Aditya Birla Chemicals ( Bihar Caustic) - Q3 results

Sensex - 8197
Price - 31.15

I had originally posted on Aditya Birla Chem here followed by updates on the Q1 and Q2 results.

The company’s Q3 results are back on track post slight downturn in Q2 because of the boiler blast which affected production. Sales has grown sequentially from Rs 46 crores in Q2 to Rs 49.8 crores in Q3. More importantly Net profit has grown from Rs 6.4 crores to Rs 12 crores where the Q2 profitability was affected due to one time expense on repair and maintenance. Quarterly EPS moved up from 2.78 to 5.14.

Cumulative EPS for first nine months 13.6 and annualise EPS works out to be Rs 18.33. The stock currently is trading at nearly 1/3rd its book value and a P/E ratio of 1.71 times.

The company also got rechristened to Aditya Birla Chemicals from Bihar Caustic. I continue to hold the stock and add at opportunities

Odds & Ends

On one of my previous post regarding Alex from Moneyvidya posed a question to me and I quote him

“Are margins of safety not based on intrinsic values which can only be estimated from the fundamentals. Do you know of a way to create or measure a margin of safety for an investment which protects you from the possibility that all your knowledge of the fundamental properties of the security are incorrect?”

I think one of the most important things in investing or in all aspects of our lives is to understand the concept of probability and the potential payoff arising out a probable event.

When we buy a lottery ticket lets assume the following structure
Scenario 1

Price of ticket – Rs 1
No of participant - 100
Potential payoff = Rs 100 – Rs 10 ( Lottery provider’s fees) – Rs 20 ( Government taxes)= Rs 70

So for a probability of 1 in a 100 we have a potential payoff of 70 times.

The net payoff of this transaction is 1*(70) + 99*(-1) = -29

Most lotteries/ casinos are structured in such a manner where the participants lose money.

Scenario 2
Now let us assume that the lottery provider waived of his fees and the government its taxes and some benevolent donor added a extra Rs 25 to the kitty. Lets examine the structure now

Price of ticket – Rs 1
No of participant - 100
Donor contribution Rs 25
Potential payoff = Rs 100 + Rs 25 = Rs 125

So for a probability of 1 in a 100 we have a potential payoff of 125 times.
The net payoff of this transaction is 1*(125) + 99*(-1) = +26 times

In scenario 2 the odds are structured in our favour and hence a margin of safety is built in the trade. This need not necessarily mean that you will win the lottery but the odds are stacked in your favour.

Lets take this forward to stocks. When I evaluate stocks my starting point is management. What is the margin of safety in terms of management?. When I see a promoters personal yacht being put on the companies books it doesn’t necessarily mean the promoter will take the company down like Satyam but for me the odds are against me on this variable. There is a higher probability that the promoter will siphon out a bigger chunk on a latter date or indulge in corporate actions that is detrimental to shareholders.

I remember in one of my chats discussing real estate with one of my fellow bloggers and he telling me how can u expect ethical promoters in a business which is intrinsically unethical in India. It was a wonderful insight. So whether there is a problem today or not the odds are extremely high of encountering a black swan event in a real estate stock because of promoter action.

Will it happen? Not necessarily but the odds are stacked against you. To compensate for this is the margin of safety high enough on the financials in terms of intrinsic value to price and on a net off basis factoring both this variables is the odds in your favour.

Let us say that one has a portfolio of 10 stocks with positive payoffs on each stock. Lets look at the following structure

Number of stocks - 10
Probability of + returns on each stock - 60%
Probability of – returns on each stock - 40%
Can I eliminate a potential black swan event in a individual stock? The answer is no. To answer Alex’s question, we might encounter a black swan event in a single stock which cannot be eliminated but by building a margin of safety in each stock position one will on a overall portfolio basis achieve positive returns.

Déjà vu

This story is about a organisation which was structured to look at potential mispricing in the bond markets in terms of spreads between 2 instruments and look at those spreads reaching the long term average. The organisation worked its models around bonds, mortgages, equities and derivatives across myraid asset classes. The organisation spearheaded extensive use of quant and modeling in bond trading.

The organisation worked on magnifying its return by taking enormous amount of leverage 30:1. In a 5 year tenure it delivered a return of over 40% per annum. However its enormous leverage in the derivatives market of over $1 trillion wend bad in a month when markets across the world collapsed with a correlation of 1 throwing all the models out of the window. So we reached the stage where the organisation was on the verge of bankruptcy and threatened to take the entire financial system down with them. The huge counterparty risk coupled with fear threatened to freeze markets across the globe.

The bankers of course rushed to the big daddy FED who promptly worked out a bailout package to save the organisation and the markets. And we all lived happily ever after or did we?

I m sure most of us will look at this and the names that will come to our mind are Lehman Bros, AIG, Citi etc

Well this was about a hedge fund called Long Terms Capital Management which went down under in 1998 before the bailout.

The fund was started by John Meriwether ex head of bond trading for Salomon Brothers where he was forced to resign after his top bond trader admitted to falsifying bids in the US treasury auction. J M managed to rope in Nobel price winners Robert Merton and Myron Scholes of the famous Black Scholes model as partners and the funds partners were positioned as a intellectual breed apart. I just finished the book When Genius Failed: The Rise and Fall of Long-Term Capital Management by Roger Lowenstein. Interesting read.

There is a strong sense of déjà vu that creeps in as you see the same cycle repeating itself bringing financial markets to a crisis and I can lay a bet that we will see it play out again. “We learn from history that we don’t learn from history” - I had earlier written a blog on this.

PS: Here’s the amazing follow up to the storyline - John Meriwether post the LTCM fiasco went on along with his colleagues to start JWM partners which floated a Relative Value Opportunity Fund where the fund document stated that it would keep its leverage down to 15:1.

The funds posted gains for several years, but in the first quarter of 2008 posted losses, of 31% in the flagship Relative Value Opportunity bond fund.

JM quotes “While we are clearly disappointed by our recent performance, we remain optimistic about the current opportunity set,".
"While we do not welcome the increased volatility in our returns, we believe that increased market volatility is one of the primary preconditions for creating interesting relative value situations," he added
And this was first quarter last year. Bond spreads kept widening significantly post that. History repeats.

The Satyam Saga - Key learnings

Lot has been written on the Satyam Saga and I had earlier posted on it when the Maytas deal was announced by Raju. The intention of this post is not to run threadbare on the scam as there is enough information in the public domain on this. I intend to focus on two key learnings for me from the scam

Lies, Damned Lies and Management.
This event has reinforced by belief that the starting point of any stock selection process is to understand the management and its track record. The ethical values that the management has displayed both in terms of their business dealings as well as dealings with the shareholders.

Its amazing how if a friend, relative, neighbour of ours asks us to become a partner and invest money in a business opportunity, our first instinctive reaction is to check whether we trust the person. The next step is to check whether the business opportunity is attractive. But when we buy stock which is effectively becoming a partner we seem to overlook this variable.

In my experience a detailed running thru the balance sheet more often than not gives you a flavour of the management and how they value the various stakeholders.

Management quality could become a go-no go criteria or should atleast form a significant weightage in the stock selection process.


Black & White Swans
I had earlier written about how I factor in Black Swans in my investment strategy. The Satyam event is a classic Black Swan event that nobody saw coming. This has reinforced by belief in my previous hypothesis that it is critical to build a portfolio factoring in a adequate “ Margin of Safety” to ride out the black swans that one might encounter in the investment journey.

Also being able to accept Black Swans ( negative surprises ) and acknowledge White swans ( positive surprises) helps in building a temperament which doesn’t get unduly ruffled by the vagaries of the market.

Satyam Maytas Deal - Audaciously Appalling

It rarely surprises me to see promoters pulling a fast one on minority shareholders but the Satyam proposed buying out of Maytas has really surprised me for the sheer audacity of the promoters.

I will not run into the finer mechanics of the deal as there is enough information on the web but the sheer magnitude of money ( US$ 1.3 Billion) being siphoned out to bailout Ramlinga Raju’s son is appalling.

The market has always been sceptical about Mr Raju’s ethical standards. Remember the 500 crore Indiaworld deal that was done during the dotcom boom. The market was abuzz with rumours on how a significant chunk of the money went back to Mr Raju and his family and got siphoned out of the Satyam balance sheet.

No wonder Satyam always trails Infosys and TCS in terms of valuation. This would be a test case to see how far institutional investors push the promoters and ensure that the deal is reversed.

Incidentally “MAYTAS” is the reverse of “SATYAM”.

Andhra Cement

This week there was a news report in the economic times talking about how MNC cement companies like Lafarge, CRH, Italicement have envisaged interest in taking over Andhra Cements which is part of the Duncan Goenka Group.

The ET also speculated that the buyout could happen around the Rs 75 mark looking at historical M& A benchmarks in the industry. The stock promptly closed the day up 20% on the circuit at Rs 18.72. The stock has been moving circuit to circuit and closed at 24.70 yesterday.

I unfortunately haven't been on this gravy train :-) and I don’t see how I will get on as a I think the stock would continue moving up on the circuit till maybe the Rs 50 mark.

So what is it that interests me in the stock?

The current promoter holding is about 73.19% and of the remaining 26.81% the holding pattern has

IDFC - 6.6%
Fidelity - 5.58%
HDFC - 4.53%
Total - 16.70%

There is very less public shareholding in the stock. Once the dust settles down post the deal announcement and based on where the price settles down there could be a arbitrage opportunity playing out during the open offer and a potential delisting play.

FCCB - Buyback time

Last week RBI in its press release announced allowing Indian corporates to prematurely buyback FCCB’s that have been issued.

1) The RBI has decided to permit corporates to premature buyback of FCCBs where the source of funds for the buyback is:
i) Foreign currency resources held in India (including funds held in EEFC accounts) or abroad and/or
ii) Fresh ECB raised in conformity with the current ECB norms, provided there is a minimum discount of 15 per cent on the book value of the FCCB.

2) In addition, the Reserve Bank will consider applications for buyback of FCCBs out of rupee resources provided that:
(i) There is a minimum discount of 25 per cent on the book value;
(ii) The amount of the buyback is limited to US $ 50 million of the redemption value per company; and
(iii The resources for buyback are drawn out of internal accruals of the company as certified by the statutory auditor.

Indian corporates have used the FCCB route to raise capital in the current investment cycle. These low cost funds which were pegged to aggressive stock prices for conversion were now coming back to haunt balance sheets. Clearly with the stockmarket crash FCCB’s were either unlikely to be converted into equity or converted at a lower rate ( Ex Pyramid Saimara) resulting in greater equity dilution.

The current credit crunch has come as a boon in disguise for corporates that are sitting on cash or have a steady stream of export income. FCCB’s are quoting at a significant discount to the face value and it is a ideal opportunity for corporates to buyback these bonds and clean up their balance sheets.

I can see a lot of corporates ( Ex Ranbaxy ) using the RBI go ahead effectively. In these tough times it is better to buyback your debt at a discount than equity.