Thursday, 13 April 2017

Learning from Security Analysis - Part 1

I have started re-reading Security Analysis, 6th edition, (also will add on things from the 5th ed). I have been putting it on the backburner for sometime, but since the last time I read this was about 14 years back, decided that I have changed too much not to re-read this once more. Hoping to learn a lot more the second time around.

From the preface to the 6th edition by Seth Klarman



Value investing is not a paint-by-numbers exercise. Skepticism and judgment are always required. For one thing, not all elements affecting value are captured in a company’s financial statements—inventories can grow obsolete and receivables uncollectable; liabilities are sometimes unrecorded and property values over - or understated. Second, valuation is an art, not a science. Because the value of a business depends on numerous variables, it can typically be assessed only within a range. Third, the outcomes of all investments depend to some extent on the future, which cannot be predicted with certainty; for this reason, even some carefully analyzed investments fail to achieve profitable outcomes.

It is not enough just to number crunch. A business participates in a complex adaptive system, which is continuously in a flux. We need to be able to understand businesses and their operating environments; political, economic and social environments are also important to be understood.



While bargains still occasionally hide in plain sight, securities today are most likely to become mispriced when they are either accidentally overlooked or deliberately avoided. 

Before buying, it is important to ask the question, why is this cheap?



When bargains are scarce, value investors must be patient; compromising standards is a slippery slope to disaster. New opportunities will emerge, even if we don’t know when or where. In the absence of compelling opportunity, holding at least a portion of one’s portfolio in cash equivalents (for example, U.S. Treasury bills) awaiting future deployment will sometimes be the most sensible option. -- This is a difficult thing to do emotionally, especially in a rising market.

Like Klarman says, this is a very very difficult thing to practice. In a rising market, most value investors get out too early, which in itself is not a bad thing, but tests ones patience and fortitude immensely, to see ones friends keep making money when one is out of the market, sitting on cash.



Even in an expensive market, value investors must keep analyzing securities and assessing businesses, gaining knowledge and experience that will be useful in the future. 

Keep sharpening your saw or as Peter Lynch has said, keep turning over as many rocks as possible. I think it is important to study business in a pattern to get the most benefit. I like to look at a particular industry and multiple stocks within it.



Selling is more difficult because it involves securities that are closer to fully priced. As with buying, investors need a discipline for selling. **First, sell targets, once set, should be regularly adjusted to reflect all currently available information.** Second, individual investors must consider tax consequences. Third, whether or not an investor is fully invested may influence the urgency of raising cash from a stockholding as it approaches full valuation. The availability of better bargains might also make one a more eager seller. Finally, value investors should completely exit a security by the time it reaches full value; owning overvalued securities is the realm of speculators. 

For stocks which are compounding machines, we need to keep updating the intrinsic value, so that we do not get out of them too early. On the other hand, a sense of what a stock is worth is a must at all times for all stocks in one's portfolio.

Saturday, 1 April 2017

Aarti Industries - Good Chemistry

Business Overview
• Aarti Industries (AIL) has 3 divisions –
    o Specialty chemicals - Polymer & additives, Agrochemicals & intermediates, Dyes, Pigments, Paints & Printing Inks, Pharma Intermediates, Fuel Additives, Rubber chemicals, Resins, Fertilizer & Nutrients
    o Pharmaceuticals – APIs, Intermediates for Innovators & Generic Companies
    o Home & Personal Care - Non-ionic Surfactants, Concentrates for shampoo, hand wash & dishwash
• One of the leading supplier to global manufacturers of Dyes, Pigments, Agrochemicals, Pharmaceuticals & rubber chemicals.
• Manufacturing units (16):
    o Specialty chemicals - 10
    o APIs - 4
    o home & personal care chemicals – 2

Specialty Chemicals
• Largest nitro-chlorobenzene producer of India with a capacity of 60,000 TPA
• Amongst the largest producers of Benzene based basic and intermediate chemicals in India
Lowest cost producer of Benzene in the world
• Exports account for 51% of specialty chemicals division with 90% of exports USD denominated
• Offers 100+ products to MNCs globally; has "strategic supplier" status with many
• Globally ranks at 1st – 4th position for 75% of its portfolio
• Works on a cost+ model. Increase in cost of benzene will increase working capital requirement funded by short term debt. Decrease may lead to inventory losses and revenue reduction
• Benzene accounts for ~60% of the company’s revenues, while aniline and sulphuric acid compounds contribute ~12% to revenues.
• With start of the Dahej facility of 30,000 TPA capacity in Q1FY18, AIL will also enter toluene chemistry.
• Exports contribute ~50% to revenue with incremental capex planned to enhance standing in the export market.
• Co supplies products to more than 500 domestic customers and over 150 international customers from 50 countries with a major presence in USA, Europe, China, Japan and India. The customer list comprises marquee brands like BASF, Bayer, Clariant, Dow, DuPont, Flint Ink, Hunstman, Makhteshim Agan, Micro Inks, Solvay, Sudarshan, Sun Chemicals, Syngenta, Teijin, Ticona, Toray, UPL Limited

Pharma
• Pharma business has broken even in FY12 and can aid in growth
• Company has two USFDA facilities one for API and another for Intermediates.
• Comprises of about 15% of total revenues
• 48 commercial APIs with 33 EDMF, 28 USDMF and 16 CEP. 12 new APIs under development

Home & Personal Care Chemicals
• Low margin business
• Expected to grow on the back of larger consumption of hygiene and personal care products. Increasing consumption is driving the demand for range of cosmetic chemicals, health care products and hygiene products using performance chemicals, polymers and oleo chemicals.
• Comprises of about 5% of total revenues

Industry Overview
• Indian specialty chemicals industry is around $25 bn (FY13-14 FICCI report)
• India contributes about 3% of global specialty chemicals industry, which leaves a very large opportunity size.
• Global chemical companies are de-risking the supply chain for their raw-material by diversifying from China to India
• The most impactful regulation from an Indian perspective has been the European Union’s REACH (Registration, Evaluation, Authorization and Restriction of Chemicals), which went into effect in June 2007. This legislation addresses the production and use of chemicals and their potential impact on human health and environment. The substantial impact of REACH will come into play following the implementation of Phase 3 from June 2018 that will regulate any chemical supplied to EU at quantities of 1 tonne per annum or more. Aarti has been REACH-complaint since 2011.

Competitive Landscape
• Chlorination (ranked among the top three globally)
• Nitration (ranked among top four globally)
• Ammonolysis (ranked among the top two globally) Hydrogenation (ranked among the
top two globally), and
• Halex Chemistry (only player in India).

Risks & Concerns
• Co operates in an environmentally sensitive sector and is open to regulatory risk. Government can put in place stringent environmental guidelines which may make their products uncompetitive internationally.
• Fire and accident hazards during operations causing major disruptions cannot be ruled out.
• Issues with US FDA / cGMP on pharma APIs
• Co has exposure to foreign currency fluctuations
• Debt is high
• Though co works on a cost plus basis model in its speciality chemical segment, any significant increase in benzene prices will increase the working capital requirement for the business funded by short term debt, leading to increase in interest outgo and decline in profitability.

Management
• Management compensation aggregates to 10.25cr and is especially high amongst the Gogri family members.
• Management has maintained a dividend payout of over 25% for the last 10 years
• Management is paying out full tax

Financials
• Net debt / Equity is 1.9 at the consolidated level, which is on the higher side. Interest coverage ratio is 4.89 which is healthy.
• Co has maintained strong operating cash flow / net profit ratio, which means they have been able to generate cash successfully over a long period of time.


Piotroski's F-score Analysis
Co fairs well in the Piotroski’s F-score with a score of 6 (out of 9). The 3 points where it did not get a score were very near misses.


Dupont Analysis


• Majority of the ROE is being derived from the financial leverage. The co is slowly improving its margin profile and can maintain its ROE at the current level, even if they reduce debt. At the same level of leverage, ROE can be improved by better margins.
• With a large part of the capex already done, specially for the toluene plant, asset turnover is likely to improve, thus improving ROE further.
• The co is consistently improving its ROE over the last 5 years

Key Assumptions & Key Monitorables
• Growth led by capacity addition will continue
• Debt-Equity levels will not rise further
• Margins will be on an upward trend based on better product mix
• No issues with US FDA or any other regulatory compliance
• Toluene and ethylation plants get onstream with good capacity utilization

Valuation

Learning from Security Analysis - Part 1

I have started re-reading Security Analysis, 6th edition, (also will add on things from the 5th ed). I have been putting it on the backburn...