Module 3_Fundamental Analysis-2.pdf

For example consider you invest Rs.100 which is expected to grow at 20% year on year (recall this is also called the CAGR). At the end of the first year the money is expected to grow to Rs.120. At the end of year 1 you have two options: 1. Let Rs.20 in profits remain invested along with th...

For example consider you invest Rs.100 which is expected to grow at 20% year on year (recall this is also called the CAGR). At the end of the first year the money is expected to grow to Rs.120. At the end of year 1 you have two options: 1. Let Rs.20 in profits remain invested along with the original principal of Rs.100 or 2. Withdraw the profits of Rs.20. You decide not withdraw Rs.20 profit; instead you decide to reinvest the money for the 2nd year. At the end of 2nd year, Rs.120 grows to Rs.144. At the end of 3rd year Rs.144 grows to Rs.173. So on and so forth. Compare this with withdrawing Rs.20 profits every year. Had you opted to withdraw Rs.20 every year then at the end of 3rd year the profits would have been just Rs. 60. However since you decided to stay invested, the profits at the end of 3 years is Rs.173. A good Rs.13 or 21.7% over Rs.60 is generated just because you opted to do nothing and decided to stay invested. This is called the compounding effect. Let us take this analysis a little further, have a look at the chart below: The chart above shows how Rs.100 invested at 20% grows over a 10 year period. If you notice, it took almost 6 years for the money to grow from Rs.100 to Rs.300. However the next Rs.300 was generated in only 4 years i.e from the 6th to 10th year. This is in fact the most interesting property of the compounding effect. The longer you stay invested, the harder (and faster) the money works for you. This is exactly why Girish decided to stay invested – to exploit the luxury of time that the market offers. All investments made based on fundamental analysis require the investors to stay committed for the long term. The investor has to develop this mindset while he chooses to invest. 10  2.3 – Does investing work? Think about a sapling – if you give it the right amount of water, manure, and care would it not grow? Of course it will. Likewise, think about a good business with healthy sales, great margins, innovative products, and an ethical management. Is it not obvious that the share price of such companies would appreciate? In some situations the price appreciation may delay (recall the Eicher Motors chart from previous chapter), but it certainly will always appreciate. This has happened over and over again across markets in the world, including India. An investment in a good company defined by investable grade attributes will always yield results. However, one has to develop the appetite to digest short term market volatility. 2.4 – Investible grade attributes? What does that mean? Like we discussed briefly in the previous chapter, an investible grade company has a few distinguishable characteristics. These characteristics can be classified under two heads namely the ‘Qualitative aspect’ and the ‘Quantitative aspects’. The process of evaluating a fundamentally strong company includes a study of both these aspects. In fact in my personal investment practice, I give the qualitative aspects a little more importance over the quantitative aspects. The Qualitative aspect mainly involves understanding the non numeric aspects of the business. This includes many factors such as: 1. Management’s background – Who are they, their background, experience, education, do they have the merit to run the business, any criminal cases against the promoters etc 2. Business ethics – is the management involved in scams, bribery, unfair business practices 3. Corporate governance – Appointment of directors, organization structure, transparency etc 4. Minority shareholders – How does the management treat minority shareholders, do they consider their interest while taking corporate actions 5. Share transactions – Is the management buying/selling shares of the company through clandestine promoter groups 6. Related party transactions – Is the company tendering financial favors to known entities such as promoter’s relatives, friends, vendors etc at the cost of the shareholders funds? 7. Salaries paid to promoters – Is the management paying themselves a hefty salary, usually a percentage of profits 8. Operator activity in stocks – Does the stock price display unusual price behavior especially at a time when the promoter is transacting in the shares 11 9. Shareholders – Who are the significant shareholders in the firm, who are the people with above 1% of the outstanding shares of the company 10. Political affiliation – Is the company or its promoters too close to a political party? Does the business require constant political support? 11. Promoter lifestyle – Are the promoters too flamboyant and loud about their lifestyle? Do they like to display their wealth? A red flag is raised when any of the factors mentioned above do not fall in the right place. For example, if a company undertakes too many related party transactions then it would send a signal of favoritism and malpractice by the company. This is not good in the long run. So even if the company has great profit margins, malpractice is not acceptable. It would only be a matter of time before the market discovers matters pertaining to ‘related party transactions’ and punishes the company by bringing the stock price lower. Hence an investor would be better off not investing in companies with great margins if such a company scores low on corporate governance. Qualitative aspects are not easy to uncover because these are very subtle matters. However a diligent investor can easily figure this out by paying attention to annual report, management interviews, news reports etc. As we proceed through this module we will highlight various qualitative aspects. The quantitative aspects are matters related to financial numbers. Some of the quantitative aspects are straightforward while some of them are not. For example cash held in inventory is straight forward however ‘inventory number of days’ is not. This is a metric that needs to be calculated. The stock markets pay a lot of attention to quantitative aspects. Quantitative aspects include many things, to name few: 1. Profitability and its growth 2. Margins and its growth 3. Earnings and its growth 4. Matters related to expenses 5. Operating efficiency 6. Pricing power 7. Matters related to taxes 8. Dividends payout 9. Cash flow from various activities 10. Debt – both short term and long term 11. Working capital management 12. Asset growth 13. Investments 14. Financial Ratios 12  The list is virtually endless. In fact, each sector has different metrics. For example: For a retail Industry: For an Oil and Gas Industry: 1. Total number of stores 1. Oil to Natural Gas revenue ratio 2. Average sales per store 2. Exploration costs 3. Total sales per square foot 3. Opening oil balance (inventory) 4. Merchandise margins 4. Developed reserves 5. Owned store to franchisee ratio 5. Total production growth Over the next few chapters we will understand how to read the basic financial statements, as published in the annual report. As you may know, the financial statement is the source for all the number crunching as required in the analysis of quantitative aspects. Key takeaways from this chapter: 1. The mindset of a trader and an investor is different 2. The investor has to develop an investment mindset if he is serious about investing 3. The investor should stay invested for a long period of time for the returns to compound 4. The speed at which the money doubles increases drastically the more time you stay invested. This is one of the properties of compounding 5. Every investment has to be evaluated on two aspects – qualitative & quantitative 6. Qualitative aspects revolve around the non numeric information related to the company 7. The quantitative aspects involve analyzing numeric data. The financial statements are the important source of finding the quantitative data. 13  Module 3 — Fundamental Analysis Chapter 3 How to Read the Annual Report of a Company 71 3.1 – What is an Annual Report? The annual report (AR) is a yearly publication by the company and is sent to the shareholders and other interested parties. The annual report is published by the end of the Financial Year, and all the data made available in the annual report is dated to 31st March. The AR is usually available on the company’s website (in the investors section) as a PDF document or one can contact the company to get a hard copy of the same. Since the annual report is published by the company, whatever is mentioned in the AR is assumed to be official. Hence, any misrepresentation of facts in the annual report can be held against the company. To give you a perspective, AR contains the auditor’s certificates (signed, dated, and sealed) certifying the sanctity of the financial data included in the annual report. Potential investors and the present shareholders are the primary audience for the annual report. Annual reports should provide the most pertinent information to an investor and should also communicate the company’s primary message. For an investor, the annual report must be the default option to seek information about a company. Of course there are many media websites claiming to give the financial 14  information about the company; however the investors should avoid seeking information from such sources. Remember the information is more reliable if we get it get it directly from the annual report. Why would the media website misrepresent the company information you may ask? Well, they may not do it deliberately but they may be forced to do it due to other factors. For example the company may like to include ‘depreciation’ in the expense side of P&L, but the media website may like to include it under a separate header. While this would not impact the overall numbers, it does interrupt the overall sequencing of data. 3.2 – What to look for in an Annual Report? The annual report has many sections that contain useful information about the company. One has to be careful while going through the annual report as there is a very thin line between the facts presented by the company and the marketing content that the company wants you to read. Let us briefly go through the various sections of an annual report and understand what the company is trying to communicate in the AR. For the sake of illustration, I have taken the Annual Report of Amara Raja Batteries Limited, belonging to Financial Year 2013-2014. As you may know Amara Raja Batteries Limited manufactures automobile and industrial batteries. You can download ARBL’s FY2014 AR from here (http://www.amararaja.co.in/annual_reports.asp) Please remember, the objective of this chapter is to give you a brief orientation on how to read an annual report. Running through each and every page of an AR is not practical; however, I would like to share some insights into how I would personally read through an AR, and also help you understand what kind of information is required and what information we can ignore. For a better understanding, I would urge you to download the Annual Report of ARBL and go through it simultaneously as we progress through this chapter. ARBL’s annual report contains the following 9 sections: o Financial Highlights o The Management Statement o Management Discussion & Analysis o 10 year Financial highlights o Corporate Information o Director’s Report o Report on Corporate governance o Financial Section, and 15 o Notice Note, no two annual reports are the same; they are all made to suite the company’s requirement keeping in perspective the industry they operate in. However, some of the sections in the annual report are common across annual reports. The first section in ARBL’s AR is the Financial Highlights. Financial Highlights contains the bird’s eye view on how the financials of the company looks for the year gone by.. The information in this section can be in the form of a table or a graphical display of data. This section of the annual report generally does a multi-year comparison of the operating and business metrics. Here is the snapshot of the same: The details that you see in the Financial Highlights section are basically an extract from the company’s financial statement. Along with the extracts, the company can also include a few financial ratios, which are calculated by the company itself. I briefly look through this section to get an overall idea, but I do not like to spend too much time on it. The reason for looking at this section briefly is that, I would anyway calculate these and many other ratios myself and while I do so, I would gain greater clarity on the company and its numbers. Needless to say, over the next few chapters we will understand how to read and understand the financial statements of the company and also how to calculate the financial ratios. The next two sections i.e the ‘Management Statement’ and ‘Management Discussion & Analysis’ are quite important. I spend time going through these sections. Both these sections gives you a sense on what the management of the company has to say about their business and the industry in general. As an investor or as a potential investor in the company, every word mentioned in these sections is 16 important. In fact some of the details related to the ‘Qualitative aspects’ (as discussed in chapter 2), can be found in these two sections of the AR. In the ‘Management Statement’ (sometimes called the Chairman’s Message), the investor gets a perspective of how the man sitting right on top is thinking about his business. The content here is usually broad based and gives a sense on how the business is positioned. When I read through this section, I look at how realistic the management is. I am very keen to see if the company’s management has its feet on the ground. I also observe if they are transparent on discussing details on what went right and what went wrong for the business. One example that I explicitly remember was reading through the chairman’s message of a well established tea manufacturing company. In his message, the chairman was talking about a revenue growth of nearly 10%, however the historical revenue numbers suggested that the company’s revenue was growing at a rate of 4- 5%. Clearly in this context, the growth rate of 10% seemed like a celestial move. This also indicated to me that the man on top may not really be in sync with ground reality and hence I decided not to invest in the company. Retrospectively when I look back at my decision not to invest, it was probably the right decision. Here is the snapshot of Amara Raja Batteries Limited; I have highlighted a small part that I think is interesting. I would encourage you to read through the entire message in the Annual Report. 17 Moving ahead, the next section is the ‘Management Discussion & Analysis’ or ‘MD&A’. This according to me is perhaps one of the most important sections in the whole of AR. The most standard way for any company to start this section is by talking about the macro trends in the economy. They discuss the overall economic activity of the country and the business sentiment across the corporate world. If the company has high exposure to exports, they even talk about global economic and business sentiment. ARBL has both exports and domestic business interest; hence they discuss both these angles in their AR. See the snapshot below: 18 ARBL’s view on the Indian economy: 19