Why do second runners outperform the leaders in Bull markets ?

In one of the videos of Basant Maheswari sir (here), he pointed out that “Second runner stocks will outperform the market leaders till the Bull market is in full force, And if you want to buy them you should be smart enough to exactly know the exit point”

In this post, lets not only try look at those numbers, but also will try to find the reasoning of such behavior.

This can be explained by using any sector, but I have chosen to go with Commodity space because of the variety of complexities this sector brings with it conventional thinking doesn’t hold good here.

For example:

a) If you are thinking of applying conventional parameters like good management, efficiently run, healthy balance sheet, less debt and manageable interest burden
to value a commodity stock, you are in for big surprise.

b) These companies are subjected to commodity cycles. Moreover, the commodity companies have varying capital structure (we will look into it in a short while)

So let’s get started:

In a commodity bull market, when commodity prices start moving up the trend is reflected in the working results of the leaders. The leaders are well run companies having a healthy balance sheet and a reasonable market share. Due to their market position they command a good respect and are tracked by many brokerage houses and analysts. When the leaders start doing well. the laggards also attract the attention from the investors, as they are perceived to be able to deliver good results in the view of hardening commodity prices.

At this point of time, investors do not see if the company is good or bad, but will buy it and the reasoning they give is “Arey yaar pura sector upar chal raha hai. Why to pay high for leader ? Get the second runner for cheap”. One in-built attribute of commodity companies is the “Low cost producer with good management on its side will do good”.

Rising tide effect:

A rising tide lifts everybody. A six foot father with his three foot son in the water would go up with the tide. How ever, the son’s rise will be far more significant that the father’s,  because the starting point is half of his father. This is be also explained by Low base effect.

Low base effect:

It is much easy to improve margins from 5% to 10% (100% Jump) than from 20% to 40% (the same 100% Jump). This is called Low base effect. “This is where the laggards score over the leaders”.  Investors are thus more excited with the laggards as they seem to be performing better than the leaders. This makes the stock go up much better and faster resulting in good good results for the investors.

It will be more important to invest in the best, i.e the Market leader especially for commodity investing. This has many advantages in the form of Scale and Size, Less debt, pricing power and the ability to with stand the downturns. In bad times such companies are able to survive for long term and thus survive for longer periods of business cycles.

Okey. Enough of gyaan. Show me the numbers Krishna !!!

Yes, here it is.

For this purpose I would like to evaluate the profitability analysis with the ratio PBDT to Net Sales to examine the financial result of selected steel industries in India. This analysis give us result of profitability with reference to study period from 2003-08 to 2009-14. Generally PBDT / Net sales is used in comparing investment opportunities with in industry.

Firstly below graph depicts the PBDT / Net sales ratio from 2003 to 2008 (Previous Bull run).

PBDT 2003 to 2008

Few Observations from this graph:

a) During 2003 to 2008, Tata Steel and Jindal Steel had the highest PBDT / Net Sales ratio compared to all other companies.
b) Prakash Industries and Bhushan Steels under performed (in terms of profitability) compared to others.

Now what should normally happen ?

The companies with less profitability should give low returns and companies with High profitability should give High returns. Isn’t it ?

No, that’s not the case.

CAGR 2004 to 2008

What happened ?

a) Prakash Industries which is not so profitable on books during those period, given the maximum returns.
b) Followed by Jindal steel, Bhushan steel and others.

Strange right ? Not so fast. Lets see what happened when the tide turned against them.

PBDT 2009 to 2014

CAGR 2009 to 2014

The main thing to observe here is “Low Base effect” (as explained above) acted in favour of Prakash Industries and Bhushan steels during the bull run. Even though their profitability is less comparatively they delivered much high returns. But after 2009 every things went upside down (observe the Negative prices in above graph) and the factors that influenced the stock prices are:

a) Low cost producer.
b) Low debt companies.
c) De-rating of the companies.
d) Interest burden declines.
e) Lower Taxes
f) Capital structure of the companies etc.

2) Other very important factor that acts in favor of second runners during the bull markets is “Operating Leverage”.

Enough Krishna. Done for today, Thanks for your post and Good Bye.

Sorry to say, but without discussing Operating Leverage here, this post is not complete. I am sorry for extended post but pardon me.

What is Operating Leverage ?

Definition says, “A measurement of the degree to which a firm or project incurs a combination of fixed and variable costs”.

Watch this 2.5 minutes video from Investopedia.

How this will impact companies and makes a difference during good and bad times ?

Here is another simple example:

Example: Consider two companies, Company A (CMP: Rs 60/-)and Company B (CMP: Rs 10/-). They are actually into same sector and have same sales,  the same operating earnings, the same everything except that Company A has no debt and Company B has a debt at a 10 percent interest rate.  (All numbers are per share basis).

In first scenario, lets consider both the companies are growing.

Scenario 1

Now the PE of Company A is (assuming EPS is 6): 60 / 6 = 10 PE.
PE of company B is (assuming EPS of 3): 10 / 3 = 3.33 PE
Company A’s PAT is 100% greater than Company B. So which is CHEAP among A & B ?

Simple answer Company B is cheap right ?

Now look here, Assume the growth has been hampered and EBIT fell from 10 to 7 this year. Tax remains same.

Scenario 2

Company B has to pay the same interest of Rs 5/- even in low growth times, where as company A can simply hand over its profits to share holders.  Now Company A’s PAT is 350% greater than Company B (Initially it was just 100% greater than Company A). This explains that, Laggards will

Finally, for mediocre business all the factors like Low base effect, Operating Leverage, Cheap valuations, Carry forward of losses etc looks in their favor during good times. But we need to differentiate between good, bad and ugly businesses. “Because in Bull markets even Donkeys look and behave like Horses.”

Happy New year and have a Great year ahead. Happy Investing :)


Why Price to Book (P/BV) ratio is important in valuing banks ?

In our recent AIFW Investors meet happened in Bangalore on 14th Dec 2014, one friend asked me why do we look at PBV ratio for banks much before any other ratio ? Hence I thought of writing a post explaining the reason behind that valuation metric.

Yes, that’s true that Equity analyists while analysing bank stocks emphasize their valuation more on PBV (Price to Book value). Reason ?

Before answering it. Firstly, lets try to understand what is unique about Financial service firms ?

Financial service firms have much in common with non-financial service firms. They also try to be as profitable as they can, they also worry about competition and want to grow rapidly over time. They are also judged by the total return they make for their stockholders. But the main problem comes in this aspect.

Is DEBT a Raw material or Source of Capital for the banks ?

Debt-for-Canadians    images  imagesCA8EIPB7

Any company can raise the capital by using 2 ways, Debt (bond holders) and Equity (shareholders).
When we value the firm, we value the value of the assets owned by the firm, rather than just the value of its equity. But when coming to a Financial Firm, debt seems to considered as a different aspect. “Rather than view debt as a source of capital, most financial service firms seem to view it as a raw material.”

In other words, debt is to a bank what steel is to Tata Motors (a Raw material). Treat is as a raw material that something to be molded into other products which can then be sold at a higher price and yield a profit.

For example, should deposits made by customers into their checking accounts at a bank be treated as debt by that bank? Especially on interest-bearing checking accounts, there is little distinction between deposits and debt issued by the bank. If we do categorize this as debt, the operating income for a bank should be measured prior to interest paid, which would be problematic since interest expenses are usually the biggest single expense item for a bank.

Usually, P/BV figures for companies in the services industries like software and FMCG are high as
compared to those of companies in the sectors like auto, engineering, steel and banking. This is due to sectors such as software and FMCG have low amount of tangible assets (fixed assets etc.) on their books and therefore, the P/BV may not be a correct indicator of valuation.

On the other hand, capital intensive businesses such as auto and engineering require large balance sheets, i.e., they have a large amount of fixed assets and investments. P/BV is a good indicator of measuring value of stocks from such capital intensive sectors.

If a company is trading at a P/BV of less than 1, this indicates that the company is earning a poor return on its assets (ROA). NPA’s are the major concern for all the PSU banks becuase of the same reason, all these banks trade at PBV ratio less than 1.

The below image compares the PSU banks (high NPA’s) w.r.t to Private banks (Low NPA’s) and their relative PBV valuations.

What does P/BV fail to indicate?

P/BV indicates the inherent value of a company and is a measure of the price that investors are ready to pay for a ‘nil’ growth of the company. As such, since companies in the services sectors like software and FMCG have a high growth component attached to them, Price to Earnings ratio (P/E Ratio) would be a better method of gauging valuations.

The ratio has its shortcomings that investors need to recognise. However, it offers an easy-to-use tool for identifying clearly under or overvalued companies.


Unfolding the Multi-folds. How multibaggers happen ?

Please NOTE: This post is not to discuss”How to create Multibaggers ?”, but to understand how does it happen and how does it unfolds during that time.

Most of the investors who come to stock market have one thing in common. They dream to have a few multibaggers in his/her portfolio. Nothing wrong in that, but the problem comes if he doesn’t know how it works.

The curiosity to understand how few things teaches a lot. And that undying quality of the investor is his strength.

Now lets try to unfold how multi-folds happen.

Their are mainly two types of multibaggers that happen:

1) Steady compounding machines: These companies usually are sector leaders and are compounding machines (read my previous article here). They compound for decades together (due to their inbuilt Longevity nature) and create HUGE wealth for share holders.

Few Examples:

HDFC Bank: It had its IPO in March 1995 and till date it has multiplied 1000 times. If you have few hundred shares of HDFC Bank during its IPO, you will be sitting next to Sanjoy Bhattacharya and Raamdev Agrawal during the investors meets.

Asian Paints: This company came public in 1982 and have give around 2400 times till date (adjusted for splits & bonuses).

ITC: In 1988, the total market cap of the entire company is just 110 crores (meaning, with just 1.1 crore you can buy 1% of this debt free company). Now, the total market cap of the company is 2 Lacs 92 thousand crores (Just imagine about those 1% if you have own, now turned to 2920 crores excluding dividends).

The list never ends.

2) The Newbies, fast runners and turnarounds:

This is the interesting part of the story. Multibaggers that happen in this category create HUGE wealth within short period of time. And most investors look for this category only.


Hawkins Cookers: A CAGR of 84% in the last 5 years. If someone invested 1Lac in 2009, now he will be sitting a cashpile of about 21 Lacs.


TTK Prestige: Returned a CAGR of close to 90% from 2009. Here 1Lac might have turned into 35 Lacs.


Eicher Motors: CAGR of around 87% in the last 5 years and still running fast.


The list also includes few other gems like Page Industries, Astral Polytec, Titan Industries, Crisil, Mayur Uniquoters, Cera sanitaryware, Kajaria ceramics, La Opala etc.

So, what made these stocks to give those spectacular returns in such a short span of time ?

What is the difference between Category 1 and Category 2 ?

Before answering that, lets understand this:

Their are 2 factors by which the stock prices move upward/downwards, PE and EPS.

EPS gives the earnings of the company per share. In most of the cases these earnings are real (this may not apply for Infra companies, Real estate company, Companies whose management is a crook and some times even for 20th or 25th company is a sector which is in bubble. Example: Penta media soft, DSQ software during 2000)

Now PE is nothing but the sentiment of the investors community (this includes everyone, Trader, Speculator, Bull Operator, Bear Operator, Algorithmic trader, and a dull and boring investor like me).
Technically, PE means “How many rupees you are willing to pay for a single rupee of earnings”. This gives the PE.

For example, Asian paints PE is 54 (or put it in another words, Asian paints is trading at 54 times earnings). This means the investors community is willing to pay 54 rupees for every single rupee that he is going to get from Asian paints on yearly basis.

Below graph shows that how PE moved with respect to its Price for ITC and Shriram transport.



Images source: http://fundooprofessor.wordpress.com/

The unexpected interest of a company among the investors makes the PE to expand in short period of time. First of its kind company in a new sector enjoy this benefit.

1) Bharti Airtel: It was an emerging company in an emerging sector in 2003. Initially people didn’t understand the true potential of the company. Veterans like Raamdev Agrawal, Basant Maheswari had a vision to see the next 5 years of the company and made a killing out of it. During those days, Bharti Airtel used to trade at a single digit PE. In the next 5 years, PE expanded to around 80 times and made it a potential multibagger in just 5 years.

2) Page Industries traded at a PE of 22 in 2008 and it expanded upto 55 times in the span of 6 years and currently trading at around 55 times.

3) TTK Prestige PE expanded from 12 to 40 in 5 years.

Now what do we understand ?

Multibaggers of category 1 happen:

When their is longevity of Earnings. In other words, these companies continue to deliver for years together and their “Earnings” increase with very little movement in “PE” of those stocks. These companies usually take decade or two to multiply 50, 100 times with very less risk to the portfolio.

Asian Paints, HDFC bank, ITC, Nestle etc always traded at premium PE’s because of the trust on its Earnings. (Some exceptions are incidents like 2008 crisis where these companies are available at throw away PE’s)

Multibaggers of category 2 happens mainly because of PE Expansion:

It can happen some where or the other sector in every bull run:

IT in 1997-2000,
Infra in 2003-2007,
Consumer durables 2007-2013,
Semi-Urban and Rural housing (as expecting by many): Currently.

It can even happen on company basis (first time companies in that sector) on both bull and bear periods:

Airtel 2002-2007,
Pantaloons 2002-2008,
Eicher Motors 2009-Till date.

Krisha enough of Gyaan. Show me the NUMBERS !!!

Yes, even I too love numbers. Lets jump into it.

PE Expansion:

Initially, the stock remains unrecognized. Therefore the PE multiple is less then the growth rate. Usually here, even though the company is
growing, market does not believe the growth that the company is experiencing.

Let us assume that a company with a growth of 30% is given a multiple of 10 for an EPS of Rs 10. The market price is Rs 100.


After one year, earnings rise to 13 (10 + 30%). Investors started believing in the company and its earnings. As the stock gains recognition and more coverage it starts getting a higher multiple of say 30 times.
This makes the market price of the company to go to 13*30 = Rs 390/-


See, even though there is no absolute increase in the company’s earnings. Just because the investors have recognized the true potential of its earnings, its price moved up 4 times in just one year.

This is just half of the story !!!

PE Expansion will make you RICH and at the same time PE Contraction will cut off the neck unknowingly.

PE Contraction: 

The heights of Infosys stock price in 2000’s weren’t reached till 2006-2007. The peak of Bharti Airtel (574 in 2007) haven’t met till date and is currently trading at 392 (as of Nov 17th 2014).

Why & How ?

Lets take the same example:

Once the stock has been recognized and the market convinced about the growth rates the PE multiples move ahead of the growth rates.  For instance during the 2000 technology boom Infosys was valued at more than 100 times its earnings since the company was delivering a growth of 100% year after year.


Let us assume that in the example given above the company’s growth rates tapers off to a more realistic 15%.
These changes in growth rates do not happen year on year but still the market responds to this change earlier
then they are out in the public domain because of this the PE multiple of the company will contract


See what made the price to move from 100 to 390 in one year and the same price to move back to 160 in next year.

Many times, the company in category 2 moves to category 1. If it doesn’t then it will be part of a next coming bubble, be prepared.

If you understand this, then next time you can classify why a company price is increasing and on what basis ?

So, tomorrow morning you go to office and check you portfolio as part of your daily routine and see the price movements. If it is NOT an earnings season, make sure you keep a close eye on PE expansion and PE contraction of your stock.

Finally, “PE expansion is like a pinch hitter in the cricket XI it makes a quick fire 40 in 25 balls but expecting it to make another 40 in the next 25 balls is difficult.”




Motilal Oswal wealth creation reports

DuPoint Analysis – The True ROE

Few days back in our Facebook group AIFW, we had a nice discussion on importance of ROE and one of the big heads in banking and financial services Mr. Balakrishnan R Balakrishnan Sir of Moneylife shared his views on it (He blogs at http://goo.gl/pJmOC6).

Following is the screen shot.

FB Comment


Now lets try to dig deep and understand the True ROE via DuPoint Analysis.

(Continue reading…)

Starting the cult of Indian Equity !!!

How did it all started in India and reached beyond Dalal Street ??

In this post let’s try to see how Equities have evolved in India and reached retail investors.

Even though Stock exchanges were in place from more than 4 centuries (Amsterdam Stock Exchange being the old stock exchange founded in 1602),

(Continue reading…)

Equity Valuation using Dividend Discount Model. Example: Coal India & VST Industries !!!

As part of our learning in Equity Valuations, we understood how to value cyclical companies,  NBFC’s and Banks, using PE multiples and how to use Discounted Cash Flow method to find intrinsic value. Now let’s try to use Dividend Discount Model to value a company.

“A cow for her milk, a hen for her eggs, and a stock, by heck for her dividends.” – John Burr Williams, The Theory of Investment Value, 1938.

In the strictest sense, the only cash flow you receive from a firm when you buy a stock is the dividend. The simplest model for valuing equity is the dividend discount model. It is nothing but the value of a stock is the present value of expected dividends on it. While many analysts have turned away from the dividend discount model and viewed it as outdated and mostly use DCF, there are still many specific companies where the dividend discount model remains a useful took for estimating value. (Continue reading…)

How to value cyclical companies ?

Starting from this, I want to make a series of posts on different valuation techniques we use to value the companies like,

1) Young companies
2) Growth companies
3) Mature companies
4) Cyclical companies
5) Commodity based companies
6) Declying companies etc

In my previous post I have already discussed, how differently we value Financial firms.

In this post, I am going to discuss on how to value cyclical company by taking Maruthi Suzuki as example.

Uncertainty and volatility are endemic to valuation, but cyclical and commodity companies have volatility thrust upon them by external factors. As a consequence, even mature companies have volatile earnings and cash flows.

It is always a challenge to value companies that have volatile earnings. (Continue reading…)