Confirmation bias is the tendency to look for confirming evidence to support an idea. As an investor, one of the risks is that once you like or fall in love with an idea, it is easy to ignore all the negatives and risks associated with the company.  In order to avoid this trap, I typically compare notes with my friends and fellow investors Ninad kunder and Neeraj Marathe( and a few more ).

We are all value investors who share the same philosophy and similar thought process. You would assume that if we look at an idea, we would come up with similar conclusions and more or less agree with each other thus re-enforcing the confirmation bias.

The reality is much different. I have routinely found that we look at the same facts and arrive at very different conclusions. I consider this difference of opinion as a good thing as it helps me in avoiding confirmation bias when I bounce my idea with other investors.

Let’s look at a live example. In the last 2-3 months I have been analyzing one such company – NESCO. Both ninad and Neeraj have been looking at the same company independently and have arrived at their own conclusions.  I am posting my analysis of nesco below. You can read ninad kunder’s analysis here and neeraj marathe’s analysis here. We have decided to do a joint post to highlight the difference in our conclusions inspite of looking at the same company at the same time.

Moral of the story : Share you analysis with other smart investors who share your philosophy but are not your clones 🙂

About

NESCO is a real estate and capital goods company. The company has a parcel of land in Mumbai on which it has developed an exhibition centre (BEC- Bombay exhibition centre) and an IT park. In addition the company has a capital goods business – Indabrator group which has plants in Gujarat.

The company was originally a capital good company, but started incurring losses in the late 90s. The company res-structured its operations and moved the plants to Gujarat. In addition the company has a large piece of land in goregaon, Mumbai where it has developed one of the largest convention centres in India and is now developing an IT park on the same land

Financials

The revenue of the company increased from 16 crs in 2001 to around 145 Crs in 2011. This revenue growth although good, does not highlight the change in the quality of the revenue.

The company had a net margin of around 3% in 2001 and was equal parts a capital goods and Services Company (convention centre). Since then the capital good segment has more or less stagnated and the service segment has expanded with expansion in the convention centre and addition of buildings in the IT Park. The company earned a net margin of 48% in 2011.

The profits of the company, especially from the services business is entirely free cash and has been used to pay off debt. The company now has almost 200 Crs cash which is around 20% of the company’s market cap. The ROE of the company is now 35% and if one excludes the surplus cash, it is in excess of 100%.

The company is able to earn such high margins as the services business (convention centre and IT Park) involve upfront investment and very low operating expenses. In addition the company’s business is now working capital negative due to minimal inventory (only in capital goods business) and low accounts receivables (due to customer advances for the services business).

Positives

The financial positives are listed in the previous section. The company is able to earn such high margins and high ROE due to the competitive advantage of the business. The company has been able to develop one of the largest convention centres in Mumbai which is not easy to develop considering the cost of land. In addition the company is developing additional buildings in the IT Park with the surplus cash (without incurring any debt).

The company thus enjoys a form of local monopoly (large piece of land at negligible cost on the books) and has used this advantage to develop an increasing stream of income. The company plans to re-invest the surplus cash into new buildings in the IT Park (building IV) which are high IRR projects.

The company has also re-structured its capital good business in the last 5-6 years and although this business is not generating attractive returns, it is not a big drain on the company.

Risks

The company has a large number of advantages and a steady cash flow. The business risk comes from a slowdown in the economy, which could impact the utilization of the convention centre and lower tenancy in the IT parks.

I personally feel the above risks are low and would be temporary in nature (will not impact the long term cash flow of the company).

The bigger risk is the re-investment risk. The company has developed 30-40% of the land and will continue developing the rest using the cash flow from the existing properties. In a period of 4-5 years, the company will be done with the development and could be generating 150-200 Crs of free cash flow with no clear avenues for re-investment in the business. At that point of time, the risk is that the management may re-invest the cash in all kinds of poor businesses.

Management quality checklist

–          Management compensation: The management compensation is around 3% of net profits which seems reasonable.

–          Capital allocation record: The management has allocated capital intelligently for the last 10 years and may do so for the next 3-4 years. It remains to be seen what will happen after that.

–          Shareholder communication: Management provides the mandated disclosure through its annual reports and details of the business are available on the website. The communication is adequate, though not extensive.

–          Accounting practice: The company has followed a bit of aggressive accounting in the past . During the period of 2000-2005, the company was re-structuring the capital goods business and also had accumulated losses. The company capitalized the VRS expenses and other costs and wrote them off till 2006 as it became profitable. The company has however followed conservative accounting since then.

–          Conflict of interest: None as yet

–          Performance track record: Above average in the last 10 years. The company has re-structured the capital goods business and expanded the real estate business which is a very high IRR business.

Valuation

The company is currently valued at around 800 Crs and has around 200 Crs on it balance sheet (which is likely to be used partly for IT Park IV). Net of cash the company sells for around 600 crs which is around 7-8 times the expected earnings for 2012. This valuation is low for a company which has an ROE in excess of 100% and can grow at 20%+ for the next 4-5 years with small amounts of added capital.

The above valuation appears low from a cash flow standpoint and the company can be conservatively be valued at 1600-1700 crs (twice the current market cap).

Another view point can be based on the assets of the company. The company has around 70 acres which itself can be valued at a minimum of 2000 crs (if not more). This does not include the value of the BEC business or the IT Park, which enhance the value of the land bank.

Conclusion

The company possess close to a local monopoly due to a large piece of land in a prime location. The management has re-structured its capital goods business and shifted focus to the real estate (exhibition and IT Park) business which has high profitability. The company is developing new projects (at high IRR) which should increase its profitability in the near future. In view the above the company appears to be undervalued as of writing this note.

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