The fourth part of Series “Current temptation, future frustration“. This series is based on the companies which are currently darling of the market and many trying to catch such opportunities but it has a probability to become a reason for future frustration. It can wipe out the majority of gains in wealth. I am trying to put some of the number-crunching facts by which we can identify ongoing issues in the companies and can save our wealth.
I am starting this series with one of the company which is engaged in Entertainment / Electronic Media Software, has a 52 weeks low price of Rs.3.05 and LTP is Rs.9.20. This company has rewarded ~3.02x of return in a year.
Let’s start looking at the numbers.
We can see that the company has operating level profits but a loss at a net level. It can be possible if the business is at the nascent stage. But major expense is depreciation so have to check why huge depreciation charge.
When we look at the balance sheet then it seems that the company does not have any issue except debt. But when we look at the fixed assets then we get shocked. The depreciation rate is ~40% in FY19 and ~72% in FY20. I have not seen such a high-interest rate in other leading IT companies, there is max ~20% of depreciation rate in other IT companies.
When we move to the next, related parties then….
Then 72% of income in FY20 and 78% of income in FY19 comes from related parties. The company has 93% of receivables in FY20 of related parties.
This entire series is based on past available data and ignored the future development in companies and the stock market always looks at the future.
Disclosure – Companies mentioned in the article are just for an example & educational purpose. It is not a buy/sell/ hold recommendation.
We need to analyze financial statements and notes to accounts with huge care so that we can identify flaws which management wants to hide.
Indian companies Examples – Companies having growing sales but the majority of sales from related parties.
The company engaged in manufactures pumps, motors, valves, and custom-built power systems/manifold blocks.
The company is a travel management company.
Warren Buffett’s Letter 2002
Berkshire has made a five investments in the year 2002 which are Albecca (U.S. leader in custom-made picture Frames), Fruit of the Loom (the producer of about 33.3% of the men’s and boy’s underwear sold in the U.S. and of other apparel as well),CTB (a worldwide leader in equipment for the poultry, hog, egg production and grain industries), Garan (a manufacturer of children’s apparel, whose largest and best-known line is Garanimals) and The Pampered Chef – Founder Doris Christopher (in a business of manufacturing kitchen tools, food products, and cookbooks for preparing food in the home).
John Holland who is managing Fruit has Rescue Company from the disastrous path. We can see that if the management of the company is capable enough then he can run the business in a good manner rather than spoil it.
Two company from the same segment one has survived under the worst period and other has made a disaster.
The company has a sales growth, growth in cash balance, free cash flow for the cumulative period, a major portion of the assets side of the balance sheet is Net Block as a company is into the capital-intensive industry but investors of the company do not lose money.
Second company which has made a disaster
Another company from the same segment where the company has does not have a sales growth, reduced cash balance, no free cash flow for the cumulative period, a major portion of the assets side of the balance sheet is other assets and investors of the company has lost money.
We can see that the management of the company plays an important role in making a company successful and survive during the worst period also.
Berkshire has made an investment into MidAmerican Energy Holdings in the year 1999 for $35.05/per share and per-share earnings of MidAmerican Energy Holdings in the year 1998 was $2.01 (P/E 17.44x, Earning yield of 5.73% – US interest rates during the year 1999 was similar to earning yield).
View on Derivatives
We should wait for the opportunity which is falling under our criteria and till that time we should be inactive. We should work for staying into the game rather than try to hit on each and every ball thrown to us.
I will be going to make a detail explanation regarding weak earning quality later on. But I learn from my Guru that we need to start analyzing every company by considering it as a “Chor” so that we will not be biased about the company. If our process proves that the company has not a weak quality of financial then only need to consider the company as a clean company.
Warren Buffett’s Letter 2003
Mr. Buffett has again mentioned waiting for an opportunity which matches our criterion.
Director of the company should have the freedom to make an independent decision and they also should be an owner of the company so that their interest and interest of shareholders will not have any kind of conflict.
One of the lesson if there is a bubble scenario and we know that the price at the business traded is much higher than what actually an intrinsic value of the business then we need to sell out our position.
One of the wealth creator from IT segment. If we have sold out shares during an IT bubble period year 2000 at half price Rs.140 from the high price Rs.279. then we have lost return of 9% CAGR since the year 2000 (current price Rs.650). Now, we have bought Nifty Bees from those sold amounts then we have earned 13% CAGR till now.
We need to wait for the opportunity which falls under our Circle of Competence and we are comfortable with it, rather catch each opportunity.
We do not have to try to capture each and every single opportunity available rather we should focus on the opportunity which falls under our Circle of Competence and our philosophy. Till the time, we need to wait for the appropriate opportunity. Those who try to capture every opportunity, they do not get a better investment result.
As we have discussed investment into the cyclical industries in one of the articles of the same series (WARREN BUFFETT’S LETTER – 1987), we further get insights from Mr. Buffett –
When higher the supply of a particular commodity then prices of that particular commodity starts falling and vice-versa with the lower supply of the commodity. We should build a position into commodity companies during an excess supply of a particular commodity and we get insights for dry out excess supply.
Repurchase of Shares
We have seen in the current market fall that many people lose their investment, many have made an investment by bringing borrowing. But those who are careful and defensive investors, those get an opportunity to acquire position into the businesses at an attractive valuation. Many of the investors, I know who was holding a good liquidity position in their portfolio. They got saved from market fall. I also have experienced similar because of having good liquidity positions into my portfolio.
Berkshire has made an acquisition into Star Furniture and International Dairy Queen (Company has a 5792 dairy stores in 23 countries)
Warren Buffett’s Letter 1998
When the company spends any money than Mr. Buffett always analyze that whether company able to create more than one dollar for anyone dollar spend or not. If the company can able to create more than one dollar for every dollar spend then they are happy to spend money. If the company is incurring a capital expenditure and consistently company is not able to earn higher returns than the company is facing capital allocation problem. We do not have to check it for 1, 2 or 3 years but we need to check it for a longer horizon.
Indian Company examples –
One of the textile machinery manufacturing company –
One of the tyres manufacturing company –
One of the largest IT Company –
Berkshire help to the CEOs of companies in which they have made an investment –
They also focus on the long-term benefits from the business rather focus on the shorter term perspective. Additionally, Mr. Buffett and Mr. Charlie provide an environment to the CEOs where CEOs can show their talent.
When CEOs does not have such kind of pressure and time freedom then they can able to perform well with the value creation among the business. Unnecessary and excess of meetings also reduces the performance. Also, those who do not have a pressure, get the freedom to work then they will produce a better result.
Berkshire has made a 100% ownership acquisition of General Re which is operated into the reinsurance business. The company is the largest U.S. property-casualty reinsurer, the company also owns 82% of the oldest reinsurance company in the world, Cologne Re. The two companies together reinsure all lines of insurance and operate in 124 countries.