December 17, 2017

Interpreting Low NFAT and Negative Working Capital Companies, Why Companies may remain Debt-Free despite Low SSGR, Are Buying & Holding Criteria Different (Q&A)

www.drvijaymalik.com has a section dedicated to answering queries of readers: “Ask Your Queries”. Over time, many readers have asked their queries related to many aspects of stock analysis and sought clarifications about investing. I have responded to these queries as replies to their comments.

“Q&A” series is an attempt to share the queries & their responses, which have featured on “Ask Your Queries” section, with all the readers. The primary aim of this new feature is to share the knowledge with other readers of the website, who might have similar queries.

The current article in this series provides responses related to:
  • Why should investors be cautious while investing in companies with low net fixed asset turnover (NFAT)?
  • How to interpret companies with negative working capital?
  • Why would a company with SSGR less than sales growth be debt free?
  • Is increase in the market cap being less than retained earnings a red flag?
  • How to calculate operating profit?
  • Are buying and holding criteria different?
Be cautious with low net fixed asset turnover (NFAT), interpret companies with negative working capital, SSGR less than sales growth, increase in the market cap less than retained earnings, calculate operating profit calculation, buying and holding criteria


Why should investors be cautious while investing in companies with low net fixed asset turnover (NFAT)?



Hi Vijay,

I get your point about asset turnover ratio being less than 1. But what about the fact that the assets which Deep Industries is creating, especially in gas dehydration, have a life of 20 years. 

So, even though they may earn only 0.4 rs on every INR spent on capex, all of their Capex gets paid after 2 odd contracts and remember, 90% of their contracts are recurring. So, after all, capex is paid off, asset turnover ratio is not what you see it as right now.

What would you comment about that?

Author’s Response:

Hi,

Thanks for writing to us!

Net fixed asset turnover indicates the capital intensiveness of any business with a low NFAT indicating that for business growth, significant new money needs to be invested in the company.


Let's suppose the company purchases one unit of revenue generating asset e.g. a manufacturing plant or a rig or any other such asset for Rs. 100 cr. which as per NFAT of 0.4 gives revenue of Rs. 40 cr.

If the company plans to keep only this one unit with itself, then it may keep on generating revenue of Rs. 40 cr. for the life of the asset (say 20 years). However, to increase revenue it would have to purchase another revenue generating asset, which would entail an expenditure of Rs. 100 cr.

If an investor is ok with the company not doing new capex and limit itself to one revenue generating unit purchased in the past, then she may remain content that the company is generating Rs. 40 cr. every year without doing any more capex.

An investor may also need to keep in mind that an asset of Rs. 100 cr. may need anywhere between Rs. 5-10 cr. for maintenance every year. If the company is not able to generate this money in the profits from the Rs. 40 cr. being earned each year (requiring a profit margin of about 12.5% to 25%), then the said asset may not remain in useful condition for its entire life of 20 years and may become dysfunctional sooner.

The key essence is that low NFAT businesses are quite capital intensive and keep on guzzling cash on a continuous basis.

All the best for your investing journey!

Regards,

Dr. Vijay Malik

How to interpret companies with negative working capital?


Hi Dr. Vijay

1. Negative working capital is usually considered not favourable as the current liabilities being higher than current assets is not a good sign.

But, at times, we have also read that negative working capital is good too. For example, if the cash conversion cycle is negative then your inflow of funds are more and faster than the outflow of funds and hence may result in the negative working capital. Is my understanding correct?

How to analyse negative working capital and find which situations are good and which situations are bad?

2. When the overall markets are richly valued or frothy, and if you find good companies at fair or undervaluation, then from where do you draw the conviction to invest in them? Because I often get confused and wait for the overall market to also correct along with these companies so that I can invest at much lower valuation :)

Is this approach correct?

Author’s Response:

Hi,

Thanks for writing to us.

1) If the negative working capital is on account of liquidity crunch and not on account of higher bargaining power over vendors/suppliers, then there would be other signs of financial stress in the company like burgeoning debt, delay in project execution, debt servicing requirements being more than CFO etc.


2) The conviction to invest is usually drawn from the process of stock analysis and selection. You may read more about our stock selection process and the steps to arrive at the price to pay for any stock in the following article:


If any stock is able to score successfully on all our parameters including the valuation, then we invest in it regardless of the market/Nifty/Sensex valuations.

We are able to elaborate/clarify the approach that we follow. We do not have any opinion on the approach being followed by other investors including your approach.

Hope it answers your queries.

All the best for your investing journey!

Regards

Dr. Vijay Malik

Why would a company with SSGR less than sales growth be debt free?

And

Is increase in the market cap being less than retained earnings a red flag?


Dear Dr.

1. Suppose SSGR is less than sales growth, then the company has to increase the debt every year to compensate it. Despite increasing the debt if the D/E ratio remains under control, can we further think about it?

2. You have told that increase in market cap should be more than the retained earnings for 10-year data. Suppose any stock became undervalued due to any reason, its increase in MCap may go down than the retained earnings. What should we do in this case?
Please guide.

Author’s Response:

Hi,

Thanks for writing to us!

1) The debt may remain under control even in some of the cases where SSGR is less than sales growth in case the company is able to free up the cash, which was otherwise stuck in the working capital earlier. You may see the cases in the following article:


2) Currently, we do not keep the parameter of cumulative retained earnings for 10 years being more than the increase in market cap over 10 years as filtering criteria. If all the other parameters are excellent, then it may be a sign of undervalued opportunity.

All the best for your investing journey!

Regards

Dr. Vijay Malik

How to calculate operating profit?



Hats off to you for the analysis and also giving your work to the public. Makes a learner’s life so much better.

Sir, I would like to know how you calculated the operating profit for the latest financial year (March 2017). The revenue for NOCIL was 742 crores. (From operations, excluding other income). Expenses are around 600 crores. Profit before tax is 150 crores.

Operating profit (EBIT): I added back the finance cost of 2.22 crores so I got the operating profit of 153 crores. But your worksheet shows an EBIT of 159 crores. So I would like to know where I am going wrong. What other expenses are u excluding?

Thanks in advance.

Author’s Response:

Hi,

Thanks for writing to us! We are happy that you found the article useful.

We calculate the operating profit from the data provided by Screener by factoring in the following expenses from the sales income/operating revenue:
  • Raw Material Cost
  • Change in Inventory
  • Power and Fuel
  • Other Mfr. Exp
  • Employee Cost
  • Selling and admin
  • Other Expenses

To reconcile these items in the screener export to excel data sheet with the annual report, we request you to refer to the following article:


Reference to this article and using the Screener data will help you.

All the best for your investing journey!

Regards

Dr. Vijay Malik

Are buying and holding criteria different?


Dear Dr.

You have told that we should invest in low PE ratio good business to get the benefit of earnings and PE expansion and keep holding the stock until the business get worse.
My doubt is:
  1. Can we invest in the stocks which are in early phase of PE expansion, means whose PE ratio is ~15?
  2. Why we focus on margin of safety only while investing, why not during the holding period?
Please clarify.

Author’s Response:

Hi,

Thanks for writing to us!

1) We should decide about investing in any stock after assessing it from all the perspectives like financial, business, management and valuation. Only looking at valuation would be taking a myopic view.

In case, an investor is satisfied with all the fundamental aspects of any company and is ok with paying the price at which it is available in the market, then she may choose to invest her money.

2) We keep the buying and holding criteria different. Once we buy a stock in our portfolio, then we usually hold it until the fundamentals are intact and in fact, add more until the price is in our buying range.

All the best for your investing journey!

Regards

Dr. Vijay Malik

P.S:
  • To know about the stocks in my portfolio, their relative composition, cost price, details of all our buy/sell transactions since August 1, 2017 as well as to get updates about any future buy/sell transaction in my portfolio, you may subscribe to the premium service: Follow My Portfolio with Latest Buy/Sell Transactions Updates (Premium Service)
  • To learn our stock investing approach “Peaceful Investing” in detail at any time & place of your convenience, you may subscribe to “Peaceful Investing” Workshop-on-Demand, which allows subscribers to watch the recorded videos (9h:30m) of a complete full-day “Peaceful Investing” workshop. You can watch the FREE Sample Video (16min) of the workshop where we have discussed the basics of balance sheet along with fund flow analysis and read about other details of this premium service at the following page: “Peaceful Investing” Workshop-on-Demand
  • The excel template that we use in our stock analysis is now, compatible with screener.in. This customized Excel template is now available for download as a premium feature. For further details and download: Click Here
  • You may learn more about our stock analysis approach in the e-book: “Peaceful Investing – A Simple Guide to Hassle-free Stock Investing”
  • You may read more company analyses based on our stock investing approach in the Company Analysis e-book series, which is spread across multiple volumes: Click Here
  • To pre-register/express interest for a “Peaceful Investing” workshop in your city: Click here
  • Subscribe for email updates at our website to get the FREE e-book: "Case Studies: Applying Peaceful Investing Approach"


DISCLAIMER


Registration Status with SEBI:

I am registered with SEBI as an Investment Adviser under SEBI (Investment Advisers) Regulations, 2013

Details of Financial Interest in the Subject Company:

Currently, I do not own stocks of any of the companies discussed above