Is your stock suffering a 'lost decade'?

May 9, 2014

In this issue:
» No money for a Post bank says Finance Ministry
» Will India's pharma exports be affected by USFDA alerts?
» An overhaul of our mining policy is the need of the hour...
» Is the oil industry risking US$ 1.1 trillion of investor's money?
» ....and more

We have all heard the term, 'the lost decade'. It was originally used to describe the poor state of the Japanese economy in the 1990's. Since then people have used it quite freely to describe any kind of a bad 10-year performance. It can certainly describe the performance of quite a few stocks in the market. Of course not all companies suffer in this way but there are many well known ones that do. We would like to highlight an important point made by Warren Buffet in 2007 by giving an example of one such a company: Tata Motors.

As per an article in the Business Standard, Tata Motors has suffered a lost decade. The reason is simple. Believe it or not, the company's car sales have remained stagnant the last 10 years! In that time, the four wheeler industry has raced ahead. Car sales have tripled in this period while Tata Motors' market share has fallen from 16.9% in FY05 to 5.5% in FY14. This sad state of affairs is down to mainly two factors: the company's failure to innovate and launch new cars as well as the failure of the Nano. In the last two years, sales of the Nano have fallen a staggering 71.6%.

This brings us to Warren Buffet. He had explained in his 2007 letter to shareholders that there are essentially three types of businesses: the great, the good and the gruesome. Allow us to clarify. A truly 'great' business will have an 'enduring moat'. This means that the business can generate high returns on capital and protect the same from rising competition. Thus over time, such a business will throw off excess cash which can be paid to share holders in the form of rising dividends.

A 'good' business will also generate high returns on capital but will need to constantly reinvest its earnings to sustain its growth. Such a business will not have a lot of cash left over for shareholders despite rising sales. A 'gruesome business, on the other hand, will destroy share holder value in the long term. Just think about the aviation industry. These businesses keep raising capital (both debt and equity) regularly but rarely generate a profit.

Tata Motors clearly does not fit into either the first or the last category. Over the last three years, it has had to re-invest high amounts of cash into the business to handle the competitive intensity. At the same time, if one was to have a look at the company's 10 year financials, it is clear that Tata Motors has created value for share holders. Thus it would be safe to say that Tata Motors would fall in the 'good business' category as defined by Warren Buffet. This does not mean that Warren Buffet would invest in the company. Nor should this be the only yardstick to evaluate any business. We have presented this example only to highlight the need for long term investors to consider the capital requirements of a company before they invest in a stock. There is a huge difference between a company that needs a lot of capital to sustain its growth and one that does not.

Do you think that Tata Motors is a good company despite suffering a lost decade? Let us know in the Equitymaster Club or share your comments below.

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 Chart of the day
Here's another indication of expectations running ahead of the ground realities in India. There's this widely followed index which shows both the business activity as well as future business expectations. And what exactly is it pointing at these days? Well, as highlighted by Livemint, it seems to be pointing in opposite directions. Therefore while the real business activity has shrunk, business expectations have remained at higher levels. The latter is solely on the basis of hopes that economic conditions would change for the better after the elections.

However, has the optimism been taken too far? Drastic changes may not happen overnight. The state of the economy isn't particularly good right now with huge headwinds in the form of high corporate leverage and deterioration in the asset quality of banks. Besides, the fiscal health of the country isn't that great either. Therefore, any expectations of a quick turnaround need to be toned down a bit we believe.

Expectations are ahead of ground reality

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The recent round of approval for banking licenses came in as a huge disappointment to most of the applicants. One amongst them was India Post. The entity claims to have a far wider reach and more number of branches than the biggest PSU bank in the country, SBI. In fact from the point of view of financial inclusion, converting India Post to a bank would have been the ideal solution. However, as it appears the PSU entity has very little financial support from the government for such a venture. It is no secret that the Finance Ministry has hardly enough funds to recapitalize existing PSU banks. The problem of bad loans eroding PSU banks' capital has accentuated the problem. Most PSU banks are falling short of huge amounts of capital to meet Basel III norms. In such a scenario the Finance Ministry has refused offer capital to India Post's banking initiative. Moreover the Ministry believes that despite handling public deposits, the entity is yet not ready to handle advances. Hence India Post's hopes of converting itself into a bank are in the backburner for the time being. We certainly do not think the country immediately needs a lot of new banks for financial inclusion. However, the government's excuse of not funding one in order to re-capitalize inefficient PSU banks is not acceptable.

The Indian pharma sector has come under fire in recent times for failing to comply with good manufacturing practices (GMP) norms. Quite a few of the well known ones have been slapped with import alerts which have prevented them from selling drugs in the US. This has not only impacted their performance but also tainted their reputation in the market. However, despite these setbacks, a report released by India Ratings & Research and published in the Economic Times states that Indian exports to the US are expected to keep growing. It must be noted that the US is the largest pharma market in the world and is also a lucrative one for the Indian pharma companies.

Given the spate of drugs going off patent, most of the companies in the past several years have been keen to capture a chunk of this market. However, the competition is intense and the price erosion has been brutal. This has compelled most of the companies to come out with different strategies to sustain and grow their businesses in the region. At the same time, the US FDA has also become stringent with respect to plant quality and has stepped up instances of surprise checks. Thus, it is critical for Indian pharma players to intensify their focus on maintaining quality so that observations and import alerts issued by the US regulator are done away with. Otherwise, the opportunities provided by the US market could well be lost.

India is a nation rich in natural resources. However, this has led to rampant exploitation of such rich resources for personal benefits. Take the case of illegal iron ore mining. Most corporates were found guilty of violating mining norms by greasing the palms of politicians. While now the ban has been lifted in most states as middle ground has been found; the very fact that illegal mining persisted raises questions on India's policy dynamics. It also displays the prevalence of corruption in the industry. This not only results in loss of revenues but also has environmental consequences.

Hence, the focus of the new government should be to revamp the entire policy and bring in more transparency in ore mining. This may help the steel industry to produce more value added products. And make India one of the largest exporters of value added steel in the world. With the new government touted to be as business friendly it would be interesting to see what changes it would make so as to remove corruption and bring in more transparency in the sector.

The importance of energy for the global macro economy can hardly be undermined. If there is one thing for which the demand is unlikely to saturate, it is energy. So it's no wonder that the big oil companies are investing huge amounts of money in exploring uncharted areas. As per a report from Carbon Tracker, a London based organization, in doing so; these firms have disregarded capital discipline. The report suggests that oil explorers are risking up to US$ 1.1 trillion of investor's cash through 2025 on such projects. The areas these companies are trying to dig oil are unconventional and environmentally sensitive. This implies less likelihood of oil discovery. And even if these companies get lucky, the production business is likely to breakeven only at a price of US$ 95 per barrel.

While these companies may show higher production volumes, it will be detrimental to shareholder value. This is because the oil can be produced from other options that will be economical at US$ 75 per barrel. We believe that shareholders would be better off getting back their money as dividends or through share buybacks. Further, as environment norms keep getting stringent; such investment is unlikely to deliver value in the long term. But it is not likely that the companies will realize this by themselves. It will need a combined effort by Government agencies, oil majors and most importantly, the shareholders to make sure that their money is not put to reckless use. Else the corporate greed will lead to everybody's doom.

The Indian stock markets continued to surge ahead after opening firm. At the time of writing, the benchmark BSE-Sensex was up by 603 points (+2.7%). Barring pharma, all sectoral indices were trading positive with banking and realty stocks being the biggest gainers. Majority of the Asian stock markets were trading positive led by Indonesia and Japan. However the Chinese index was trading weak. Most of the European markets have opened the day on a negative note.

 Today's investing mantra
"We don't get paid for activity, just for being right. As to how long we'll wait, we'll wait indefinitely." - Warren Buffet

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