April – June 2006

July 26, 2006

A value investor I respect, Whitney Tilson, in a recent issue of “Value Investor” (March 2006) identified eighteen types of value opportunities. Categorising an investment opportunity is important because the time horizon, temperament, timing, time and trouble taken on research and follow-up vary with each category.

Out-of-favor blue chips:- Great companies sometimes fall out of favor for temporary rather than permanent reasons. If they trade at significant discounts to their conservatively capitalized normalized earnings power, they can offer equally great investment opportunities.
Out-of-favor cyclicals:- Success in this case depends on correctly anticipating when a cyclical industry will rebound.
Distressed industries:- Buying a good company in a distressed industry is often a good way to make money.
Turnarounds:- One is betting on a reversion to the mean. Management and timely injection of finance are of critical importance here.
Overlooked small-caps:- Many analysts do not track fine businesses that are cheap because institutional interest is absent and there is thin trading in the stocks. These tend to be volatile almost always in their prices and sometimes in their earnings. The first should not bother an investor but the second should concern him.
Fallen growth angels:- When growth companies stumble on the growth and momentum traders sell them indiscriminately, they can offer a great opportunity for value investors IF the high growth resumes or the stock falls so much that it’s a bargain even at lower growth rates.
Growth at a Reasonable Price:- These are high quality growth businesses which may not appear cheap on traditional valuation metrics, but can be excellent investments if the high growth can be maintained.
Shareholder activism:- Great money can be made by understanding whether there is opportunity for genuine value creation via a recapitalization, spin-off, better capital allocation, management change etc and analyzing the support for change that exists and lastly, when the odds are in favor, investing alongside the activist. Two years back, Jeetay was an activist in Sardar Sarovar bonds and more recently supported shareholder activism against Wyeth India.
Spin-offs:- Many stock-price inefficiencies can occur when a company is spun-off. Our experience, as we will show in the portfolio, is that price inefficiencies occur even before a spin-off.
Post-bankruptcies:- Many companies emerging from bankruptcy can be inefficiently priced.
Stubs:- Stubs typically occur when a public company owns a significant stake in a subsidiary that is also publicly quoted. When the value of the subsidiary – especially when it is absurdly overvalued – is not reflected in the share price of the parent company, an investor can reap big gains by going long the parent and shorting the subsidiary.
Let someone else do the investing:- It can pay to let others do the investing for you – if you can invest with them at a reasonable price. Example, Berkshire Hathaway.
Net-nets:- These are traditional Ben Graham “Cigar-butt” investments – companies trading at a discount to the value of their current assets minus all liabilities.
Stocks at a discount to cash:- These stocks are even cheaper than net-nets: they trade at less than cash on hand minus all liabilities. Try to buy them when they are not bleeding cash.
Free/mispriced option:- An investor gets a potentially valuable option for almost nothing. We bought Mukta Arts three years ago when it was trading at cash/share on the possibility that a hit movie could make it fly.
Declining cash cow:- At the right price – and if the management wisely milks the business and allocates capital – the stock of a declining business can be a great investment.
Oddball companies:- Some companies have economic characteristics that are very different from the typical company in their industry, resulting in analysts and investors initially misunderstanding them and mispricing the stock.
Discount to the sum-of-the-parts:- A company can be a great buy if the whole is trading at sufficient discount to the pieces – especially if a break-up is likely.

A broad classification of some of the shares we hold in your portfolio and the way we look at them:

a. MALCO:- The company has investments in Sterlite, the market value of which at Rs.360 is Rs.120/share net of debt (we think Sterlite itself is undervalued). The basic aluminum business earned an eps of Rs.21/- in the last quarter and Rs.42/- for the year ended June 2006. The market price of MALCO, net of the Sterlite investment is Rs.180/- which puts it on a prospective P/E of 2 to 4. This is demonstrably cheap and at a steep discount to the sum-of-the parts valuation.

b. Diamines and Chemicals:- Cheap, with growth coming for free. Company working at less than 25% of installed capacity with a RONW of 70%. Likely to do considerably better in the current year. Dividend yield at current price of around Rs.60 is 8.25% on a historical basis. Prospective yield might be even higher. An investor is being paid to wait. This is an overlooked small cap-stock. This is even more surprising given that the promoters were the promoters of DSP Merill Lynch.

c. Ultramarine and Pigments:- This company has disappointed in the last year and is fairly poor at investor communication. At the last AGM, the Chairman mentioned about the problem of raw material in the surfactants division. What seems heartening however is the increase in the run rate of the BPO division. At a price of Rs.35, the company is trading on a historical P/E of 6.5 and a prospective P/E which could be significantly lower. The historical dividend yield is 6.3%. All the negatives seem to be already priced in and there seems to be little downside at current prices. The return on capital employed is high and looks sustainable for the foreseeable future.

d. Diamond Cables:- The company has gone through a successful restructuring with total outstanding debt of Rs.130cr. being settled at Rs.44cr. An FII, Clearwater Capital Partners, is investing to the tune of 14.8% of the equity at Rs.95/-/share. The debt of the existing lenders (after settlement) is to be held by the FII, who will be investing over Rs.125cr. in the form of long-term debentures and a short-term loans. The company, one of the largest players in the conductor industry, has an order book of over Rs.400cr. EPS in the next three years should be Rs.25-30. This is a post-bankruptcy turnaround.

e. NIIT:- The company’s growth plans and focus on improving margins should mean that on a “normalized” basis, the EPS for FY06 should be Rs.30/- instead of the reported Rs.21.3. There are strong entry barriers to this business and the current price of Rs.350/- does not fully capture the intrinsic value of this franchise. This is growth at a reasonable price.

f. NIIT Technologies:- The company is doing well and the current year consolidated EPS should in the vicinity of Rs.22-25. The stock on a prospective single digit P/E is demonstrably cheap, given the strong double-digit growth rates.

g. Gruh Finance:- This is a HDFC subsidiary which has in the last three years demonstrated high earnings power in a niche area – financing low cost housing. It is trading at a prospective price to book value of 2.5 and a prospective P/E ratio of less than 12 – much lower than its growth rate. There is a rights issue at Rs.75/-/share which we intend to subscribe to fully.

h. Binani Industries:- The company’s cement operations continue to do well – its FY07 production of cement will be 2.5 million tonnes whilst FY08 will be 5.3 million tonnes. The company should make a net profit of Rs.95 cr. in FY07 and Rs.150 cr.+ in FY08. Binani Zinc’s financing of its Zinc mines and power plant for its Kerala smelter estimated at Rs.130 cr. has yet to be finalized. The future profitability of Binani Zinc is dependent on captive mines. At the current price, based on the announced swap ratio of Binani Cement and Binani Zinc for Binani Industries, Binani Zinc is coming for free.

i. Shyam Telecom:- For 100 shares of Shyam Telecom, we will receive 35 shares of Shyam Telecom Manufacturing and 800 shares of Shyam Telelinks. The sum-of-the-parts valuation is worth at least twice the current market price. There is a small risk of delay in the listing of Shayam Telelinks.

j. Futura Polyster:- The key attraction of Futura Polyster is the embedded “rights” of Innovasynth Technologies which is doing pioneering biotechnology work on nucleotides and amitides – it is partnering in custom research and synthesis with global leaders. Innovasynth should break-even in FY07 on a turnover of Rs.75cr. The ratio of Innovasynth to Futura is 10:23 i.e. for 23 shares of Futura one will get the right to subscribe to 10 shares of Innovasynth Technologies at par. Innovasynth should quote at 5-6 times sales, in line with bio-tech valuations. Futura itself is undervalued with a market cap of Rs.60 cr. on a turnover of Rs.600 cr. This is a classic case of an inefficiently priced spin-off.

k. Crisil:- This is a S&P subsidiary with strong entry barriers to its credit rating, advisory and equity research businesses. Last quarter’s EPS on an annualized basis was Rs.100/- and on that performance the current price of Rs.1500/- is reasonable.

l. 3M India:- The company is not expensively valued in relation to its projected growth rate in excess of 40%/annum.

m. HPCL & BPCL:- Both are leaders in an industry which is out of favor and are trading at large discounts to replacement cost.

n. Sarla Polyster:- A company with some moats making polyamide and polyster yarns and catering to niche area applications like car air bags, sewing threads for leather shirts and hosiery. A substantial portion of the turnover is exported. The company is earning high returns on capital employed and is quoting at a prospective P/E of under 6.

o. Pricol:- For FY06, the returns on capital employed was depressed due to rising input costs and stagnant exports. The balance sheet size also increased substantially due to expansion in Indonesia and the setting up of a greenfield plant at Pantnagar in UP. EPS for the current year should be Rs.4.25 and the prospective P/E of 8 does not look expensive.

p. Torrent Pharma:- The company is cheap on a EV/Sales and EV/EBIDTA basis against its peer group. The company should improve its margins going forward on the strength of the shifting of products from its subsidiary Heumann Pharma, Germany to its new plant at Baddi and also increased exports to regulated markets.

q. Poly Medicure:- The company is growing at the rate of 40%/annum v/s an industry growth rate of 15%. It is expanding its capacity of manufacturing medical disposables from 130 million to 180 million. It has recently applied for 8 patents and two US FDA approvals for its new range of safety syringes and safety blood collection holders. It also made a recent US acquisition. The company is quoting on a historical P/E of less than 8 and is generating high returns on capital employed. Negative is that the management does not interact with investors, so that transparency is low. Also the recent communication that the management intends to deploy its surplus cash in higher yielding (i.e. higher risk) investments rather than government-securities.

r. Navneet Publications:- Syllabus change and increased stationery exports will drive growth. EPS for Rs.2006-2007 should be Rs.22-25. Given the moats to this business, the company is not expensively priced. This is a classic case of growth at a reasonable price.

s. Century Enka:- This was a mistake at the price at which it was bought (Rs.225-250). I underestimated the severity of the problems facing the polyester industry and the Chinese dumping of nylon yarn. However the current price is below the price the Birlas paid to Accordis. The nylon tyre cord expansion is on track and the equity is very low – Rs.20 cr. in relation to the turnover Rs.1000cr. The risk is of any unfavorable merger with another Kumarmangalam / BK Birla Group company.

t. Novartis:- This is one of the cheapest stocks in the MNC Tier – I Pharma Space on a EV/Sales basis, although the current working is uninspiring.

Here are three mistakes that I made in the last three months.

1. I made the mistake of not selling when some target prices were reached. This was a loss of discipline, not hindsight bias.

2. I also lost patience, again unforgivable.

3. I fell prey to a small amount of euphoria and greed.

How much of investing is science and how much art? I’m currently reading a brilliant book by the late paleontologist Stephen Jay Gould “Leonardo’s Mountain of Clams and the Diet of Worms” in which he writes, “Science progresses; art changes. Scientists are interchangeable and anonymous before their universal achievements; artists are idiosyncratic and necessary creators of their unique masterpieces.” The principles of value investing are almost scientific, but the investor has to have the eye of the artist. It is in crossing the difficult chasm between science to art that fortunes and reputations are made or lost – a truly humbling thought for the artist in me.

Should there be any questions or clarifications, please do let me know.

Thanking you,

Warm Regards,

Chetan Parikh