Free Reports

How to Separate Dalal Street Diamonds from Worthless Stones

Mar 12, 2016

In this issue:
» Capex by India Inc still poor
» Global markets end the week mixed
» ....and more
0.00
Rahul Shah, Co-Head of Research

Back in 2003, an author of a new book approached Warren Buffett for a review. Given Buffett's choc-a-bloc schedule and the fact that he gets tons of books to read every year, there was a high probability he would politely turn down the offer. And that's precisely what happened.

I wish Buffett would have read the book. Its message would have certainly struck a deep cord. At least, it did with me.

The book is It's Earnings That Count.

Before we spill the beans, a small exercise...

Take a blank page. Now fold it both horizontally and vertically to divide it into four boxes of equal size.

Hewitt Heiserman Jr, the book's author, claims that for a growth investor, the top-right box of the page is what matters. For it will contain the true diamonds of Dalal Street. More on this in a bit...

There's nothing earth shattering in Heiserman's book. It's his framework that gets my vote.

That earnings drive stock prices is easily one of the biggest myths in investing. The conventional thinking is that if you want to know how a company's share price will do, check out its earnings trajectory. Nothing could be further from the truth.

Not all earnings are created equal.

I have seen a lot of companies grow their earnings at a good pace only for the wheels to come off suddenly. Nearly all the cash gets sucked out of the company, leaving it high and dry. I am yet to see a company get into trouble because of earnings issues. It is usually the liquidity or the cash the company has as its disposal that determines whether the company will continue its operations.

Cash flow - not earnings - is the key. And this is the framework behind Heiserman's book. It puts cash flow into the driver's seat and argues that the real profits aren't on the company's earnings statement. The real profits are what remain after accounting for capex and the company's working capital needs. If the company is still profitable after accounting for these expenses, only then it can be considered profitable. Heiserman calls these profits 'defensive profits'.

And then there's 'enterprising profits'.

Picture a new-age company that mostly does intellectual stuff. Its key assets are not plants and machinery but patents or the great R&D it does. A pharma company or an IT firm would fit the bill perfectly.

Since we can't touch and feel these assets, they are rightly called intangible assets. The way accounting works, these assets are not allowed to be capitalized over a period of time.

If you spend Rs one million on R&D, you have to expense the full one million in that year. You can't break it up and expense it over say five years.

This is plain wrong says Heiserman. Why penalize a company because its assets are intangible? Since the benefits of the investment are going to come over a period of time, they should be amortised over a period of time and not in one shot.

We agree. Furthermore, these new-age companies are funded through equity and not debt. So to calculate whether they are making real profits, we have to subtract the cost of equity capital from the final profits.

If we demand a return on equity of say 15% on an equity base of Rs 400 and the company makes profits of Rs 100, then the real profits are Rs 40. The remaining Rs 60 is the cost of equity capital invested in the business. This exercise is to ensure the company earns more than its cost of capital.

Make these two adjustments to the profits and what you have are enterprising profits.

Now, back to those boxes. How does a company get into the top-right slot? Along the X-axis are enterprising profits and along the Y-axis are defensive profits. True-blue growth companies will appear in the top-right box. They not only have free cash flows but also earn a return on capital significantly higher than its cost of capital.

We would love to use this approach for Indian companies to see which ones make it into the top-right box. These companies would be the potential diamonds of Dalal Street. The worthless stones would filter down to the bottom-left box. And we would avoid them at all costs.

Heiserman is of the view that this framework is the closest an investor can come to 'margin of safety' while practicing growth investing. I think he's right.

How about you? Do you think a company with defensive as well as enterprising profits is the real mark of a Dalal Street diamond? Let us know your comments or share your views in the Equitymaster Club.


--- Advertisement ---
Profit From Junior Blue Chips...

We have released our latest Special Report on the best of the best small caps - Junior Blue Chips!

Yes, we believe Junior Blue Chips possess the high growth potential of small caps along with the stability of blue chips.

That is an amazing combination every investor would want in his portfolio.

And the best part is you can get this report for FREE!

Just click here to know how...
------------------------------

3.45 Chart of the day

The corporate investment scenario in India remains dull. With over capacities built up, the asset turnover of India Inc. has fallen close to its decadal low. While the government is making attempts to do its bit by upping investments, the fact of the matter is that there is a lot of catching up to do when compared to the past. Today's chart of the day gives an indication of the new investment projects announced over the past decade and a half.

When It Comes to Capex Revival, There's a Long Way to Go

Please note that the above data is only the gross figure. It does not take into consideration the value of projects stalled, abandoned or shelved. If one were to gauge the trend of total investment of projects dropped and also that of the outstanding projects under implementation, these data points have been on a gradual rise over the long term.

Nevertheless, with Union Budget of 2016-2017 laying a lot of emphasis on boosting infrastructure spending - mainly towards the power, new and renewable energy (NRE) and transport space, the hope is that of this translating into a capex cycle revival over time. Spending towards these sectors has been increased by 50% (from the revised budget). The figure making rounds is Rs 3.4 trillion. The largest allocation is towards transport (roads and railways), followed by power and new and renewable energy.

4.20

Global markets ended the week mixed. Stocks in the US and Brazil topped the gainers. However, Asian markets were under pressure. The recent economic data from the US is satisfying. The US markets ended higher for the fourth consecutive week. However, markets are worried that positive will cause the US Fed to speed up its's interest rate hikes. The fed will meet this week to decide its next course of action. The US markets have almost erased all their 2016 losses.

The most noticeable event of the week was ECB's decision to cut its benchmark interest rate to zero and its deposit rate further into negative territory to -0.4%. It also, increased its asset purchase program by an additional Euro 20 billion. Surprisingly, the European markets did not respond significantly.

China equity markets closed lower by 2.2%. Investors seem unconvinced about the Chinese government's new five-year plan which has targeted 6.5%-7% GDP growth.

Back home, the BSE Sensex ended the week up 0.3%. After a sharp run up post the budget, stocks took a breather this week.

Performance During the Week Ended 11th March, 2016

4:52 Weekend investment mantra

"Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return." - Warren Buffett

This edition of The 5 Minute WrapUp is authored by Rahul Shah (Research Analyst).

Today's Premium Edition.

Today being a Saturday, there is no Premium edition being published. But you can always read our most recent issue here...

Recent Articles

This Rs 71 Trillion Business Could Make or Break (Your) Wealth in the Next Decade October 17, 2017
How to profit from behavioral biases afflicting the industry.
Sometimes the Market Makes Me A Crazy Person October 14, 2017
It's necessary to guard yourself when euphoria surrounds the market.
A Grave Mistake Both Companies and Investors Make October 12, 2017
When a company is making acquisitions or an investor is buying shares, this one important factor cannot be ignored.
Timeless Stocks on the Electric Car Assembly Line October 10, 2017
Are they on their way to create Coca Cola-like wealth?

Equitymaster requests your view! Post a comment on "How to Separate Dalal Street Diamonds from Worthless Stones". Click here!

1 Responses to "How to Separate Dalal Street Diamonds from Worthless Stones"

HEMANT K T

Mar 14, 2016

I agree that cash flow is the key in any business. Just wanted to know what you say of the e-commerce business which is burning cash but still gets valued higher and higher every time.

Like 
  
Equitymaster requests your view! Post a comment on "How to Separate Dalal Street Diamonds from Worthless Stones". Click here!