Saturday, 18 October 2008

A Tale of Two Companies

The frequency of my posts have dropped drastically. I am at a loss to decide whether this is attributable to market conditions, or me not having anything significantly intelligent to say...I am tempted to vote for the latter.

After months of contemplating what to write, I settled for an exposition on something that I term "beautiful". Capital structure is something that does not get as much importance as it should by investors, analysts and management in general. What is the optimal capital structure? I wish someone knew the answer. In this post, I take a look at how the markets treat two companies that are similar in most respects except for their capital structures. I then take a look at a case of possible mis-pricing and how often, even 'good' companies never seem to get their due.

Capital Structure irrelevant? Hmm... I consider Chambal Fertilizers and GNFC (fertilizers again!) for this post.

Most finance experts and academics advocate having 'some' debt in a firm's capital structure. "You get a tax-deduction...debt is cheaper..." are some of the reasons cited. Not wrong in my opinion. What is the right mix? That's a question that doesn't really have one right answer. For the moment, even if we assume the company's management knows the 'right' mix, the broad market participants are mostly unaware of the 'right' mix. What do they do in such cases?

The example exemplifies the point beautifully.

Lets start with margins. Both companies generated about the same EBITDA margin for fiscal year ended Mar-08. However, GNFC topped at the net income margin level. It generated a good 3 percentage points more than Chambal.

Turning our attention to the capital side introduces a fresh perspective to these numbers. GNFC managed to generate 100% more profit for common shareholders, while employing 30% less capital and only 62% more equity compared to Chambal. Impressive? my opinion.

So what did the markets do? They rewarded GNFC's superior performance by ascribing a 50% less equity value, and 70% less enterprise valuation, compared to Chambal. In terms of multiples, Chambal is currently valued at ~4x more than GNFC on the EBITDA multiple and 3.5x more on the P/E multiple. What could possibly explain this wide discrepancy? Is it a sign of terrible mis-pricing or is there something else at play?

Traditionally, apart from the arguments put forward for assuming debt, common equity holders like debt as it bolsters Return on Equity. Taking on debt gives a firm leverage, which is a double edged sword. Take on too much and the management risks destroying enterprise value, take on too little and again there is a risk of firm value not being maximized. The optimal funding structure is, in my opinion, like a moving target. One cannot get it right all the time, but one can try and get as close as possible to the 'right' number.
When analyzing two companies within the same industry, the investor faces the tough prospect of forming an opinion on whether a company is over/under-priced compared to the other company.The statement seems innocuous, but is one of the most important factors for an investor to answer, in my opinion.

In the above case, assuming other things being more or less equal, it seems a bit intriguing to me that the markets are valuing GNFC only at 0.5x book value of equity and valuing Chambal at 1.5x book value of equity. Especially considering that GNFC scores on all other operational metrics. To some extent, the differences in capital structure could explain the difference in market values for the two firms. Firms with some debt in their capital structure get rewarded with a greater enterprise value, compared to an all-stock firm. The other explanation that comes close to rationalizing the huge discrepancy is that the markets are probably expecting far better growth rates in Chambal's case compared to GNFC. But in a lollipop business, most companies face similar growth prospects, give or take a couple points.

Maybe Chambal has a better history compared to GNFC?
Lessons from the past
A look at history reveals some very interesting insights into the two companies. The comparison is so striking that commentary is mostly unnecessary. GNFC's growth rate over 4 years on almost every operational metric is better than Chambal's. Notably, GNFC has managed to grow Net Income at 34% CAGR with only 12% CAGR on Total Capital employed. This compares very favorably with Chambal's performance (13% Net Income CAGR, 10% Total Capital CAGR).

GNFC has also managed to grow dividends at 3x Chambal's rate. Dividends are important, as shareholders typically put a premium to companies that not only pay dividends but also manage to grow them at a good rate.

Turning to averages, its clear that GNFC beats Chambal hands down on every metric. It uses debt sparingly compared to Chambal and has turned in better return ratios.

However, the market and enterprise values, and valuation paint a very different and interesting story! The market value of both companies have grown at about the same rate over the past 4 years. Turning finally to valuations, one can see that GNFC has historically traded at a discount to Chambal.
Over/Under/Rational-pricing? Why should a company that is larger in size (in terms of revenues), has demonstrated a history of better operating metrics, grown dividends at a much faster rate and is comparatively conservatively capitalized, trade at a big discount to its peer?

A look at 1H2009 results for both companies show that there has been a significant dip in operational performance. Since Mar-2008 Chambal's stock has corrected 20%, while GNFC's stock has fallen 58%. The latter had a production disruption for 3 weeks in July related to a plant shut-down, but how much will this materially impact results 5-year out? Not too much in my opinion. GNFC will most likely post a pretty bad 2Q2009 result, however, a long-term investor shouldn't be too bothered with a on quarter dip.

The stock action reveals something striking about the markets. Yet again it demonstrates the short-term thinking that determines the actions of market players. The markets conveniently forget the long history of superior performance and beat down the stock only on the back of short-term negative news. Rational?

While the past, admittedly, cannot be used to linearly extrapolate into the future, it does reveal some important clues about companies. If I were to take a 5-year view - and was forced to buy a fertilizer stock - I would choose GNFC. The likelihood of management continuing to do the good things it did over the last 5 years is far more in GNFC's case than in Chambal's.
So is GNFC under-priced or is Chambal over-priced? Tough call to make, on a standalone basis. However, in my opinion, it's far easier to form an opinion on GNFC than Chambal. A company with a demonstrated history of superior performance trading at 1.5x last year's EBITDA and 2x last year's earnings merits a close look, even if it isn't a screaming buy.

The comparison reveals the market's implicit appraisal of difference in capital structures of two firms in the same industry. The markets, on balance, prefer firms which have some debt to no debt. What is the ideal 'some' is an open question.

More importantly, the comparison reveals a beautiful insight into the way the markets think and act. Sadly, holding on to a 'strong' company for around 4 years, did not guarantee proportional outperformance over an inferior peer in GNFC's case. It is an interesting lesson. While in lots of cases, the long term is a good judge of true value, the markets don't seem to get it right in some cases. The long term investor in this case loses out.

This, however, does not undermine the importance of numbers in the investing decision. While numbers are important, it is far more important to try and think far ahead. Thinking five years or more makes the investing decision that much more easier than predicting two quarters ahead. Most times, the key to a good investing decision lies outside the cosy world of multiples...

Every day its in the nature of this business to force people to take decisions on imperfect and incomplete information. However, over time, some get better at it as they develop a 'feel' for the numbers.

At the end of the day, the guy who keeps his head when everyone around him are busy losing theirs, is the one who takes home the biggest prize...

Monday, 7 April 2008

Delinquent Future?

My brain requested me to let it go on a vacation...So I listened and went on a sabbatical. I hope you missed me!

Much has changed - both in India and globally - since my last post. Markets around the globe seem to have caught a collective cold. I am probably feeling happy after quite a while in the markets, with so much pessimism going around. The markets have now tuned their radars to pick up the slightest of negative news flows to go on a free fall.

In this post, I take a look at some interesting developments in delinquency rates related to real estate and the response of the equity markets (S&P 500). Admittedly there are number of factors that have a bearing on the movement of the S&P 500 and one cannot see the causal effect of one on another in isolation. But as they say…sometimes the part is better than the whole…especially when trying to get a sense of how things fit together to form the larger picture!

Delinquency rates – to put it crudely – measures how many loans default as a proportion of total loans outstanding. The more people default higher is the delinquency rate. Why would people default? Simple, an economy goes into a tailspin --> people lose jobs --> low or no income --> can’t meet monthly loan payments --> increase in defaults --> higher delinquency rates.

What could be the relationship between delinquency rates and equity markets? One line of reasoning goes this way. Increase in delinquency rates --> people have less money to spend --> decrease in consumer spending --> liquidating of investments to meet important outflows --> collective negativity leads to slowdown in corporate earnings --> decreased stock prices.

Again, what is the cause and what is the effect is a debatable issue here. Here is a chart depicting the movement of the S&P 500 and movement in delinquency rates for real estate, residential and commercial properties.

Back in 2000, delinquency rates had just begun to rise and peaked in early 2001. What happened to equities? The S&P peaked just as delinquency rates started rising and then went into a free fall. The excessive froth that built up during the internet bubble took quite some time to settle down and the S&P continued its down trend till mid-2002.

Post 2001, delinquency rates started falling as the Fed intervened and cut interest rates. Interest rate cuts stimulate the economy, leading to a virtuous cycle of positive things resulting to a bull run in equities.

Looking at the low interest rates several players entered the real estate market with dollar signs in their eyes. They thought that the only way home prices could move was up and they leveraged themselves…well almost…to buy their dream home! But as they say all good things come to an end and this housing bubble too…

…The uptrend in the S&P which began in mid-2002 continued over the next five years. However interest rates were continuously rising during this time as the Fed worried about several things, not in the least among these being the build up of a possible housing bubble. Somebody had finally arrived to spoil the party. The continuously rising interest rates gradually led to a rise in defaults as people started feeling the pinch of costlier money. But somehow the equity markets were still oblivious to this development and continued rising…

Then suddenly – as always – the markets woke up and saw the above chart. Delinquency rates were at 8/9 year highs and everyone started wondering why on earth they were loading up on equities…

And the S&P started dropping...

2008 has been a forgettable year for most global markets. The fall in the S&P has triggered a fall in equity markets around the globe due to the coupling effect. What remains an unanswered question is whether the end 2007 peak will mark a repeat of the 2000 peak. Because if it does then those unfortunate people who correctly picked the top are in for a one way ride. Everyone says equities are one of the best asset classes in the long run. Ask a guy who picked the 2000 peak and see if you get the same answer. There is nothing that makes an asset class inherently good. Price paid is everything…

Delinquency rates have never been higher in the past 8/9 years but the S&P touched about the same level seen in 2000. The housing trouble seems far from over and a recession is almost the grim consensus currently. So till that time equity markets could be in for a choppy ride with an increased inclination to moving south rather than north. But there will be pockets of value waiting to be picked. One just needs to be patient and keep looking…

In the complex web of interconnected linkages, it is extremely tough to isolate one factor as the cause that leads to A, then B and then C. However, certain ‘indicators’ stick out like a sore thumb when overlapped with another. Delinquency rates and equities is one example. Credit spreads and equities are another. (For the curious: Check out this earlier post where I first played Dr. Doom. The S&P was at ~1520 then, its at 1380 now.)

I am fascinated and interested in unearthing these relationships. My other idol, the physicist Richard Feynman used to say this about physics – and something that is true in investing too –

“It’s all about asking the right questions and to keep looking. You do an experiment not with the intention of proving your prophecy but to learn about reality. This integrity will lead you to ask questions that you would have never thought of asking otherwise. In the process you unearth something about the way Nature works…it is fascinating!”

I totally agree.

I will never claim to ‘predicting’ market levels. I cannot do that. I don’t know how to do that. But by continuously looking at things that might have a bearing on each other I maximize my chances of staying out of big trouble.

As my guru, Warren Buffett says,

“I have made money by staying out of trouble.”

Pearls of wisdom from God himself.