Nandan Chakraborty, Head of Research, Enam Securities, said there are two major schools of investing. “One is value investing and growth investing.”
So, what is the relevance of the balance sheet while looking for stocks using the two methods? According to Chakraborty, in value investing you are not attempting to forecast the company’s earnings. “In terms of margin safety, you see how much can that stock fall and what coverage does it have. The use of balance sheets in value investing is trying, matching, and removing all the hidden bombs to make the balance sheet more representative of the company’s current situation.”
While in growth investing, the balance sheet is the starting point of a whole host of analysis, he said. “You pick up something from the balance sheet and say that my overall intention is to find out what is the scalability and sustainability of the entire business model.”
Excerpts from CNBC-TV18’s exclusive interview with Nandan Chakraborty:
Q: What is the relevance of this balance sheet, how important is it when you go about looking for stocks?
A: There are a million ways of making money out of that. Two of the major schools are value investing and growth investing. In value investing, you are not attempting to forecast the company’s earnings. In pure value investing, as advocated by Graham and Dodd, you take a number of companies who have a high margin of safety and then when you have that pool over a period of time some of them become multi-baggers. Even if some of them drown, when the prospects are bad or something is wrong with the company, on the overall package you will basically make a lot of money. That is the essence of value investing.
In value investing, you actually see, in terms of margin safety, how much can that stock fall and what coverage does it have. For example, liquidity and current ratios, interest cover and margin protection that it has. Essentially you are protecting the downside as much as possible without any thought of the upside and leaving the upside completely unknowable. The use of balance sheets in value investing is trying, matching, and removing all the hidden bombs to make the balance sheet more representative of the company’s current situation. In this way the balance sheet is used completely for value investing.
For growth investing, it is a completely different paradigm. The balance sheet is the starting point of a whole host of analysis and it is almost like a Sherlock Holmes thing. You pick up something from the balance sheet and say that my overall intention is to find out what is the scalability and sustainability of the entire business model.
Q: You are a follower of the growth school theory about stock picking, so take us through the key business drivers that you look at when you are trying to identify stocks?
A: There are four major factors that we look at to figure out whether a stock has scalability and are there any early warning signals of any hick up in growth because that is ultimately what growth investing is all about.
The first one that we look at is volume growth. Is there a huge scalability in volume growth that is possible, for example in cell phones, retails, and where the addressable market is huge. Therefore, the part that the company plays in terms of the addressable market is basically very small compared to the entire universe. Over a period of time, we expect margins to actually fall but see volume growth due to its brand image, distribution, and stuff like that to more than offset that.
Second, we look at is pricing power. The most loved pricing power stories are essentially the brands or oligopolies and then there is cyclical investing for example cement, metals, and other commodities.
Third, we look at volume growth and pricing power. This has to translate into increasing efficiency over a period of time because ultimately you are going to have competition and the pricing is going to drop. So, you have to constantly increase your asset utilization and cost structure.
Last, there are catalyst such as privatization, M&A, divesting, or buybacks which are corporate specific activities.
Q: In the context of all these four parameters that you see, you have business cycles in the economy, how do you view the business?
A: So far, I have spoken on really how you see micro businesses. At the end of the day a lot of things depend on predicting cycles and a sense of history helps you with this. You have to think long and hard about cycles and not just the life cycle of the company, the stage of maturity and so on but the life cycle of the entire industry. Overlay on that is the overall business cycle. So, there will be situations like inflation in which some companies actually take advantage of to increase their pricing power, so that they can pass on that inflation in terms of their pricing. However, there are some who cannot. So, business cycles are the third important thing.
Fourth, what are the key sources of advantage be it personal, research, brand, or distribution for that particular company. What is it doing to improve that and where is competition trying to eat into each of these specific sources of advantage?
Q: We have seen how you look at the entire business cycle, the key drivers. If you wanted to put a financial litmus test for the company, what would be the key numbers that you would be looking at?
A: Something typically which has low asset requirements. In nutshell it means the business that you get divided by the number of assets that you deploy. If that ratio is large, it translates into scalable earnings growth.
Second, low credit to inventory is a proxy for your strength of business. Somebody can tell you that I have got this and that. But unless it translates into higher margins, low credit and inventory levels, and the ability to push all this onto either your suppliers or buyers then only is it demonstrable. There are likely to be cyclical valuations and themes in most businesses.
Q: How easy is it to find companies with high margins, that you can defend with low credit?
A: We have many stocks in the Indian universe, but at the end of the day you have to keep checking and the balance sheet actually is the first step. It is almost like a Sherlock Holmes process to verify the degrees of freedom that the company has by talking to suppliers, buyers, and people within the company, and figuring out what has been translated into the balance sheet is repeatable or not.
Q: Once you have seen some of the companies, tell us some typical hidden bombs to be beware of?
A: It is extremely important to look at the notes to the accounts in each and every balance sheet because most of these hidden bombs would come out in the notes to the accounts and in the fine print.
One class would be the conflict of interest structures, on the private businesses of the promoter and whether he has truly arms length relationship with the current business, which is listed in the stock markets or not.
Second is an interparty relationship; is he indebted to a very key supplier or a buyer? Is there something which is non-evident, where he is actually passing some of the profits in some other way to this particular entity.
Third is split ownerships and the fourth is also loans in advances. Are there too many loans in advances, which are given to either directors, suppliers or buyers, which make you feel that there is some other way in which the reward system is operating.
The other class is the off-balance sheet liabilities; this is a time bomb. This includes unfounded pensions, litigations, family settlements, etc. As a matter of fact, there is a book which has been written which is called accounting pitfalls. It is commonly available in the market and it actually discusses the entire length and breadth of creative accounting.
Q: If you want to pick out one-two sectors where you could apply and disaggregate the market for us, could you just quickly do that with an example?
A: Emerging businesses are typically the ones where you will have high valuations but very high failure rates, which is the reason for the high valuations. So this is one where the volume growth is constant and for an unforeseeable future. But there should be ways that the company should have early warning signals that you should be able to get for competition to come in.
There are cases where the demand is far more than supply but where the competition is going to be global rather than local. Domestic demographics are again growth companies, which are FMCG, auto and banking, which have an element of cyclicality in them and they move in cycles of volume cycle and margin cycle. When the volumes are high they can afford to increase margins, when the margins increase they can afford to decrease it and increase volumes.
For global commodities, you can operate at good marginal costing because the price is global and not under your control. What is under your control is operating efficiencies and access to your raw material.
So, what is the relevance of the balance sheet while looking for stocks using the two methods? According to Chakraborty, in value investing you are not attempting to forecast the company’s earnings. “In terms of margin safety, you see how much can that stock fall and what coverage does it have. The use of balance sheets in value investing is trying, matching, and removing all the hidden bombs to make the balance sheet more representative of the company’s current situation.”
While in growth investing, the balance sheet is the starting point of a whole host of analysis, he said. “You pick up something from the balance sheet and say that my overall intention is to find out what is the scalability and sustainability of the entire business model.”
Excerpts from CNBC-TV18’s exclusive interview with Nandan Chakraborty:
Q: What is the relevance of this balance sheet, how important is it when you go about looking for stocks?
A: There are a million ways of making money out of that. Two of the major schools are value investing and growth investing. In value investing, you are not attempting to forecast the company’s earnings. In pure value investing, as advocated by Graham and Dodd, you take a number of companies who have a high margin of safety and then when you have that pool over a period of time some of them become multi-baggers. Even if some of them drown, when the prospects are bad or something is wrong with the company, on the overall package you will basically make a lot of money. That is the essence of value investing.
In value investing, you actually see, in terms of margin safety, how much can that stock fall and what coverage does it have. For example, liquidity and current ratios, interest cover and margin protection that it has. Essentially you are protecting the downside as much as possible without any thought of the upside and leaving the upside completely unknowable. The use of balance sheets in value investing is trying, matching, and removing all the hidden bombs to make the balance sheet more representative of the company’s current situation. In this way the balance sheet is used completely for value investing.
For growth investing, it is a completely different paradigm. The balance sheet is the starting point of a whole host of analysis and it is almost like a Sherlock Holmes thing. You pick up something from the balance sheet and say that my overall intention is to find out what is the scalability and sustainability of the entire business model.
Q: You are a follower of the growth school theory about stock picking, so take us through the key business drivers that you look at when you are trying to identify stocks?
A: There are four major factors that we look at to figure out whether a stock has scalability and are there any early warning signals of any hick up in growth because that is ultimately what growth investing is all about.
The first one that we look at is volume growth. Is there a huge scalability in volume growth that is possible, for example in cell phones, retails, and where the addressable market is huge. Therefore, the part that the company plays in terms of the addressable market is basically very small compared to the entire universe. Over a period of time, we expect margins to actually fall but see volume growth due to its brand image, distribution, and stuff like that to more than offset that.
Second, we look at is pricing power. The most loved pricing power stories are essentially the brands or oligopolies and then there is cyclical investing for example cement, metals, and other commodities.
Third, we look at volume growth and pricing power. This has to translate into increasing efficiency over a period of time because ultimately you are going to have competition and the pricing is going to drop. So, you have to constantly increase your asset utilization and cost structure.
Last, there are catalyst such as privatization, M&A, divesting, or buybacks which are corporate specific activities.
Q: In the context of all these four parameters that you see, you have business cycles in the economy, how do you view the business?
A: So far, I have spoken on really how you see micro businesses. At the end of the day a lot of things depend on predicting cycles and a sense of history helps you with this. You have to think long and hard about cycles and not just the life cycle of the company, the stage of maturity and so on but the life cycle of the entire industry. Overlay on that is the overall business cycle. So, there will be situations like inflation in which some companies actually take advantage of to increase their pricing power, so that they can pass on that inflation in terms of their pricing. However, there are some who cannot. So, business cycles are the third important thing.
Fourth, what are the key sources of advantage be it personal, research, brand, or distribution for that particular company. What is it doing to improve that and where is competition trying to eat into each of these specific sources of advantage?
Q: We have seen how you look at the entire business cycle, the key drivers. If you wanted to put a financial litmus test for the company, what would be the key numbers that you would be looking at?
A: Something typically which has low asset requirements. In nutshell it means the business that you get divided by the number of assets that you deploy. If that ratio is large, it translates into scalable earnings growth.
Second, low credit to inventory is a proxy for your strength of business. Somebody can tell you that I have got this and that. But unless it translates into higher margins, low credit and inventory levels, and the ability to push all this onto either your suppliers or buyers then only is it demonstrable. There are likely to be cyclical valuations and themes in most businesses.
Q: How easy is it to find companies with high margins, that you can defend with low credit?
A: We have many stocks in the Indian universe, but at the end of the day you have to keep checking and the balance sheet actually is the first step. It is almost like a Sherlock Holmes process to verify the degrees of freedom that the company has by talking to suppliers, buyers, and people within the company, and figuring out what has been translated into the balance sheet is repeatable or not.
Q: Once you have seen some of the companies, tell us some typical hidden bombs to be beware of?
A: It is extremely important to look at the notes to the accounts in each and every balance sheet because most of these hidden bombs would come out in the notes to the accounts and in the fine print.
One class would be the conflict of interest structures, on the private businesses of the promoter and whether he has truly arms length relationship with the current business, which is listed in the stock markets or not.
Second is an interparty relationship; is he indebted to a very key supplier or a buyer? Is there something which is non-evident, where he is actually passing some of the profits in some other way to this particular entity.
Third is split ownerships and the fourth is also loans in advances. Are there too many loans in advances, which are given to either directors, suppliers or buyers, which make you feel that there is some other way in which the reward system is operating.
The other class is the off-balance sheet liabilities; this is a time bomb. This includes unfounded pensions, litigations, family settlements, etc. As a matter of fact, there is a book which has been written which is called accounting pitfalls. It is commonly available in the market and it actually discusses the entire length and breadth of creative accounting.
Q: If you want to pick out one-two sectors where you could apply and disaggregate the market for us, could you just quickly do that with an example?
A: Emerging businesses are typically the ones where you will have high valuations but very high failure rates, which is the reason for the high valuations. So this is one where the volume growth is constant and for an unforeseeable future. But there should be ways that the company should have early warning signals that you should be able to get for competition to come in.
There are cases where the demand is far more than supply but where the competition is going to be global rather than local. Domestic demographics are again growth companies, which are FMCG, auto and banking, which have an element of cyclicality in them and they move in cycles of volume cycle and margin cycle. When the volumes are high they can afford to increase margins, when the margins increase they can afford to decrease it and increase volumes.
For global commodities, you can operate at good marginal costing because the price is global and not under your control. What is under your control is operating efficiencies and access to your raw material.
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