I wrote about hinduja global solutions (Now HGS) in jan 2009 (see here). The company was selling for below cash and thus the operating business was available for free.

As we know, the stock markets recovered by May 2009 and HGS was up 200% in a short span of 4 months.

first

In case you are wondering, this post is not about how I smartly exited in July and make 200% of capital.

The company performed extremely well in 2010. Net profits were up by 100%, Net margins hit 14% and this was inspite of the company carrying a large amount of cash on the balance sheet. I was feeling pretty smart about it.

The slow slide

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The price action from the peak in 2009 shows only part of the story. The company has increased its sales from around 900 Crs in 2010 to around 1550 Cr in 2012 at a CAGR of 30%+. The net profit  however dropped from 130 Crs to around 106 Crs in 2012 and may drop further to around 80 Crs in the current year.

I kept buying the stock during this period, anchored to the earlier levels of profitability.

The company has thus been able to grow through a combination of organic initiatives and acquisitions, but saw a drop in profitability due to lower margins and lower capital turns. In effect, the growth came through, but the economics of the industry has deteroriated during the same period. The company has gone from above average profitability (20%+ROE) to below average levels in the current year (single digit ROE)

The lessons

There are two key takeaways from the above loss.

The first lesson is that if the initial expectations on the economics of an industry do not play out, one should accept the reality as soon as possible and act on it. The second lesson for me is that I should give a higher weightage to the qualitative aspects of the business and not focus too much on the valuation. In case of HGS, the large amount of cash on the balance sheet (and corresponding low valuation) distracted me from the deteriorating economics of the business – A value trap.

The blind spot problem

I have looked at the various companies in the past and have wondered why others keep buying/ recommending it when it is obvious that the company does not have above average profitability and cannot be a good long term investment.

The thing with blind spot is that the same issues are not visible to yourself, where one may keep rationalizing your own decision for a long time.

It is not easy to accept a mistake, especially a slow one , resulting in the boiling frog problem. Hopefully this lesson will stay with me for a long time and prevent me from making the same mistake again (new ones will however happen)

 
 

There are two numbers I want to highlight

-13% and -15%

This is the drop in the CNX midcap and CNX small cap index since the start of the year. If these numbers look troubling, they don’t even represent the vertical drop in some stocks. I wrote about some such stocks in this post and now that seems to have become a daily affair with some stock just dropping like a stone.

I have to be honest about one thing – I have never seen such bungee jumping in the Indian markets. In the good old days, the market took its own sweet time to react to any fundamental or corporate governance issue and as a result an investor had a lot of time to get off the train wreck.

No such luck these days!!

If the company you own comes out with slightly disappointing numbers or if there is whiff of a corporate governance issue, the punishment is brutal.

The good news

It would take real optimist to look for any good in this. I am in that camp.

If  you are looking closely at the carnage, you may have noticed that companies with a weak business model or poor corporate governance are getting punished severely. At the risk of sounding insensitive, I would say that is the way markets should work. A properly functioning market should reward companies with sound business models and good managements and punish the wealth destroyers.

In case you think I am being insensitive to the plight of a lot of small shareholders, let me tell you that I have suffered for my poor decisions in the past and some of my current holdings have got impacted too. The market is not a good place to discover yourself.

Digging through the rubble

A lot of investors, if there any left, are shell shocked with this sudden turn of events.  The most common advice is to wait for the uncertainty to resolved. The reality is that the future is never certain – it is just that investors sometimes get optimistic and pay for the illusion of certainty.

One can choose to either wait for the fog of uncertainty to clear up or better yet have the courage to start digging through the debris to see if there are some gems lying around.

The first point to keep in mind is to avoid anchoring to the pre-crash prices. A stock is not cheap just because the price has dropped by 90% – look at Deccan chronicle holdings. A large drop in the stock price is a good starting point, but not a sufficient condition for a bargain

The second point to keep in mind is to look closely at the fundamentals of the company. Is the company highly leveraged and with a weak business model? In addition, it is important to avoid companies with corporate governance issues.

The final point is regarding one’s own emotions and conviction. Once you have identified a good idea and believe that the market is being irrational in beating it down, it will require a lot of emotional fortitude to hold onto the stock. One is likely to get a daily dose of negativity via falling stock prices and bad news or reports about the company. It is unlikely that a company with a beaten down price is enjoying great growth and high expectations from the market. One needs to do his or her homework that the current downturn is a passing phase and the stock will give above average returns over the next 2-3 year time frame.

I am currently looking at some of the following companies. This is just a preliminary list and I may or may invest in any idea

  1. BHEL
  2. Infinite computer s ltd
  3. Manapuram finance
  4. FAG bearings
  5. Whirlpool India
  6. Eros international
  7. Tata motors
  8. Canfin homes – thanks to ayush mittal.

I am sure some of you would have rolled your eyes on reading this list. Well, I have never been the one to buy popular stocks anyway. I am usually fishing in areas where you will not find most investors.

A roller coaster ride since 2007 and negative returns since then in comparison to double digit returns in gold and real estate means that if you tell someone that you are investing equities, they think you need to be assigned to a mental institution. It is not easy to be any equity investor these days. However if you look past the gloom, then the current downturn is a decent time to pick good stocks.

Disclaimer : Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions. Please read disclaimer towards the end of blog.

 
 

In an earlier post, I discussed about a new mental construct – value trade. This is basically an investment operation where one buys a super cheap stock in the hope that it will become merely cheap (as my good friend neeraj puts it).

The idea is to buy a stock which is selling at dirt cheap price due to various short term reasons such as selling pressure, unexpected bad results or sheer neglect. The hope is that the market will get over this extreme pessimism (temporary) soon and will price it at slightly more reasonable levels (though still cheap). 

In such cases, I am out as soon as the stock recovers (as I have done with some ideas in the past – Globus spirits).

About

Infinite computers is a 1400 Cr IT services company. The main business segments of the company are application management services, infrastructure management services, Product engineering services and a new division – Mobility solutions.

The application management services involve the usual ADM and other support services. This is the bread and butter of the Indian IT industry. This segment contributed to around 68% of the revenue for the company and is characterized by repeat revenue, moderate levels of margins and high levels of competition

The infrastructure management services contributed around 16% of the revenue and is similar to the application management services in terms of profitability and competitive pressures. These two segments are being commoditized across the industry and the days of fantastic profits are gone.

The product engineering services involves some kind of IP based revenue sharing model. I could not find any revenue data for this segment, but based on the other segments would assume around 14-15% of the total revenue.

The mobility solutions segment is a new segment referred to as Infinite convergence solutions. This is a messaging platform (details here) acquired from Motorola and supports around 100 Mn+ global subscribers.

Financials

The company has grown from around 350 Crs in 2007 to around 1400 Crs for the year 2013 which translates to around 25% CAGR growth.  The net profit for the company has grown from around 3 Crs to around 120-130 Crs for the current year.  The net margins have improved from around 9% to around 11% levels, mainly due to a small reduction in the manpower cost (as % of sales)

The company has been able to deliver an ROE of 20%+ in the last five years. In addition the company been able to maintain receivables at around 25-30% of revenue which seems reasonable for a company of its size.

The company is a debt free company and has around 130 Crs cash on the books (30 % of market cap). The management has been investing capital into the business, has a 30% dividend payout ratio and the rest has been accumulated as cash on the books. In addition, the company also did a small buyback in the last one year.

Positives

The company has a very strong balance sheet and good returns ratio. The management has invested capital sensibly in the past and has a reasonable dividend policy in place. In addition, the top management is a buyer of the stock at the current levels (though one should not read too much into it)

The company has a high level of repeat business, which provides a high level of confidence to the sustainability of the revenues.

Risks

The company has been able to grow the topline and profits since 2007 and now has considerable cash on the books. At the same time, the company was not very profitable from 2005 to 2008 (average 2-4% margins) and had a very low topline growth of around 5% per annum during this period.

The company operates in a highly competitive, global and fragmented industry – IT services. The industry is facing commoditization and is very likely to have lower profitability in the future. The company is focused on the telecom industry which has its own competitive pressures with the additional risk of a very high proportion of revenue from the top 5 clients. This exposes the company to a high level of topline and profit risk, if there is any loss of  business from the top few customers.

 Finally, the company is also expanding into the product space which is a high risk, high return kind of a business. The company has invested in excess of 80 Crs on various product related businesses and these intangible assets may incur a write down if these ventures were to prove unsuccessful.

Catalyst

In case of a long term idea, a buy and hold strategy works quite well as the company is growing its intrinsic value. In case of mid cap IT companies, the economics of the industry over the long term is not very clear (atleast to me). As a result, the returns have to come over the next 9-12 months and this is usually driven by a catalyst.

In case of infinite computer solutions, the 2013 profits have been a bit suppressed by the forex losses and once this headwind dies down , we should see a better growth in the net profits. A consistent dividend payout of 30% – growing with the profits should serve as another catalyst.

What can go wrong?  A loss of any of the top 5 customers would hit the topline and profits. A sudden slowdown in north america would impact the company as this region accounts for almost 80% of the revenue. If any of this happens, the stock is likely to drop in the short term

Finally, if the management does an overpriced acquisition or has to write down the intangible assets, the market is not going to like that.

Conclusion

The company sells at a PE of around 4 and an EV/EBDITA of 1.7 (after excluding cash). At these levels, the market believes that the company will soon be out of business. The company does face multiple risks (which company doesn’t), but none of the risks appear to be fatal. In addition, as far as I can tell, the management seems to be doing a good job of managing the business and a fair job of allocating capital.

If one believes that the company is not going out of business, then one does not need any fancy calculations to realize that the stock is cheap.

Why a value trade?

I am not comfortable with the economics of the IT services industry. This industry is commoditizing and the wage arbitrage game is slowly coming to an end. The super high returns on capital are likely to trend down – as has already occurred for several mid cap companies in this space.

At the same time, I cannot resist an undervalued stock which can deliver above average returns in the medium term (9-12 months).

Note: This idea was emailed to me by chaitanyya and it is not an original idea. I have a small starter position and will add or reduce based on the price and performance of the company.  Please do your own due diligence.

Disclaimer : Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions. Please read disclaimer towards the end of blog.