Mid-caps and small cap stocks have an average standard deviation of around 18-20% per annum. The implication of this factoid is that these stocks can drop or rise by 15%+ over a year for no fundamental reason at all.

Anecdotally most of us have seen a drop or rise in the stock price by 15% or more within a quarter, even in absence of any stock specific news. One can say that the stock price in such cases is being driven by noise.

What is noise?

In layman’s term, noise is variation without any underlying cause. In other words, the probability of the upside or downside is around 50%, which is the equivalent of a coin toss (random event). So if you expect a 15% variation due to noise, the probability of increase or decrease is the same with the expected value being zero ( expected value = 0.5*upside+0.5*downside)

Trading on noise

If your trading or investing strategy involves a 15-18% upside on the current price within a year, it is quite likely that the stock price may rise for no reason other than random fluctuations. In such a scenario, you may end up making money for no specific reason – though you may think that it was the result of your accurate analysis.

The risk of making money in such a way is that one ends up with the wrong conclusions, even though the real  cause of success was sheer luck (for further understanding of this phenomenon , you should read the book – fooled by randomness).

In addition to a faulty understanding, the long term returns can turn out to be sub par as the expected value for a series of such trades is essentially zero (upside and downside being equally likely).

Financial news is all noise

I am sure most of you have watched the financial news channels. Almost 90% of the time is spent on explaining the fluctuations during the day, which for the predominant part is just noise. Ofcourse you will get some information or insight if you spent the entire day watching this circus, but it is like chewing a ton of grass to get a litre of milk.

There are far more efficient and easier ways to get the required information – annual reports or magazine articles being some of them. One should watch these channels for entertainment and not for information.

Noise trading quite pervasive

IF you think that trading or investing on noise is a rare occurrence, you may be mistaken. I am sure most of you would have seen analyst reports or talking heads recommend some stock with a 10-15% upside in the short to medium term.

If the random fluctuation of stocks is 15% or more, then some of the recommendations will achieve this upside for no reason at all. The unsophisticated investor would erroneously consider the analyst to be skilled at picking stocks and may start following such people or worse, even pay for such advise.

How to see through such tricks?

I will suggest a simple set of rules to ignore analysts and their stock picks if the following is true

–          A price target with a 15-20% upside within the year

–          A success rate of 55% or less in terms of success rate (preferably over a year)

–          Completely confident and sure of the picks (no allowance or probability of error)

Now, you may be thinking that the above is an unrealistic and harsh set of expectations. Let me ask you this – In your job or business, does your boss or customer give you a raise or money for being wrong more than 50% of the times?

As far as I know, if someone goofed up 20% of the times or more, he or she will be out of a job or business. Why should the expectations from an analyst be any lower?

 
 

I get emails from a lot of readers to write about various topics. The topics requested are important for most investors and I think a majority of the readers of the blog would benefit from them.

I have put a poll on the list of topics which have been requested in the past (except point 6) and would write on the topic which gets the most votes. If you want a different topic to be written about and is not on the list, please leave a comment and i will take it up in a future poll.

I am sure you can guess, which topic will get my vote 🙂

Create your free online surveys with SurveyMonkey, the world’s leading questionnaire tool.

 
 

About
Triveni turbine is a Bangalore based company in the business of manufacturing and servicing steam turbines upto 30 Mw. In addition the company has a JV with GE (general electric) for turbines in the range of 30-100 Mw.

The company has around 2500 turbine installations globally and is a market leader in India in the sub 30 Mw range with a market share of around 55%.

Steam turbines have multiple applications such as co-generation, captive power plants, and Industrial drives and in ships. The company supplies industry specific turbines to multiple industry segments such as sugar, cement, steel, chemicals, municipal solid waste and textiles.

Financials
The company was spun off from triveni engineering in 2011, which also has a sugar, water management and gears business. The turbines business has grown from around 280 crs in 2006 to around 670 Crs in the current year at a CAGR of around 13%. PBT has risen from around 37 Crs to 140 crs in the current year at a CAGR of 20%+.

The company has been able to maintain an operating margin of roughly 25% during this period and a return on capital in excess of 100%. The company is able to earn such a high return on capital due to negative working capital and high operating margins.

Positives
The company earns a very high return on capital which points to the presence of a sustainable competitive advantage. It enjoys a very high market share in India and is now expanding into export markets too

The company also has the following four growth engines working for it
–      Industrial demand for power via captive power plants. Additional demand from co-gen opportunities
–      Service demand from the install base and for turbines of other manufacturers.
–      Demand from the JV with GE in India and abroad for the 30-100 Mw range
–      Export demand for sub 30 Mw product range

In addition to the above growth opportunities, the company is currently running at around 40-50% of capacity and can expand sales with minimal capex.

Risks
The key risk for the company is a delay in the revival of the capex cycle. The investment cycle has slowed down in India and in the export markets. As a result the company has struggled to grow the topline and profits in the last 2 years. If the capex does not revive, the company could face stagnant profits for some more time.

Competitive analysis
The key competitor for the company in India is Siemens. However companies like Siemens and BHEL have a very wide range of products and are not as focused on a single product in a narrow range (below 30 Mw). Most companies in this sector enjoy a decent return on capital and hence triveni turbine should continue to earn a high return in the foreseeable future.

Management quality checklist
– Management compensation : reasonable at around 1-2% of profit
– Capital allocation record : In the short operating period as an independent company, management has used the free cash to pay down the debt and the company should be debt free by the end of the year
– Shareholder communication – fairly good. The company shares adequate details via the annual report and quarterly investor updates and conference calls.
– Accounting practice – appear conservative
– Conflict of interest – none

Valuation
The company is currently selling at around 20 times earnings. On the face of it, this does not appear to be cheap. At the same time one has to look beyond the raw numbers. The topline and profits for the company have stagnated in the last 2 years with a complete collapse of investment demand.

During this period, several capital goods companies have made losses and have seen their working capitals blow up. During one of the worst downturns in the sector, the company has remained solidly profitable and continues to operate with a negative working capital.

In addition the company expanding its export business has a thriving and growing turbine services business and should see additional revenue from the JV with GE. We may not see a PE expansion as the company is already operating very efficiently, however as the topline and profits start expanding, we should get a return commensurate with the growth.

Conclusion
The company operates in a niche and has a sustainable competitive advantage due to its customer relationships and service network. In addition the company has formed a JV for the 30-100 Mw range which should enable it to expand the target market for its products. The company’s performance has stagnated in the last 2years due to the macro economic conditions. However the long term prospects remain intact and the company and its stock should do well in the long run.

Disclosure: No position in the stock as of writing this post
Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please read disclaimer towards the end of blog.