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Learning To Look Down Before Looking Up

Conservative investment requires primary focus on downside risk, not upside potential While evaluating any investment opportunity, conservative investors always look down before they look up. They ask, "what can go wrong with this investment?" before they ask "what can go right?" Aggressive players, on the other hand, always look up before they look down, and sometimes they don't look down at all. At times, such aggressive players produce far better returns than conservative investors. This was, for example, the case in 1993-94 when a large number of individual as well as institutional players, made fortunes in The Great Indian Primary Market Boom. These fortunes were made by those who were only looking up, never looking down. Conservative investors, who did take the pains of looking down before looking up, kept well away from the primary market. Consequently, they did not make the fortunes that others made. What's more important, however, is that such conservative investors also did not suffer from the horrendous losses subsequently produced by aggressive players as a result of The Great Indian Primary Market Bust. Fortunes made were not kept. Therefore, even though there will be times when aggressive players will do far better than conservative investors, in the long-run it is the conservative investors who will make and keep their fortunes. The Speculative Attractiveness of Financial Weakness Think of a company which produced operating earnings (after depreciation but before interest and taxes) of Rs 10 crores last year. If the annual interest was Rs 9 crores, the pre-tax profits would come to only Rs 1 crore. Assuming a tax provision of Rs 40 lakhs, being 40% of pre-tax profits, the company earned a post-tax profit of Rs 60 lakhs for its shareholders. If the total number of shares outstanding was, say, 10,00,000, then the earnings per share would come to Rs 6. That such a company has a very weak financial position can be seen from the fact that it's creditors took away 90% of its operating profits, leaving only 10% for the government and the shareholders. Such a company, however, will see it's earnings for shareholders surge if things improved even marginally. For example, assume that next year operating earnings are expected to rise by 20%, that is, from Rs 10 crores to Rs 12 crores. After deducting the annual interest of Rs 9 crores, the pre-tax profits would rise by 200% to Rs 3 crore. Assuming a tax provision of Rs 1.20 crores, being 40% of pre-tax profits, the company's post-tax profit would also treble Rs 1.80 crores. Earnings per share will also treble to Rs 18. The above example demonstrates how a 20% rise in operating earnings translates into a 200% rise in earnings per share. It is for this reason that aggressive players are attracted to such companies. For, if their expectations about the 20% rise in operating profits were to materialise, then they would hope to treble their money in a short period of time. Note, however, that the aggressive players who buy stocks of such companies are only looking up, and not looking down. Before thinking of investing in such a company, however, conservative investors would first think about the downside risk instead of the upside potential. Assume that instead of operating earnings rising by 20%, they fell by 20%, that is, from Rs 10 crores to Rs 8 crores. After deducting the annual interest of Rs 9 crores, the company would end up with a pre-tax loss of Rs 1 crore. Assuming a nil provision for taxation, the post-tax losses would also amount to Rs 1 crore and the earnings per share would be negative Rs 10. A 20% decline in operating profits will result in large net losses for the shareholders of this
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company. As explained in the earlier example about the Indian primary market, fortunes can be made by buying stocks of such companies if things go the right way, but in the long run, such fortunes can rarely be kept. Indeed, this is exactly what has happened in the last one year or so. The tight-money conditions which prevailed in the Indian economy during 1996-97, have played havoc on the earnings picture of companies with weak financial foundations. Those who invested in such companies have not only not made the fortunes they had dreamt about, they have also suffered from a permanent loss of their capital. The Investment Attractiveness of Financial Strength Leaving the question of price aside, an equity investment in a company with a strong financial position is far less risky than in one with a weak balance sheet. A strong balance sheet gives the investor a margin of safety. Even if the business is deteriorating, as long as it's not doing too badly, it allows it to fight another day. Put simply, companies which have ample financial strength can withstand long periods of adversity without going bust. They possess the staying power which is fundamentally essential for conservative investment. The absence of this staying power is the primary reason for corporate distress and eventual bankruptcy. Just take a look at many "walking dead" Indian companies such as NEPC Micon, Modiluft and Montari Industries, and you will know what I mean. How does one go about defining what a strong balance sheet is? What exactly is meant by "financial strength?" The answers to these questions are not as simple as it might first seem. For example, a company which has no debt on its balance sheet is generally considered to be a financially strong company. While, this is usually true, there can be situations when this is not true. Similarly, the presence of a large amount of cash on the balance sheet is not necessarily an indication of financial strength. A company may have no cash and yet possess the characteristics of what constitutes a strong financial position. Defining Financial Strength Martin Whitman, a highly successful American mutual fund manager, taught me the true meaning of "financial strength." Whitman is an ultra-conservative investor who restricts his funds' equity investments to those companies which, in his opinion, have ample financial strength. However, his meaning of "financial strength" is different from its conventional definition. According to him: "A strong financial position is something that is measured not so much by the presence of assets as by the absence of significant encumbrances." Understanding Encumbrances The important point to note here is that these encumbrances (1) may be disclosed on the face of the balance sheet; (2) may be disclosed "off-balance-sheet" in the notes to accounts; or (3) they may not be disclosed at all in any part of the financial statements of the business being examined. Debt, the most common of all encumbrances usually appears on the face of the borrowing company's balance sheet. Often, however, there may be encumbrances which are disclosed as part of notes to accounts instead of being disclosed on the face of the balance sheet. For example, a company may be not be acknowledging a claim made by a third party on it, as a debt. This claim will usually appear as a "contingent liability" in the notes to accounts of the company. The presence of large contingent liabilities relative to the financial resources of the company as stated on the face of its balance sheet, should, in the ordinary case, be a cause for worry for the potential buyer of its equity shares.
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The most important thing to know about encumbrances, however, is that they can exist even though they appear nowhere in the financial statements of the company. Three examples will explain: The first example is that of an airline which, by law, may be obligated to operate on unprofitable routes at its own cost. Similarly, Indian sugar companies are obligated to sell their produce at prices set by the government. These onerous obligations are nothing but encumbrances, which appear nowhere in financial statements of such companies. If the present value of these encumbrances were put down as liabilities on the balance sheets of these companies, their "real" book values would turn out to be a lot less than their stated book values. In other words, just because these encumbrances do not appear on the financial statements, it does not mean they do not exist. The second example is that of obligations imposed by law on certain companies which require them to spend money in a manner which may benefit society as a whole but does not benefit their shareholders directly. Recently, thanks to the efforts one award winning environmentalist, many Indian businesses have been asked by the Indian courts to either spend money on installing pollution control equipment (an expenditure which does not result in increased revenue) or to relocate their manufacturing facilities to different locations. Many European chemical companies are moving their production facilities to Asia because they find the cost of complying with the new European rules of environment-friendly manufacturing too high. The third example of encumbrances which exist but do not appear anywhere in the financial statements applies to a large number of companies in India. Many companies may have current balance sheets which display a strong financial position only because they fail to make needed expenditures to modernise, expand or replace outdated equipment. This necessary expenditure will eventually have to be met if the business has to remain competitive enough to survive. Therefore, in such cases, a strong current financial position is deceptive because the strong balance sheet will tend to be dissipated in future years as the business suffers large operating losses, embarks on massive capital-expenditure programs, or both. This is particularly true of companies in (1) capital-intensive businesses whose plants are approaching the end of their useful lives; and (2) technology-intensive businesses which suffer from a high degree of obsolescence. The Quality Of Assets For a conservative investor, in order to determine the true financial strength of a company, the quality of its assets is more important than its quantity. This quality is determined by reference to three separate, but related, factors. First, an asset or mix of assets has high-quality elements if it is owned free and clear of encumbrances. Conversely the assets of debt-ridden companies tend to be of low quality. The second factor to consider in evaluating the quality of assets of a going concern is its operations. Does it have a mix of assets and liabilities that appears likely to produce high levels of operating earnings and cash flows? Good operations are the most important creator of high-quality assets and are likely to contribute to a company's having a strong financial position. The third factor the investor must consider is the nature of the assets themselves. An asset tends to have high quality when it has any or all of these characteristics (1) it's value can be accurately estimated; (2) it can be separated from other assets without undue expense and without adversely affecting the remaining operations of the business. For example, a company which owns a significant amount of highly liquid assets such as shares and other marketable securities whose value can be estimated simply by taking their current market value are highfile:///Volumes/Data/sanjaybakshi/Dropbox/Personal%20Site/SB's%20SArticles_&_Talks_files/Learning_To_Look_Down_Before_Looking_Up.HTM Page 3 of 4

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marketable securities whose value can be estimated simply by taking their current market value are highquality assets from the viewpoint of conservative investment. At times of need, such securities can easily be (1) sold; and/or (2) used as a collateral for raising loan funds. The presence of such assets in large quantities, together with the absence of any material amount of encumbrances, virtually guarantees that the owner will not suffer from any financial distress. Other financially strong companies could be ones which own illiquid assets which are worth a lot more to a third party than to its own shareholders. For example, a conglomerate with low debt levels but poor profitability may still be considered financially strong. This will happen, for example, if it owns a business division which (1) is worth several times its book value to a potential buyer; and (2) can be separated from its other businesses without hurting them. A Final Example Two weeks ago, in this column, I wrote about a company whose financial strength is, in my opinion, extraordinary. This company is Sundram-Clayton Limited (SCL). SCL does not have any significant amount of encumbrances using the Whitman definition of the term. At the same time, SCL owns a highly liquid and valuable asset in the form of 75,00,000 equity shares of TVS Suzuki Limited. This asset has a current market value of around Rs 375 crores. SCL's total debt in its last published balance sheet was only around Rs 20 crores. The presence of this highly valuable, liquid and separable asset, together with the absence of any material amount of encumbrances makes SCL as strong as an impregnable fortress. To see how, imagine a situation where the automobile ancillary industry in which SCL operates is suddenly faced with prolonged and extremely depressed demand conditions. As a result, all the industry players including SCL will have to cut back on their production, cut their product prices and face increased costs, all at the same time. Under these circumstances, the companies, including SCL, will quickly run out of cash. What will happen next? The weak players, those with large encumbrances will be forced to shut down. SCL, on the other hand, would stand tall amidst the disaster facing its industry. The reason for that is simple: SCL possesses the staying power to withstand almost any type of adversity. It could raise cash easily simply by either (1) selling some of its TVS Suzuki shares for cash; and/or (2) raising a loan by using the TVS Suzuki shares as collateral. That cash could then be utilised to grab market share from the weaker industry players who simply do not have the ammunition to fight SCL. In fact, the more severe and prolonged the disastrous industry conditions, the more SCL would benefit. Conclusion In looking at any investment opportunity, the single most important question that a conservative investor asks is, "What have I got to lose?" Only when he is confident that investment risks can be controlled or minimised does the second question come up: "How much can I make?" Conservative investors who have learned to ask the above questions in the correct order are the ones who are likely to make and keep their fortunes. As Warren Buffett once put it: "To finish first, you have to first finish." Note This article is submitted by Sanjay Bakshi who is the Chief Executive Officer of a New Delhi based company called Corporate Investment Research Private Limited. Sanjay Bakshi. 1997.
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