specs can be compared with the risk preference/ appetite of Individuals.

e.The distribution/ service network can be compared to the Market Capitalization of the stock. The large cap stock would have diverse and multiple shareholders compared to small cap.

f.The resale value of the car can be compared to the liquidity of the stock. As resale value has a direct link to market share/ distribution/ service network for cars similarly there is direct link between Market cap and liquidity of the stock.

VALUATION -1

How do we value a company?

This is probably one of the toughest questions that we need to answer before we decide on investment in any company.

Lets take a more practical example:

I wanted to pursue 1 year MBA finance in UK a few years back. The fees at the premier institutes were exorbitant (Rs. 30 lacs). So I asked went up to my dad and asked him “Would you please fund my UK education? I will pay you back in 5 years”
Now apply this to an industry (in this case me) seeking funds from a potential investor (my father) to expand its business and prospects (getting an MBA degree).

My father gave me a Stern look and said “I need to think about it” (meant he needs to do the analysis).

At this point in time he was considering the “Value-add” the degree would have to me. He asked me the following questions?

1. Why an MBA in Finance? Why from UK? Aren’t there other options? What plans after you complete an MBA? Can’t you do CA/CS and pursue the same? (Seeking to know whether the industry (degree) has future scope/ relevance and how does it plan to position/compete in the industry.)

2. Which college are you planning to join? Is it ranked? How are the placements? ( Whether the strategy to better the prospects is right)

3. What has been your GMAT, TOEFEL score? What was your graduation percentage? Have you ever been exposed to the subject you want to pursue? Did you have it as a subject? Did you top the exam?( A historical analysis on how the company has fared so far)

4. Are you aware any guy who went to UK to pursue MBA and is doing well? ( Peer comparison)

5. Which are the companies that come for placements in finance? How much do they pay? (Calculating the visibility of Free Cash Flows that would get generated post the expansion (MBA)).

6. What is the best salary and worst salary in the recently concluded placements? (Best case and worst case scenario analysis).

Let us now use some financial terminologies:

Educational loan rate (Father is the guarantor): Cost of Capital (WACC)

Expected Salary on placement: 1st year free cash flow

Yearly increments/ raise for 5 years after passing out: Growth rate

Average Yearly increments after that: Terminal Growth rate

I discount the expected incomes to the present: Discounted cash flow (DCF)

This is how valuations are done in the financial industry. This is for a basic understanding.We can involve the complexities in later sessions.

Concluding the story, after the extensive analysis my father realized there is no point betting on his son with so much of cash. So i went to him with another proposal and GIM happened. :)

Alternative Investments

Alternative Investments

This topic is an interesting read. To be very frank I had not heard of alternative investments during my MBA curriculum.
So what do you think is an Alternative Investment?

It is very similar to the concept of alternative energy sources. The whole world is looking at alternatives to gasoline. People talk about wind energy, solar energy, tidal wave energy etc as alternative energy source.

So even in investment there are alternatives to traditional sources of investments.
Commoners like us look at equity and debt (Fixed Deposits/ Bonds) for investment purposes. But most of us unconsciously invest in assets other than the above. These investments typically yield great returns and have absolutely no correlation to equity or debt markets.

What are these alternative Investments?

1. For ages Indians have invested in property (real estate) for investment purposes. They see this as an amazing investment opportunity now given the property prices have more than trebled in the last 5 years.

This is the first of the to-be discussed alternative Investments – THE REAL ESTATE

2. You have often seen your father / mother investing in Gold/ Silver also as an investment vehicle. Given the Gold prices have shot up more than twice in 2 years produced even greater interest in these metals.

This the second of the alternative asset – THE COMMODITY

3. Often you find people in your family of the entrepreneurial enthusiast breed requesting you to help them with capital. You give them money after hearing their business proposal and pray that they give you back the borrowed money.

This is the third of the alternative asset class – THE VENTURE CAPITALIST

4. Given the rapid increase in land prices, commodity prices and revival in equity markets and debt markets you anticipate further increase. But since you have only limited cash available you borrow money from people and assure them an interest of 10% on it. You have leveraged your position. Now to prevent your investments from incurring a loss you undertake forward contracts with buyers and approach insurance firm which says they will insure your property (real estate), jewellery (Commodity) by paying them a premium.

You do all this with the intention to earn higher returns with the lowering the risk (forward/ insurance). This seemingly complicated but relatively easy exercise is termed as Hedging.

And the fund you invest would be termed as HEDGE FUND- which is the fourth kind of Alternative Investment

5. Now you find your uncle having an Auto garage which is financially troubled. He is planning to sell it off. You visit him to find if you could have some investment interest. You find that the garage occupies a large area in the prime location of the city though it is in a dilapidated condition.
Your own analysis concludes that your uncle is offering the garage at near dirt cheap rates. You offer to buy the garage from him to which your uncle readily agrees.

You open an authorized maruti dealership at the same site with some financial assistance provided by them. In a couple of years this venture becomes highly profitable. Your uncle is presently surprised on how you have managed to turnaround his garage business.

This is the fifth of the alternative investment option which is “DISTRESSED ASSET” investment

6. The last of the 6 alternative investment option is called “INACTIVELY TRADED SECURITIES”.

Let us suppose you believe in the story of Bio-diesel and “Jatropha”. You believe with increased Global warming alternative sources of energy with low emissions would be preferred. You realize the companies which invest in such production, though listed, are rarely traded on the stock markets as people lack visibility about the future of this field. Since you are very sure about the growth prospects of the company you take a large exposure in the security with the hope that the "INACTIVELY TRADED SECURITIES" would yield high returns in the future.

Financial Statement Analysis

Financial Statement Analysis

Financial statement is simply keeping the accounts.

One would usually find me do some kind of accounting every month end after I receive my salary:

Lets me take you through my 3 month accounting

This is done to check how much money I have spent during the month and how much I could save. The above table is a representation of an Income statement.

My monthly saving would change depending on how prudently I spend my money. There are months I am reckless while spending (Jul’09) and have borrowed money, used credit card extensively and there are months where I have a surplus (May’09).

Having completed one year with SBI I now wanted to check how I have spent the money, how much have I invested, how much I have borrowed, how much do others owe me, how much do I owe them. Just to know how much was I worth.

So I set out to scrabble for each investment made, money spent. Finally I prepare a statement which turns out be the following:

I have received Rs. 384000 as monthly salary and got a bonus of Rs. 180000

This calculation immediately made me realize I needed to be worth another Rs. 9,99,99,79,000 to be called a billionaire.

So what is an asset?

Asset is anything which you own (liable to own) and has monetary value (quantified in rupees). If I have lent money to you, it is still my asset as you have an obligation to pay me back that sum.

What is a Liability?

Liability is anything which I have borrowed has monetary value and has an obligation to repay. I have Vodafone post paid mobile connection and have an obligation to pay for the services (call, sms, caller tune) provided.