Investment Bargains

Talking of analyzing stocks, the most important factor to consider before making an investment is the price you pay for the stock. Benjamin Graham in his writings has laid a very strong emphasis on the price you pay for any stock.

When we talk of bargains, we are particularly looking at stocks which are selling cheap. Different opinions might exist in the market for the meaning of this word "cheap". For some people, if a stock is quoting at/near its 52 week low, then it is cheap, but the value investor should keep in mind that a stock is cheap only when it is selling below the value the investor think the stock is worth. Graham referred to these investments as Investment Bargains.

Stocks that are selling below their liquid asset value for reasons varying from poor industry performance to temporary losses. These stocks are worth much more than they are selling for. Under such conditions, if the market price of the stock suppresses to a point that it is below the cash on the balance sheet of the company, then the stock presents a very interesting opportunity which is termed as "Cash Bargains" by investment gurus. But Graham warns the investor to stay away from companies that may show signs of dissipation of these assets in the future. Also, the value investor should seek for companies that have shown large earning power in the past. The past earning power is in no way an assurance for future earning power, but the point which is being made here is to look for stability in companies in order to reduce your odds of making a wrong decision. 

Investment philosophies of different investors might contain different standards for a stock to be declared as a bargain and I believe, these standards are formed by one's experience in the market. Generally during the bull markets, it becomes difficult to find investment bargains as most of them are quoting at high prices but its not impossible. 

Looking at the current scenario in the Indian markets, with the stock markets shooting up after the election results, I believe it will become a bit more difficult to find bargain issues in the market. But there will always be some unpopular stocks out there that will present bargain opportunities to people moving on the path of Value Investing.

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Understanding Debt Capacity Bargains

The complexity of Debt Capacity Bargains made it very difficult for me to understand the concept. Thus, for my own understanding I tried to give a shot and try explaining in words. I hope some of the readers may find it useful.

In the Security Analysis, Benjamin Graham said

"A senior issue cannot be worth, intrinsically, any more than a common stock would be worth if it occupied the position of that senior issue, with no junior securities outstanding."

Better known as the "Rule of Maximum valuation for senior issues", it states that the value of the common stock of a company (here, the common stock is the only issue of the company) cannot be less than the value of the senior issues(had they been there) of the company. 

To make it more clear, let us use an example similar to what Graham used in Security Analysis:

Consider a company which has issued both senior issues and common stock. If now, the company is recapitalized in a way that the common stock is eliminated and the senior issues are converted into new common stock, what will be the price of the new common. Earlier, the senior issues had a limited claim on the assets of the company (a characteristic of senior issues), and let us assume that they were selling at a price x. Now the new common has the overall claim i.e. the claim of the old senior issues (selling at x) in addition to the claim of the old common stock. 

Looking from the perspective of an investor, we would like to pay more for more claim in the company. As we saw, the new common has more claim on the company than the previous senior issues, so it should sell at a higher price. This is precisely the Rule of Maximum Valuation for Senior Issues.

To understand Debt Capacity Bargains, we will have to follow the above process in the reverse order. Suppose a company has only issued common stock (a debt free company), so applying the above stated rule, the price of the common should not be less than the value of the senior issues of the company. But the company does not have any senior issues, so we have to find out the possible value of senior issues that this company can issue. In other words, we have to find out the maximum amount of debt this company can raise comfortably and this is what we call the debt capacity of the company. To calculate the debt capacity, we have to see what is the amount of debt which the company can comfortably service with its earnings.

With regard to the calculation of the debt capacity, different people may end up getting different values because of the difference of the assumptions they make. Assumptions like the Cost of Capital, a suitable Interest Coverage Ratio will affect the value of the debt capacity for the company. Instead of Interest Coverage Ratio, some people might want to consider the coverage of both the interest and the principal repayment, but I believe these things are more of personal decision while making calculation. You might end up getting a value, which is somewhat different from the debt capacity but as Warren Buffet says "I'd rather be approximately right than precisely wrong".

Further, according to Graham, a debt free company which is selling at a price less than its debt capacity, should be considered a debt capacity bargain. 

In my previous posts, you might have noticed that I had used a process longer than the one described above to conclude a stock to be a debt capacity bargain. This additional approach is one followed by some of the new Era investors like Prof. Sanjay Bakshi. The new approach suggests that for a credit-worthy borrower (which the company must be in order to raise debt), there should be present a collateral value in excess of the debt capacity. Thus, the value of the new common should be more than the debt capacity. So while calculating the total value of the common, we should add the surplus cash and a suitable value for the equity (which Graham suggests is more than 75% of the debt capacity) to the debt capacity. The value thus calculated should be used as the value below which the company should be treated as a bargain.

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Jindal Photo - Stock Analysis

Jindal Photo Limited is engaged in manufacturing of photographic and allied products. The Company's product range includes Color Roll Films, Cameras, Photographic Color Paper, Medical X-Ray Films & Equipments, Cine Color Positive Film, Photo Processing Equipments and Photographic Chemicals. The Company markets the products under the brand name FUJIFILM. It also sells photo-finishing labs. Jindal Photo is also marketing the Fuji digital range of products, including Digital ID Systems, Digital Cameras and Digitized Photographic Processing Equipments. The Company’s subsidiaries are Jindal India Thermal Power Limited, Jindal India Power Ventures Limited, Hindustan Powergen Limited and Jindal Imaging Limited.

The performance of the company in FY 2008 looks good with around the same turnover os FY07 and much better profitability. This is because of increased share of the medical equipment business and the downward trend in the US currency. The net profit in FY08 has shown an increase of around 70% compared to the previous year. To look deeper into the position of the company during the recessionary period, we see some dampening in the demand in the second and third quarters of FY 09 but the last quarter has resulted in growing demand and sales.

Jindal Photo is a debt free company, with a market capital of around Rs.137 Crores (a market price price of Rs.133.15). In recessionary times, debt free companies which have had some periods of sub-normal performance often turn into debt capacity bargains. When we look at the Cash Flow of Jindal Photo for FY08, their is a net cash outflow. Does this mean that the company does not have any debt bearing capacity? The cash flow from investing activities show that a sum of around Rs.99 Crores have been used to buy investments. The schedule for investments in the Annual Report show that around 57 Crore of the total investments of the company are in Mutual Funds. As these can be assumed to be a liquid equivalent of cash, we assume a suitable cost of capital and interest coverage ratio to arrive at the debt capacity of Jindal Photo.

My estimates and analysis say that Jindal Photo can easily srvice debt of around Rs.110 Crores. Graham said that the value of equity of a company can never be less than the debt bearing capacity of a company. Though the previous statement is a very restrictive one, but it is true to some extent. Now following the principles of Graham and adding 75% of debt capacity as a value for the equity of the company, and also adding the cash and cash equivalents (I have taken here cash and Investments) of Rs.101 Crores, we reach a final value of Rs.293.5 Crores. The outstanding 1.02 Crore shares bring the value to Rs.287 per share.

The current value of Jindal Photo stock as of today is Rs.133.15, which is way less than the value we just calculated. Thus, I believe there is a great amount of value to be uncovered in this stock.

Risks: In my opinion the biggest risk to the business of Jindal Photo are the fast 

technological developments happening around the world. The demand for the color photo rolls has been reducing fast due to the increased usage of digital cameras. Even in medical equipments, the evolving technologies present a inherent risk. The company has been doing well in this regard till now and we can hope for the same in the future too.

Note: When reading about debt capacity bargaians for the first time, it took me a lot of time to grab the concept. To make it more clear, I suggest going through some readings on the subject available on the internet.

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Triton Corporation - Stock Analysis

Business - Triton Corp Ltd. is an India-based company carrying out business process outsourcing (BPO) services. The Company’s subsidiaries include Maple eSolutions Limited, which is engaged in call centre activities and Westtalk Corporate Limited. Triton acquired 100% stake in Westtalk Corporate Limited, UK in 2008 which is in the business of distribution of wireless communication / contracts on behalf of various network providers (Orange, Vodafone, T-Mobile , O2 etc.) in UK.

Looking at the last annual report (2007-08), the company looks in a very healthy position showing a high growth in both revenues and the net profits reported over the corresponding period of 2006-07. But if we go further and check the quarterly results for FY 08-09, the bad shape of the company is very apparent. For the first 3 quarters itself, the company has accumulated losses of around Rs.14.04 crores with the revenues for the third quarter hitting as low as Rs.4.27 crores compared to Rs.42.59 Crores for the corresponding period in FY 07-08.

But as the emphasis on the Balance sheet is highly laid in value investing world, let us take a look at the value investors are getting for the price they are paying for the stock. The consolidated balance sheet for Triton corporation and its subsidiaries presents an interesting picture. The investments of the company alone amount to around Rs.19 Crores which comes out to Rs.0.94 per share. Compare this to today's closing price of Rs.0.58, which will need a 62% hike to meet just the investments per share. 

In Security Analysis, Graham suggests that the liquidation value of a company is more or less equal to the Current Assets less all liabilities. For Triton the liquidation value comes out to be around Rs.27 Crores (i.e. around Rs.1.34 per share). Thus, we see that the company is selling in the market at a valuation of Rs.11.5 Crores which is at a discount of around 57% to the liquidation value. Thus, an investment bargain opportunity is clearly visible in this case. Graham referred to these types of bargains as "net nets". 

The bad performance of the company in the prevailing recession is probably the reason of the discounted price of the company. In my opinion, the stock is a reasonable buy at this price as the value it offers to the investor is immense.

Risks Associated with Triton

Considering the poor performance of the company in the last fiscal and the ongoing recession, predicting the future of this company can be very speculative. Also, in the recent past there have been some instances where the promoters of Triton have offloaded their shares in the market (though still around 75% stake rests with the promoters). After the Satyam fiasco, some people might want to look at it as a negative signal for getting into this company. But I beloeve that at current prices, the investment offers more upside potential than a downside risk.

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Sesa Goa Limited - Analysis

Sesa Goa Limited is engaged in the business of prospecting, mining, processing and exporting iron ore. It is also involved in support activities like shipping and shipbuilding. The Company exports iron ore, fines and lumps to customers in Japan, China and Europe from ports on both the east and west coasts of India. Besides its mining activities in Goa, the Company has mining operations in Karnataka and Orissa.

Looking at the financial statements the future of the company looks promising. But is the current price at which it is trading lucrative enough for a sound investment?

Even after analysis, we may end up being wrong. To keep the probability of such a situation low, I would primarily stick to bargain issues with sufficient "Margin of Safety". Here I will be looking at two types of investment bargains. The first where stocks of companies are selling at discount to the cash and cash equivalents held by the company (generally known as Cash bargains) and the second, where debt free companies under depression conditions are selling for less than the amount of bonds (debt bearing capacity) that can safely be issued against its property and earning power (known as Debt Capacity bargains). The second type of bargains are deduced from the inverse of the "Rule of maximum valuation for senior securities" given by Ben Graham. Sesa-Goa being a debt free company, can be analyzed for both types of bargains.

Considering it is a debt free company, it has been trading on is trading in the lower range of its 52-week spectrum (see price chart), I thought it might prove to be a debt capacity bargain. Calculating the debt a company can carry needs some assumptions where we can go wrong, but I think we should remember the Margin of Safety priciple (given by Graham) and understand that if we keep a good margin of safety in our investments then minor errors in our assumptions might not be of great significance.

Source: Google Finance

Looking at the Cash Flow statement, we can see that the Net cash flow for the year 2007-08 is negative, but a more detailed look will tell you that most of the cash generated from operations (Rs.1100 Crores) has been used up for buying up investments. Assuming this cash to be a part of Free Cash Flow, and taking conservative assumptions for Cost of Capital and a Interest Coverage Ratio, the debt bearing capacity of this company comes somewhat in the range of Rs.2000 Crores. Adding 75% of the debt capacity (Value of Equity as suggested by Graham) and the surplus cash to the debt capacity, we get the value of the company in the range of Rs.5500 Crores. The value of this Sesa Goa's stock through this valuation comes out to be around Rs.139/share.

At the current price of Rs.130, and also discounting some errors in my assumptions the stock seems to be correctly priced by the market. In my opinion, it is time to sell this stock (if already holding) and wait for it to dip and present a sufficient margin of safety on the value derived through the debt capacity.

A mere glance on the balance sheet will tell us that the company is not cheap when looked as a cash bargain.

Explanation for the interested: You can see that at the end of 2008, the company held around Rs.2000 Crores in investments (Cash equivalents). Adding inventory and Cash would add another Rs.275 Crores to the figure. After the stock split (10:1 issue) in 2008, the outstanding shares have reached 39.36 Crores. If we try to find out the cash available per share, the figure comes out to be around Rs.58. Thus, it is not a good idea to get into this company at the current price of Rs.130.

This was my first analytical post on a company. I may not be right with certain things, so please feel free to correct me/express your opinions and help me learn (it is for this reason that I have started this blog.)

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The start of this blog!!!

I have been into blogging for quite sometime now on some of my other interests but investing was one interest which has not been blogged upon. I have been learning about investing the Graham way. Reading about value investing and related subjects gives rise to a lot of questions and also a lot of insights which I thought should be shared with the world. For this very reason, I have started this platform where I would be sharing my learning's and at the same time, learn from others.
I would be sharing my ideas here and I am very much open to criticism, unlearning and re-learning. So, please feel free to comment.

Happy Investing!
:)

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