The reason for HUL's outperformance...

Aug 14, 2014

In this issue:
» Which sectors' stocks have fallen the most from their peaks?
» Dr. Rajan speaks up against corrupt politicians
» A strange development at Cisco
» Investors, analysts upset with L&T's management
» ...and more!

In our endeavor to educate retail investors about the basics of investing and accounting. we had released a series of articles titled Investing: Back to Basics a while ago. We thought it would be a good idea to touch upon some of the topics from this series to remind our readers about some of the basics.

In today's edition of the 5-Minute Wrap up, we would like to discuss about cash flow statement and why it's important for investors to understand the same.

Amongst the three accounting statements - the profit & loss, balance sheet and cash flow - it would not be wrong in saying that the latter is the least popular. But it would also not be wrong in saying that it is as important, if not more, as compared to the other two.

If one was to describe the purpose of a cash flow statement, it would be to gauge whether a company is making real money or not. The cash flow statement helps investors understand how a company's operations are running, where the cash is coming from and how it is being spent during a particular period. In essence, it helps an investor assess a company's cash generation ability.

As compared to the cash flow statement, the other statements are prepared on an accrual basis - recognized in the accounting periods to which they relate to - while the former is prepared on a cash basis. What this means is that the cash flow statement shows all the inflows and outflows of cash during a particular period. What is also required to be done is to adjust out non-cash transactions, such as adding depreciation back to net earnings.

While it is true that stock prices tend to follow the earnings, what is also true is that it is much easier to manipulate the same. Which is why it would be important to assess the quality of earnings - a discussion we will take up sometime soon.

Nevertheless, the impact of this statement can be quite an eye opener. Let's take up an example to explain this in a better manner:

FMCG major Hindustan Unilever's consolidated revenues grew at an average pace of 7% over the past five years. Profits during the same period grew by about 10%.

However, the stock of HUL has appreciated by over 22% per annum during this period.

Why this wide gap?

Well, it turns out that the company's cash flow from operations (CFO) - the amount of money the company made (or lost) through its operations - grew at a pace of 13% per annum during this period. What is more interesting is that the company's free cash flow - CFO minus capex - grew at a faster pace of 18% during this period.

However, it should be kept in mind that HUL's very strong position allows it to have negative working capital, a situation that helps in funding its operations with the help of other peoples' money. In fact, it is such competitive positions that would perfectly fit our 'Buffett would buy' list for the ValuePro portfolios.

So... next time you find yourself very fond of a company whose revenues and profits are growing at a very fast pace, make sure you do not ignore its cash flow position.

Do you make sure you gauge a company's cash flow statement before buying its stock? Have you had any poor experiences concerning the same? Let us know in the Equitymaster Club or share your comments below.

Editor's note: By the way, we are coming out with a new series starting 15th August 2014 wherein we will reveal the three most important factors that have helped Warren Buffett pick out some winning stocks. To ensure you receive this, all you need to do is reconfirm your free-for-life subscription to The 5 Minute WrapUp.

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 Chart of the day
The Indian stock markets seem to have hit a speed bump. The sharp appreciation that we had seen due to the change in government is well and truly behind us. After the middle of the road Union Budget, the markets have clearly lost momentum. However, in terms of a correction, large cap stocks have fared much better than mid and small caps. This is quite evident from today's chart of the day. High beta sectors like infra and realty have also faced the brunt of the selling pressure.

Largecaps prove to be way more stable than peers

As per an article in the Hindu Business Line, about 560 stocks from the mid and small cap space has lost over 25% in the last one month. Many of these stocks had run up far ahead of their fundamentals and a correction was overdue. This clearly reflects the importance of asset allocation as per us. During times of euphoria, stocks of companies with questionable fundamentals are often the ones to run up the most. But when the tide turns, the same stocks are also the ones that see the biggest tumble. The last one month has given investors yet another reason to remain invested in high quality business for the long term.

Our long time readers may know our dislike for IPOs. They hit the street when sentiments are high. Caught in the frenzy, investors disregard valuations and business prospects while applying. But later, more often than not, they see the value of their investments fall. Since we prefer dissecting IPOs with our valuation/fundamental lens, most of them end up being avoids.

However, it seems that the word AVOID is absent from the Chinese dictionary as investors are literally caught in the IPO whirlwind. There is a complete frenzy amongst investors to put money into IPOs for quick gains. After all, Chinese IPOs returned on an average 43% in a single day post listing last year! Quite understandably investors have gone berserk with such returns in the offing. So much so that they are blindly investing in any company that is planning to hit the street. And that too with levered money!

Also, what is interesting is that investors have made money in this hysteria if they have sold the stock on the listing day itself. Long term investors have on an average lost money in Chinese IPOs. This only suggests that speculative money is driving prices up in China. May be it would be best if the Chinese regulator steps in to tighten norms surrounding IPO trading. Else the Chinese IPO market would be no different than a casino.

Now, here's another interesting example of why we believe the whole recovery talk in the US is nothing but hot air. reports how Cisco just terminated close to 8% of its workforce. While this is certainly permissible, what is not quite fathomable is the fact that simultaneously, the company has also announced a US$ 1.5 bn share buyback. Well, usually, these two things seldom go hand in hand. Layoffs mean bad times around the corner and buybacks signify that times are good and the company is flush with cash.

This is not all. Since 2011, the company has repurchased US$ 21.9 bn in stock but has also fired close to 21,000 of its employees! If you try making sense of this, you will realise that it is nothing but the terrible side effects of the Fed's zero interest rate policy. Courtesy the same, firms are able to raise debt at virtually throwaway rates which are then used to do buy backs. So while the shareholders are being rewarded, employees are getting the boot. Not a healthy sign at all if you ask us.

Tomorrow India will complete 67 years of independence from British rule. But are we still free? This is a question we must never stop asking ourselves. Because even after so many decades of independence, a large section of society still remains poor and exploited. Our freedom fighters didn't just mean to drive the British away from our shores, but they envisioned a vibrant democracy where the fruits of economic development would be shared equitably among the countrymen. But what we have after so many years of independence leaves very little for us to be really proud of. It seems as if exploitation by the British has been replaced by exploitation by corrupt politicians.

And unless we firmly address, if not uproot, this problem of corruption and crony capitalism from our country, we will continue to remain a vulnerable economy. Luckily, we do have some strong institutions and voices in our country that do their bit in the interests of the country. We are glad to see the RBI Governor Dr Raghuram Rajan come out strongly against corrupt politicians and crony capitalism in the country. These are the biggest reasons why India's economic development has been adversely impacted. But why is corruption and crony capitalism so endemic in our country? Dr Rajan takes a shot at this question. As per him, the public services remain highly inaccessible for the poor. For instance, many ration shops across the country do not supply what is due. The police tend to be laxed in terms of registering crimes and taking action. Education and healthcare too suffer from poor staff attendance and amenities. This is where corrupt politicians fit in. They become temporary fixers for the poor. And this is why people have such high tolerance for corruption. And the politicians in turn continue to exploit the situation to their advantage.

The Middle East market has become an attraction for various engineering companies. While growth prospects in these markets are appealing, at the same time the risks are also quite high. High market fragmentation, higher bargaining power of the buyer has plagued the margins of various companies who have entered in these markets. And Larsen and Toubro (L&T) is not an exception here. The company has reported huge losses during the June quarter in its hydrocarbon subsidiary. This subsidiary is dedicated for projects in oil & gas, chemicals and petrochemicals related sectors. Investors have shown apprehensions towards this event. As per an article in Business standard, many investors and analysts have raised concerns regarding the same. They claim that L&T has bought sales growth by sacrificing profitability. Others allege the company had never indicated that it was incurring such huge losses while implementing hydrocarbon orders.

In our view, the company has been over optimistic regarding the projects. However one should note that risks are present in all big engineering projects owing to their long term time periods coupled with complex scope of work. And thus investors should not undermine the risk of a project failure. Ideally investors should buy such stocks after discounting such events, at attractive valuations.

The Indian stock markets continued to trade firm in the afternoon trading session. At the time of writing, the BSE-Sensex was trading up by 141 points (+0.5%). Barring IT, all the sectoral indices were trading in the green. Capital Goods and Consumer durable stocks were witnessing maximum buying interest. Most of the Asian markets were trading negative led by China and Indonesia. However, Japan was trading in the green. European markets opened the day on a weak note.

 Today's investing mantra
"As an investor with small capital, one should prefer businesses that have high returns on capital and that require little incremental investment to grow." - Warren Buffett

Please note that there will be no issue of The 5 Minute Wrapup on 15th and 16th August 2014. We wish our readers a Happy Independence Day!

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3 Responses to "The reason for HUL's outperformance..."


Aug 16, 2014

It will be great value addition to all of your research reports w.r.t. Stockselect, Midcap select, Hidden Treasure ......if alongwith p/e , p/s, p/b ratios ..u also include Price-to-Free_cash_flow ratio; Though I use to note my Price-to-Operational_cash_flow for all of my stockholdings from; but actual need is of Price-to-Free_Cash_Flow ..which I get nowhere; I hope u ll soon start making effort to fill this gap & making ur Stock Research Reports more robust !


Gopal Kalpathi

Aug 15, 2014

The very fact that HUL ( and such companies like HUL) have been around for such a long time is proof enough that they are good companies, not just with good product (what people want at prices they can afford) and good governance (very important in current scenario)but also quite innovative and change masters. I remember my uncle telling us how they use to market "Dalda" the hydrogenated vegetable oil. They even had the folding steel chairs made out of steel tubes and plates named after "Dalda" then known as Dalda-Chairs for marketing their vanaspati. At one time it was also marketed as poor mans Ghee (though later this kind of marketing was discontinued as misleading the consumer). They have also been doing the "constructive-destruction" and brand extensions and brand replacements.

My point is they were able to survive in a very regulated (pre-1990s) market and thrive in later liberalized Indian markets because of their International parentage and money power. They also had the good fortune to have good Indian managers who could foresee the transformations of the world markets, in general, and Indian markets in particular (T. Thomas & Dr. A. S. Ganguly). Not many company can boast of such good fortunes, in India though, especially in such dire circumstances & economy as in the past few years.


Ralph Rau

Aug 15, 2014

Larsen & Toubro has become a wealth destroyer. The board has failed in its key responsibility of succession planning. Its CEO has overstayed his welcome feathering his nest while share-holder wealth languishes. There is a clear lack of sound Corporate Governance when this company is run like some publicly listed but family controlled companies.

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