Intelligent Speculation with Benjamin Graham - The 5 Minute WrapUp by Equitymaster
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Intelligent Speculation with Benjamin Graham

Oct 3, 2016
In this issue:
» PSU banks' performance deteriorates despite capital infusion
» Market roundup
» ...and more!
00:00
Rohan Pinto, Research analyst

Is there any such thing as intelligent speculation?

  • An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.

Graham's classic definition does not seem to allow for any intelligent speculation.

Nevertheless, dear readers, I am compelled to share a few observations, and I think you will find that Graham is indeed open to some intelligent speculation.

Blasphemous, you say.

Allow me to explain.

In his book, Security Analysis, Graham provides an example of two companies with different cost structures, i.e. one with a high production costs and one with lower productions costs.

Now, what does conventional wisdom tell you?

Always keep an eye out for the lower cost producer. The lowest cost producer is better placed to survive a downturn in the market cycle.

In fact, Mr Market also favours the low cost producers and assigns a premium to such companies.

Most of the time, this line of reasoning is correct.

However, this might not always be the case. Let's deep dive into a slightly modified version of Graham's example.

Both companies produce and sell copper. They are able to manufacture a kilogram (kg) of copper annually. The cost of production is higher for company B than company A.

Now, company A being a low cost producer earns a higher profit per kg it produces.

Items Company A Company B
Total Production (in kg) 1 1
Total cost of production per kg (Rs) 200 250
 
Case A
Price of copper per kg (Rs) 300 300
Profit per kg (Rs) 100 50
Total earnings (Rs) 100 50
Market Value at 10x earnings (Rs) 1,000 500
 
Case B
Price of copper per kg (Rs) 400 400
Profit per kg (Rs) 200 150
Total earnings (Rs) 200 150
Market Value at 10x earnings (Rs) 2,000 1,500

Things get interesting when the price of copper increases 33% to Rs 400 per kg.

In case B, note that company A doubles its profit per kg. Importantly, the profit per kg of company B triples.

The market value of company A in turn doubles after the price increase while the value of company B triples.

What just happened there?

Here's Graham:

  • When a rise in the price of the commodity occurs, there will ordinarily be a larger advance, percentagewise, in the shares of high-cost producers than in the shares of low-cost producers.

Graham gives you the license to intelligently speculate:

Contrary to the general impression in Wall Street, the stocks of high-cost producers are more logical commitments than those of the low-cost producers when the buyer is convinced that a rise in the price of the product is imminent and he wishes to exploit this conviction to the utmost.

This is because a pure play commodity producer who has higher fixed costs of production will report higher profits than the low cost producer.

There you have it. A little known teaching from Graham for you to explore and exploit.

I just have a small caveat here. Prices of any commodity can be extremely volatile and unpredictable. But having an open mind to identify such opportunities can prove immensely beneficial.

Now, with returns of over 100% since its inception in February 2014, Microcap Millionaires has handily beaten the benchmark indices by following Grahams timeless principles.

The thing is Rahul Shah, managing editor at Microcap Millionaires uses multiple tools from Graham's arsenal to identify opportunities and is always on the lookout for the next profitable idea. Click here to know more.

03:10 Chart of the Day

Banking sector is considered the back bone of an economy. Indian PSU banks, however, have become a burden on the economy. As an article in The Hindu Business Line suggests, despite Centre's capital infusion worth Rs 850 bn, the market cap of PSU banks in comparison has been eroded by Rs 1,370 bn over last five years. Today's chart shows the loan growth and net income performance of the PSU banks that have received highest funds between FY14 to FY16.

Capital Infusion in PSU Banks: Is It Worth it?


So where is this money going?

Well, the answers are not very encouraging. The hard earned money of the tax payers in keeping these banks afloat has not helped these banks turn efficient. The only gainers at everyone's expense have been the unscrupulous corporates, to which their loan book remains highly exposed.

Be it credit growth, earnings, margins, quality of assets or provisioning parameters, the banks are slipping on all these parameters it seems. The losses for some of these banks have now been carried to reserves. The loan growth for these banks has lagged the increase in borrowings. Could it be possible that these banks are meeting depositors' obligations by borrowed money due to the default on loans?

While it would be convenient to blame all these issues on the state of the economy, the real issue is structural. After all, in the same economy, their private counterparts, without such help from the Government, have fared much better.

As we have been highlighting, the PSU banks have serious structural issues - be it their independence, accountability, or management. There aren't going to be easy solutions for this deep rooted crisis.

So should investors bet on these PSU banks? This is what Madhu, our public sector banks' analyst has to say:

Betting on profits of PSU banks over the next two to three years is as good as throwing darts. The RBI's mandate has definitely front loaded most of the provision pain for these banks. But that is not to assume that the banks have seen the end of it. Provisions will continue to hurt profits...and in some cases even the net worth of the banks. Hence, if at all, investors should bet on the banks that will be around even 5 to 10 years down the line. And value them conservatively. That's what we have been doing...

04:40

After opening the day on a positive note, the Indian indices have registered further gains and continue to trade in the green. Ahead of the Reserve Bank of India's bi-monthly monetary policy review scheduled tomorrow, sectoral indices are trading on a positive note with stocks from the automobiles, metal and realty sectors leading the gains.

The BSE Sensex is trading higher by 324 points (up 1.2%), while the NSE Nifty is trading higher by 107 points (up 1.2%) at the time of writing. The BSE Mid Cap index is trading up by 1.9% and BSE Small Cap index is trading up by 2.1%.

04:50 Today's Investing Mantra

"Should you find yourself in a chronically leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks." - Warren Buffett

This edition of The 5 Minute WrapUp is authored by Rohan Pinto (Research Analyst) and Richa Agarwal (Research Analyst).

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1 Responses to "Intelligent Speculation with Benjamin Graham"

DS

Oct 4, 2016

While I don't refute the logic behind the effects of operating leverage on profits. However, you yourself write "In fact, Mr Market also favours the low cost producers and assigns a premium to such companies." but then assign the same multiple to both the companies - this logic is flawed IMHO.

Like (2)
  
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