How to avoid common mistakes and uncommon losses – 10X10Y

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We all think timing is very critical when investing in the market. There are two misconceptions:

  • Bull Markets are all rosy
  • Bear markets are bad

In a bull market, we forget all rationalities, we don’t research much and are in a hurry to invest due to the fear of missing out and creating quick money. This usually results in not-so-good results. Thus, the statement, Bull Markets are all rosy is a big misconception.

On the other hand, in a bear market, we do all the research and try to act very wisely. However, Mr. Niteen says that in his career, he has not seen even one instance where any money has been lost when invested in a bear market even with little due diligence. But a lot has been lost is most cases when invested in a bull market amidst all the frenzy.

Let’s look at The Wealth Creation Formula, 

The Compound Interest Formula – It is an extremely simply formula which we’ve studied all our lives, but the outcome is phenomenal. Here’s a different interpretation to the formula for wealth creation,

P, the Principal invested is critical to making big wealth (A, the amount). But if you invest early, the amount (A) could still be enormous because of the large T (Time Invested). There is an R (Rate of Interest) which everyone obsesses over, thinking what is the rate of return I am gaining but T is much more important than R. This is the importance of investing for the long time and its impact on creating enormous wealth.

Here’s another wrong misconception among retail investors, we look at the price and automatically think that the 4-digit priced stock is more expensive than a 2-digit stock. But look at Jain irrigation which has gone from a 140 high to a 3.05 low. On the other hand, MRF Tyres has gone from 1000 to almost 80000. For analysis we should look at the market capitalization of the company to avoid biases and definitely avoid the price. 

Here’s a list of companies where investors have been attracted to the stock due to the bull frenzy and the retail investors have invested for a quick buck but have later found themselves being trapped. Retail investors have had the majority shareholding in all these companies. This just goes on to prove how we retail investors are obsessed with such fraudulent stocks. But the key to making money in the market is to avoid such stocks as the first rule of making money is to not lose money. I personally have lost money in a few such companies over the years like IL&FS, YES Bank and Jain Irrigation and have learnt this lesson the hard way. But I hope you don’t.

Annual Report is one of the key documents for any investor. What we should look at:

  1. Financial Statements
  2. Cash Flow Statement (Most Important, Least Understood)
  3. Profit & Loss Statement
  4. Balance Sheet

Key Study Points in Annual Report
(A) – Cash Flow Statement – A Cash Flow Statement provides essential data regarding all cash inflows and cash outflows pertaining to its operations, investment activities, and financing activities of the company.

Key Check Points – 

  • Compare the CFO to NI (or EBITDA, your call) – But the ratio of CFO to NI should be 1 and with EBITDA should be 0.7. Anything lower should be looked into.
  • WC changes – If any huge changes, then we should understand the reason?
  • Taxes paid in Cash Flow vs P&L
  • Cash Flow from Investing trend – If you notice a jump then the company is probably expanding or investing. In such a case, we should also check for Balance Sheet Fixed assets, Capital Work-In-Progress, if it increases for 2/3 years then fine for 5/6 years and longer, we have to be cautious.

    Sales – You can sell your product for either cash or credit, either way it’ll be both recorded in the Profit & Loss Statement.
    In the Cash Flow statement, the sale is recognized in Operating cash flow but only if it’s in cash. If it’s in credit, it’ll go to receivables and when the receivables are paid off, it is then recognized in operating cash flow. But if the receivables are not paid off, it’s recognized as a bad debt. The bad debt now goes to P&L, because we have to reverse the sale and profit which we recognized earlier when it was sold

    Warning – whenever you think there is a problem with Operating cash flow, check the receivables amount and check the age of receivables. Also, check if the company is aggressive in revenue recognition or slow in recognition. But the exception to this are Banking and Financial Institutions.

Can Operating Cash Flow Be Manipulated?

Cash flow statement is one of those financial statements which is extremely difficult to manipulate, almost impossible. It is because of this reason that everyone emphasizes on its importance in judging a company’s performance. It’s also why they say Cash is king. Because cash never lies.

Operating Cash Flow = Net Income + Depreciation/Amortization – Working Capital Investment

A company can prop up the OCF by reducing Working Capital

 Working Capital = Current Asset – Current Liabilities
 
So to reduce WC the company will: 

  • Reduce CA – Decrease inventory / receivables
  • Increase CL – Increase payables 

But all these methods are not sustainable, because for how long can you keep selling your inventory at a fire-sale discount as soon as the financial year ends. Or for how long can you delay paying your suppliers or for how long can you keep yourself from not giving credit to your purchasers. They are not sustainable options because you end up disappointing related parties.

(B)  Profit and Loss Statement – P&L – Look at the Net Profit and Sales Trend (positive, rising or falling), Operating performance, Operating margin, Operating profit, Interest component (if it is going up or down and why?), depreciation, taxes paid amount (and compare it to the figure in cash flow), dividends paid (mentality of the company to pay dividends and the reasons for dividend). 

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(C)  Balance Sheet – B/S – Look at the share capital (Equity + Preference shares) and check if any equity dilution in the company? Constant equity dilution is alarming. Also, check if any preferential allotment (If not, it’s a strong signal). Look at Borrowings – Short and Long-Term borrowings vs Interest component. Should be within the vicinity of 10-20% max. Paying higher cash interest is fine but less would be questionable.

(D) Management Discussion And Analysis (MD&A)

Always read the first two and last two paragraphs and check if they’re implementing what’s being said.
A few Negatives to look for in MD&A – flowery language used by management, away from reality future numbers and growth forecasts.
A few Positives to look for in MD&A – The management is elaborating risks while talking about opportunities, they’re acting a little conservative, etc.
Key points to look out for – result of operations, changes in financial condition, risk management strategies, etc.

Warning – A lot of these annual reports are prepared by IR team, so check for those companies. They’ll directly pick stuff from net/articles/blogs that you’ve maybe even read before.

(E) Other key items to look at –

  • P&L along with Cash Flow – Check if Operating Cash Flow after Working Capital adjustments is positive or negative and compare with Net Profit.
  • Balance Sheet along with P&L – Check if Net debt is rising or falling and also compare it with interest amount. If it doesn’t match, the company is capitalizing the debt which is wrong or maybe the company has foreign debt. Now, if the company has exports, so they would be able to earn the foreign income and service the foreign debt. So that is fine. But if the company doesn’t have foreign income and when the rupee depreciates, the debt servicing will become expensive and they’ll end up defaulting upon the loan.
  • Interest – Interest paid divided by Net Profit, (a ratio of more than 0.4/0.5 is risky, anything higher will mean debt is not being utilized properly) 
    Another alternative which can be used is, Interest coverage ratio, which is EBIT divided by Interest. However, a better method would be (CFO divided by Interest) which is a better estimate as it doesn’t show the correct picture for companies with higher credit sales. Also, CFO which is the cash with you is also directly comparable with Interest which is again a cash expense. Thus, the use of cash interest coverage ratio is a much practical method of assessing the interest situation.
    Thus, it is extremely important to compare interest paid to Net Profit to Operating Cash Flow
  • Shareholding Pattern – It is very important to look for changes in the shareholding pattern. Always check for pledged holding by the promoter because any holding which is pledged should be automatically considered sold. Unpledged holding above 50% is good. 35-50% is still fine. Below 35% is bad, but there are still exceptions to this like when there is a statutory requirement for a promoter to keep his stake below a certain percentage or maybe the founders are very professional and keep it very low. We have to try and understand the situation.
  • Trend in receivables – Constant growth in receivables is not healthy. Also, when not in line with sales could be an indicator for manipulation.
  • Market Capitalization – We have to look at the entire company (RIL) and not just the subsidiary we find interesting (Jio), because when we look to invest in Jio, we buy the shares of the entire company RIL. Thus, always look at the enterprise value which is Market Value of Equity (Market Cap) plus Market Value of Debt. Also, look for consolidated numbers and not standalone numbers.
  • P&L along with Cash Flow – Check if Operating Cash Flow after Working Capital adjustments is positive or negative and compare with Net Profit.
  • Balance Sheet along with P&L – Check if Net debt is rising or falling and also compare it with interest amount. If it doesn’t match, the company is capitalizing the debt which is wrong or maybe the company has foreign debt. Now, if the company has exports, so they would be able to earn the foreign income and service the foreign debt. So that is fine. But if the company doesn’t have foreign income and when the rupee depreciates, the debt servicing will become expensive and they’ll end up defaulting upon the loan.
  • Taxes – Look for taxed paid in cash flow statement and the P&L statement. It could be different due to provision or unpaid taxes, deferred taxes, etc. But cash flow will give you the exact figure paid. But over time, the figures have to match.
  • Other Income Components – Compare the figures with previous years and find more details and check if sustainable or not.
  • Expenses – Understand the main expense heads like raw material, salaries, etc. 
  • Inventory Trends vs Finished goods vs Work-in-Progress – Helps us understand if the inventory is building up? Because if so it will lead to lot of problems like lowering margins to sell goods in future or giving credit to clear inventory and even for future sales
  • Salary of Directors and Auditors – Check if there are any revisions in the salary. If yes, is it in line with industry trends?
  • Board of Directors – Check if the board is of respectable members. Are they really independent? What is their attendance? Also check the same for Members of the committees. Make it a point to read the Independent auditors report.
  • Notes – Read them for additional important details.
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Let’s look at a few examples:

Example 1 – Fate of two infra companies
Company A – Multiplied at 3x
Company B – multiplied at 15x

Both companies listed together, survived post 2009 real estate correction, excellent execution track record. Keeping everything aside, A traded at 150-200 vs B at 100-130. 

  • We look at A and see that its pledged holding is continuously rising even though % ownership is also rising. In B, % ownership has fallen a bit but has zero pledged shares. Therefore, B is in a much better position.
  • The ratio of CFO to PAT should be at least 1. Company A showed a ratio of less than 1 for most years, whereas B had most being higher. A ratio of less than 1 will result in companies requiring cash and would need to borrow or sell equity. And, we can see that the share capital is rising (which proves that they’re raising cash)
    At the same time, Company B had CFO higher than PAT in most years which meant the company had sufficient. This is proven correct when you can see the Share capital being the same for years (thus, no equity dilution).

Example 2 – Manufacturer of Sound Systems

Key red flags in the company – 

  • One of the independent was only 23 years old and was studying MBA from Symbiosis
  • The company dealt in Woofers, Amplifiers, Computer Speakers, Personal Speaker System, Headphones and Earphones. Basically, competing with Bose. But the company was also trading in one other segment, Fabric.
  • The company also said that they had a ‘’strong presence’’ in African Continent, UAE, South America, Singapore, Dubai, Bangladesh, Vietnam and Nepal. They said that sold products in 56 countries across 6 continents. 
  • The company said that they had a dealer network of more than 240. They also had showrooms in multiple cities like Dehradun, Saharanpur, Patna, etc. But if you visited any of these cities, you won’t be able to spot either the showroom or the dealer. 
    The company was biting more than it could chew. The company is currently banned from being traded on the stock exchange. 

Example 3 – Dairy Company – Milking the company

  • The company called itself one of the fastest growing private sector dairy companies with a new range of innovative products and enjoys a large presence in northern India. The share price has fallen from 170 to 2.6. 
  • The company had very low depreciation number, small gross block and no major change over the years
  • Yet the company’s debt was continuously rising and so was the share capital. The sales, profit and receivables were also rising every year. It basically meant that all the money raised from debt and equity was used to increase sales and then moved to receivables. Because even the receivables will not be realized, all the amount would end up as bad debts. Now the company is in an NCLT case.

Example 4 – ‘’A vertically integrated multinational medical technology group’’, that’s what the company called itself. The share price has fallen from 140 to 3 and lower. This company was a hot favorite stock for all celebrity analysts. Most of them wrote pages and pages worth of blog recommending this stock. 

Key red flags in the company – 

  • CFO was lower than the PAT for years
  • The share capital was continuously rising, which meant that the company was regularly raising money by selling equity.
  • As on 12/07, the FII holding in the company stood at 25.49% but increased to 37.34%. At the same time, MFs cut their holding from 4.3% to 0.07%. Thus, it is not always ideal to blindly run behind companies with FII money. 
  • The company was doing a lot of acquisitions around the world. Acquisitions are perfect for siphoning off money as nobody can quite perfectly know where the money is going. 
  • The company was significantly increasing its debt and preferential allotment and showing fictitious sales.

Example 5 – A leader in the Security Surveillance domain, the first company of its again. Here too, share capital and borrowings were continuously rising, and so were the sales. But CFO was much lower than the profit and was rapidly decreasing. In fact it was negative in most years. Many big investors had invested but the stock price fell from 80 to 3. 

Example 6 – A specialist across the varieties of cables

The company was a fast-growing cables manufacturer with high double-digit growth in profit and sales. It also had high 20s ROE and ROCE numbers. It showed all characteristics of a growth company to lure investors which is why the share price rose from 6 to 235 in four years. But later fell to 29 in a month, and almost zero now. 

Key red flags in the company – 

  • The company’s net profit went from 10cr in 2010 to 163 cr in 2016. However, the net profit was not backed by CFO. CFO was minimal when compared to Net Profit in all these years.
  • Promoter holding was 41.19% but the entire stake was pledged. As we learnt earlier that any stake that is pledged shouldn’t be counted as part of the promoter’s stake. Thus, the stake in this company should be considered zero.

Let’s also now look at a few case studies:

Case Study 1: 

Suzlon – Power gone with the wind.

When a company is constantly in news and everyone seems to be invested in it, you need to be extra careful. One such company was Suzlon –

  • Suzlon won a takeover a battle for RE power in June 2007. 
  • We should be very careful with a company when news talking about big acquisitions, especially involving Foreign companies constantly come around. Such news with a frenzy behavior more often leads to disappointment later.
  • 3 months later, September 2007, Suzlon announces FCCB issue, which meant they required funds.
  • In Jan 2008, 6 months after takeover news the stock made a high at 424 right when they announced phenomenal results – 66% annual growth in MW sales, 53% EBITDA growth, orderbook of $4.3B. Since then, it has fallen from 424 to now 2.35
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Now let’s go back to June 2007 when the takeover was announced to spot problems, and if we can.

Key red flags in the company – 

  • The ratio of CFO and PAT was less than 1, in all years except 1 out of 8.
  • Investment numbers in 2007 were -3790 cr, which is a cash outflow meaning you’re investing. 
  • Finance numbers are positive, which means you’re raising money from debt or equity. 
  • A – 527cr Negative cash flow in investment in subsidies, which means investment was made in subsidiaries. This was a one-time number and wasn’t there before 2006, and subsequently has only increased. 
  • Loans and advances amounting to 269 crores were also given to subsidiaries and partnership firms and this has only increased.
  • There has also been consistent equity dilution. Debt has also been increasing, especially from 450cr in 2006 to 5162cr in 2007.
  • Income / Revenue – From 2002 to 2007 the revenue grew 16 times, from 500cr to 8000cr. Profit has also increased from 111cr to 864cr, 8 times.

Case Study 2 – Logistics company which defied all logics

2011 vs 2017

This case study company too was part of all the news and frenzy when GST was going to be implemented because everyone was looking for companies which will receive the biggest benefits under GST implementation. 

GST in Logistics: A Game Changer for logistics company – one such article said. Input credit to help logistics companies with assets to neutralize assets, another article said and so on. Such news was everywhere from May 2016 when GST bill was passed in Lok Sabha to July 2017, when GST was implemented.

As we learnt before that, when a company is constantly in news you need to be extra careful. We have to understand if all this disruption news already priced in? What’s the basis of all this hype? Is it accurate? One should try and stay away from such news. you won’t miss anything.

The stock went up from 130 in May 2016 to 260 in June 2017 and it is now below 10. The rise was just around when the GST news started coming in. 

Key red flags in the company – 

  • Tax paid in Cash Flow consistently mismatched the tax paid in P&L.
  • Investing Cash Flow showed that they were investing heavily. But Depreciation was not going up, it was almost the same, Gross Block was also not changing much. The Capital WIP was also going up but not at the same pace. Net block was also rising. Maybe they were not able to implement the heavy investments made. 
  • Sundry debtors were extremely high at 286cr and so was investment in in subsidiaries.
  • Equity was also being diluted. It went from 39cr in 2011 to 55.62cr in 2017
  • Total debt went from 600 to 1257 cr. 
  • Contingent liabilities from 600cr to 1220cr in 2017.
  • The company was not paying any dividend even though they were making a good amount of profit from -20 to 38cr in 2017.
  • Low interest cost (expense) compared to Debt liability. Most likely, the company was capitalizing the interest cost. It could also be possible that the company raised foreign debt at lower rate, but in this case of a logistics company, how will a company with no exports benefit?

Case 3 – Irrigation Company – Irrigated but no water.

This is another company which was a focus of a lot of news. It had a great story build up as the budget ‘18 and ‘19 had a great amount of focus on agriculture.

Just during the hype around GST rate cut on drip irrigation products, the company’s share topped at 146 and is now below 5. 

Understanding business and numbers are critical. We have to also understand the risk of the company’s receivables when the subject company is dealing with government organizations. 

Key red flags in the company – 

  • In 2017, the company has a debt of 4000 crores. Debt was continuously increasing and so were contingent liabilities.
  • Share capital was also getting diluted, from 90cr to 95cr. 
  • Sales were also ordinary
  • The company also had 2200cr of debtors. 
  • The company also had a good amount of foreign debt.

At such situations, when and how to sell,

  • Don’t sell in one go, sell incrementally on every share price rise.
  • Over excitement on your stock, be extra careful when everyone is excited about your stock.
  • When promoters are selling be aware.
  • When fundamentals are deteriorating be aware.
  • When financial parameters are extremely high be aware.
  • When price target achieved (after re-evaluating assumptions and pricing)

The video ends with the marshmallow test where,

A kid enters the room. He was offered a marshmallow, and told that he would be offered an additional one if he doesn’t eat it until the experiment moderator returns. The video teaches us about delayed gratification and how it solves a lot of problems in life.

This article is based on a presentation by the immensely reputed co-founder of Aurum Capital, Mr. Niteen S Dharmawat, the video of which can be found here

Thank You.

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Moulik Jain
Moulik is 24, an Entrepreneur, and a successful Angel Investor at Beardo (exited). He is currently one of India's youngest Angel Investors.
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