Q&A: Cairn India Limited & Others

Modified on July 2, 2018

The current article in this series provides responses related to:

  • A new valuation perspective on Cairn India Limited by one of the readers, Nilesh Kumar.
  • How should one invest: Entire amount in one go or in a staggered manner
  • Importance of the sector of a company in stock analysis
  • Relevance of ROE & earnings yield as business metric parameters vs stock market return parameters.
  • Investor’s concerns about an unlisted company about to acquire a listed company
  • Having a view on stocks for a time bound investment horizon

 

Cairn India Limited

Hi Sir, I have done some work on Cairn India Limited. Please share your views.

Looking at the cash flows (CF) of company on an average in last 8 years, I find that Cairn India Limited has ₹4,649 cr cash flow. Cairn India Limited is debt free and holding cash of ₹16,363 cr.

How much loan can be given to Cairn India Limited?

If we assume that Cairn India Limited can pay one third of its cash flow i.e. ₹4,649/3 = ₹1,550 cr, as interest, then total loan amount would be ₹17,218 cr (9% pa). So ₹17,218 Cr is required to get one third of cash flow.

If I want to get entire CF then definitely that price would be higher than ₹17,218 Cr. So total worth of company should be at least ₹17,218 + ₹16,363 (cash amount) = ₹33,481 Cr. Total number of share is 187 Cr, so minimum price of a share should be ₹180.

Currently share is trading @₹225, which not much higher than our conservative valuation. Other financial ratio like P/E, BV etc. are also very attractive.

Currently Cairn India Limited is going through some problems like income tax notice and prices of crude have also affected its business. But I think in long run crude prices will go up. Hence, its business will improve.

Do you think that it’s an opportunity for value investing or trap?

Regards,

Nilesh Kumar

Author’s Response:

Hi Nilesh, thanks for writing to me!

I appreciate your perspective of analysis and a different approach to valuation. However, you would appreciate that market factors many other parameters while deciding about stock price of any company.

How to do Valuation Analysis of a Company

In case of Cairn India, its crude is not one of the best qualities. It has very high sulphur content and solidifies at room temperature. There are many challenges to transport it to refineries and only select refineries can process it.

Royalty of govt. is also another factor that is uncertain and involves frequent issues.

Above everything, the current management (Vedanta group) used cash reserves of cairn to give loans to its group companies at very low interest rates (Libor+3%), which amounts to about 3.5% (6 month Libor is 0.4% currently). This rate is very low compared to 9-10% which cairn could have got by keeping the money in bank FDs or liquid mutual funds. This amounts to loss of returns for cairn shareholders. Thus there are doubts on shareholder friendliness of current management.

And when management intent is under question, then an investor should stay away from the company.

Also Read: How to do Management Analysis of a Company

These factors among many others might be the reasons that its share price is trading at P/E of 4.37.

Regards,

Query

Can you enlighten me on how to go about buying such shares, which are hidden from major market players? Please also tell in what proportion of one’s capital, should these shares be bought.

I know it depends up on individual risk appetite. But suppose for an aggressive investor with capital (say about ₹500,000), how to do it? Also if one decides to allocate say 20% of capital so about (₹100,000), how much quantity one has to buy at one go in the first purchase?

Author’s Response: 

You have rightly pointed out that the investment pattern would depend upon the risk appetite of the investor.

There cannot be any fix rule, which may meet requirements of all the investors. I believe that an investor should invest only that much in markets so that she does not lose her night’s sleep.

However, fund manager Peter Molluck recommends that while investing in stock markets, an investor should invest her entire money in one shot. He has cited many studies in this aspect. You may read my review of his book “The 5 mistakes every investor makes and how to avoid them” here:

Book Review – The 5 Mistakes Every Investor Makes and How to Avoid Them

Hope it helps!

Query

I see you don’t mention anything based on sector related info when analyzing.

Author’s Response: 

Thanks for writing to me!

I follow a bottom-up fundamental analysis approach in which I look for high growing companies available at attractive stock prices. I agree with Peter Lynch that high growth companies in no growth industries are very good investments.

I believe that in bottom-up fundamental analysis, an investor should not worry about the industry in which a company operates. Instead, she should focus on identifying companies with sustainable distinct business advantage (Moat).

You may read about choosing stock picking approach here:

Step by Step Process of Finding Multibagger Stocks

Follow-up Query

I meant to say about the stock you are analyzing and not about the approach using which you picked particular stock. Like when one analyze a stock from banking sector then few different ratios will be needed to check. When analyzing stocks in realty/infra, then debt can be little high and one need to give little pass through in that case.

After reading your analysis, I got impression that you analyze using flat approach for all kind of stocks.

Thanks for the reply.

Author’s Response:

Thanks for your inputs.

I appreciate your observation that I use a framework for analysing business performance of different companies. The framework around few basic premises:

  1. Companies need to grow
  2. Maintain or improve profitability
  3. Operate efficiently
  4. Convert profits into free cash
  5. Use internal cash accruals to fund future growth.

How to analyse operating performance of companies

This premise remains the same for all businesses. Even though there can be a lot of other parameters to access business performance, I believe that if an investor tracks performance of any company over the years, on these five parameters, then she would be able to gauge the business performance of almost all the companies.

You are right in citing that companies in one industry would have different levels of ratios (say profitability or D/E ratio) than companies in other industries. An investor might give a little pass while comparing two companies of different sectors.

However, if you analyse business performance of any company over past, then the trend of change in its ratios when compared with previous years would indicate, whether company is showing improved business performance or not. E.g. an infra company might have higher debt than a pharma company. However, if the debt level is increasing year on year without associated increase in sales and net worth, then it would indicate poor business performance for both infra and pharma companies.

I do not track Banking sector companies, therefore, would not extend my views on that.

Hope it clarifies your query!

Query

Why Return on Equity (ROE) is not meaningful for Stock Market Investors!

Vijay,

  1. The purpose of ROE metric is not to measure the “stock market returns”. It’s rather a business return metric, which is completely different from earnings yield.
  2. ROE when decomposed has three components, Profitability, Asset Turnover and Leverage. You are right the Leverage component can be manipulated. But why would management do that?

Author’s Response: 

Thanks for your inputs!

You are right that ROE is more suitable as a business evaluation parameter.

I believe that solely chasing high ROE companies without looking at the price one pays for them, might not suit the investors. Warren Buffett has highlighted it time and again to his shareholders. He says this in latest (2014) letter:

“Of course, a business with terrific economics can be a bad investment if it is bought for too high a price.”

“This cheery prediction comes, however, with an important caution: If an investor’s entry point into Berkshire stock is unusually high – at a price, say, approaching double book value, which Berkshire shares have occasionally reached – it may well be many years before the investor can realize a profit. In other words, a sound investment can morph into a rash speculation if it is bought at an elevated price. Berkshire is not exempt from this truth.”

You may read more about my take on Warren Buffett’s latest letter at:

Warren Buffett’s 2014 Letter: A Complete Book for Investors. What to buy, How to Buy,When to Sell & lots more.

Management might have more than one reason to manipulate ROE. Keeping ESOPs “in the money” can be one of them.

Regards,

Query

Hi Vijay,

I am doing a detailed analysis of Gujarat Automotive Gears Limited (GAGL). Though the fundamentals and valuations were satisfactory for me, HIM Technoforge – an unlisted company is likely to acquire GAGL sooner. It seems this acquisition is a win-win situation for both companies in terms of business developments.

My concern is what will be the likely scenario if an unlisted company acquires a listed company? Will they continue in the exchange / de-list / original promoters will buyback before closing the deal?

Is it good to enter the company at this stage (If valuation permits) or wait till to see the developments without burning our fingers?

Thanks,

Author’s Response: 

Thanks for writing to me!

The news of HIM taking over GAGL has been doing rounds since 2013. I do not know whether any acquisition has yet happened or not. Anyway, I do not buy stocks based on the tentative acquisition scenario. If GAGL is a good company, I would invest. If it’s not, then I would not invest.

Unlisted entity, if takes over listed entity, then would acquire certain shares of promoters/controlling shareholder. Shares of listed entity would keep trading. Substantial acquisition may trigger mandatory open offer. The company may subsequently decide to delist or remain listed. There is no set path, which companies follow.

If your analysis indicates that GAGL in itself is a good business, then you may think about investing it.

Analysis: Gujarat Automotive Gears Limited

Regards,

Query

Hi Vijay, Thanks for the report. I have two questions

  1. How are you calculating “Total increase in m-cap in 10 yrs.” Amtek m-cap on 2005 is ₹287 and on 2014 it’s ₹3,127. Shouldn’t it be ₹3,127-₹287=₹2,840?
  2. I understand you are using the custom excel feature of screener.com I am in the mid of creating it. But I wonder how you derive “Receivable Days” from the data sheet. Can you give me that formula?

Author’s Response:

Thanks for writing to me!

1) Market cap of 2005 (₹287 cr.) has been compared with the market cap of the date on which I did the analysis (March 24, 2015: ₹44.55/- per share & market cap of ₹1,238 cr) Hence the increase of ₹951 cr. (1238-287)

2) Receivables days: 365/ (sales/average of debtors at start and end of year)

You may find the description of receivables days calculation in the following article:

How to analyse operating performance of companies

Hope it clarifies your queries!

Query

Hi Vijay, I am very impressed with your support for small investors.

I came across with Kanoria Chemicals and Industries Limited. Its debt has reduced and promoters’ stake has increased recently. Last 3 yrs.’ ROE is around 31%. Book price is greater than current market price.

But they are venturing into various new verticals, which are not related each other. So please share your thoughts in this for 3-5 yrs.’ prospective.

Thank You.

Author’s Response: 

If you are convinced with the business performance, then you should buy the stocks of the company. Restricting the time horizon to 3 or 5 years might not be helpful, as stock markets are known to test the patience of investors and keep ignoring the companies despite good business performance.

I find myself unable to provide any views with a time bound perspective. You already seem to have found out the key strengths of the company. I believe that you should now take the decision based on your analysis.

Regards,

P.S.

 

DISCLAIMER

  • The above discussion is only for educational purpose to help the readers improve their stock analysis skills. It is not a buy/sell/hold recommendation for the discussed stocks.
  • I am registered with SEBI as an Investment Adviser under SEBI (Investment Advisers) Regulations, 2013.
  • Currently, I do not own stocks of the companies mentioned above in my portfolio.

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