Its time for the yearly stock recommendation. But before doing that lets look back and see how last two year’s stock picks have performed.

In Nov, 2007, TTK healthcare Limited (http://www.capitalideasonline.com/articles/index.php?id=2397 ) was recommended and over the last two years it has outperformed the broader market movement by a wide margin. The current price of 220 Rs is almost 3.67 times of the recommended price and during last two years, the investor has also received a tax free div of 6 Rs/share. As per the expectation, the company disposed the non-core activities and concentrated in its strong brands…It has also done a share-buy back (as expected). Going forward, the stock is expected to perform reasonably well.

In Nov,2008, Balmer lawrie investment Limited (http://www.capitalideasonline.com/articles/index.php?id=2830) was recommended at Rs 60 and over the last one year, it has appreciated by 2.25 times. The return is exclusive of a tax free dividend of 6.40 Rs per share. As mentioned earlier, Balmer Lawrie Investment Limited(BLIL) does nothing but to hold the shares of Balmer lawrie(BL). It holds 61.80% equity of Balmer Lawrie. In a nutshell, every equity share of BLIL represents 0.45 share of BL. Given the current mkt price of BL , BLIL is still traded quite cheaply, even after considering the holding company discount factor. Balmer Lawrie’s current performance is quite robust and it is expected to do well in the coming years. Balmer Lawrie has become totally debt free and it is expected that dividend will increase significantly going forward. The best way to look at BLIL shares is to think of it as a high yielding bond (dividends) that can appreciate (divestment of BLCo shares).

While going through the past recommendations, it is important to revisit the investment rationales that I believe and it is particularly important when indices are moving ahead and small investors are once again flocking to the market.

The investment philosophy will revolve around owning a part of business rather than following the quotation and trade in short term. We will strictly follow the sage word of Mr Warren Buffet in this regard “quotations are the quotidian diet of the day trader, forging a casino culture where quickness of action fed by irrational impulses displaces quality of thought”. To make this concept simple, let’s take an example. A company into the business of FMCG is having10 cr paid up capital (consisting of 1 cr of equity shares with 10 Rs as face value) and we buy 10,000 shares. We should think that we own 0.1% of this FMCG business. This thinking will ensure that we will stay with this investment for long term and will not be impacted by short term (quarterly) gyrations in earning. As Mr. Buffet once pointed out …. “In fact, we purchased several companies whose earnings will almost certainly decline this year from peaks they reached in 1999 or 2000. The declines make no difference to us, given that we expect all our businesses to now & then have ups and downs (only in the sales presentations of investment banks do earnings move forever upward)”.

The principle objective will be to buy a share of an easily understandable business with a significant “margin-of-safety”. Our principal objective will be to not to lose the money. As Will Rogers once said –“I am more concerned about the return of my money rather than return on my money”

We will follow the following investment rationales:

• Invest in a easily understandable business
• We will take the investment decision on the basis of BS and not on the basis of P&L nos. In order to elaborate it further …. in most of the investment advises, focus is on profitability, margin, EBITDA, EPS and P/E ratio. Very few investments advice covers the analysis of balance sheet and cash flow. Return on capital employed (ROCE) and return on net worth/equity (RONW/ROE) are the only two ratios, which an investor should look into as these separate men from the boys. We are not undermining EBITDA / net profit but these should be seen in light of cash flow from the operation and capex figure. A business, which is not generating enough cash flow from the operation, should be avoided in spite of the fact that the business has reported substantial increase in the EBITDA and net profit. In this case the cash flow is blocked in debtors and inventories or may be reduction in the credit available from the creditors. This has happened as the company has dumped its products to the dealers/distributors with a promise of extended credit. This is a worrying sign as the company is facing intense competition but they can not get enough credit from the suppliers (I.e., credit from the suppliers gets reduced). Another scenario would be that a company is generating cash flow from its operation but the entire amount is being spent on capital expenditure (capex). These types of companies are also to be avoided, as there would be nothing left for the shareholders. Some exceptions may be there for some companies, which may be at the starting stage of their business and need capex. One should only invest in a company, which generates good amounts of cash from its operation, and has minimal working capital and negligible capex requirement.  In many research reports and management discussions, we have observed emphasis on EBITDA. While it is true that EBITDA is a good reflector of business health, we miss out three very important things. One is depreciation, the second is capex and the third is blockage in working capital. Though depreciation is found out in the profit and loss account of the companies, for capital expenditure & blockage in working capital, one has to refer to cash-flow. Many people think that depreciation is a “non-cash expense”, while there is no doubt of its correctness prima facie but one needs to dig little further to understand the importance of depreciation. In this respect, I think this is apt & appropriate to what Warren Buffet has said: “depreciation is a particularly unattractive expense because the cash outlay it represents is paid up-front, before the asset acquired has delivered any benefits to the business. Imagine, if you will, that at the beginning of this year a company paid all its employees for the next ten years of their service (in the way they would lay out cash for a fixed asset to be useful for ten years). In the following nine years, compensation would be a “non-cash” expense – a reduction of a prepaid compensation asset establishes this year. Would anyone care to argue that the recording of the expense in years two through ten would be simply a bookkeeping formality? “. A Company with increasing trend in EBITDA may not be a good investment if its capex and blockage in working capital takes away almost all of its EBITDA. One should be comfortable with the companies, which are having negligible capital expenditure requirement and minimal working capital blockage.
• We will strive for continuous reasonable compounded return on corpus
• A company having zero debt or marginal debt is always a good investment bet as it will be able to withstand competitive pressure on its business up to a certain point. Debt is not bad either. For a utility company like power and water supply, where cash flow is steady, debt often boosts earning for the shareholders. But from a safe investment point of view, companies with zero or marginal debts are preferred due to its inherent strength in withstanding competitive pressures. Another reason could be that if the company decided to expand in order to tap the growing demand, it may access cheaper finance due to its “zero/marginal debt” status and the shareholders would be benefited in the long run (subject to successful expansion). To elaborate further, like alcohol, debt can make the good times better and the bad times worse. By this, money managers mean that debt is a relatively cheap form of finance that helps companies really gear up return on equity - as long as things go well. Debt financing is good for shareholders because it does not dilute earnings the way issuing new stock does. If used well, debt boosts earnings, and at the same time it allows companies to avoid increasing the number of shares among which profits must be split. Debt, in other words, makes the good times better. On the downside, when things go poorly, a company with a lot of debt might have trouble meeting interest payments and go bankrupt. Debt makes the bad times worse. This is a problem that equity financing does not cause. Too much debt can put another constraint on a stock price. Once a firm has borrowed a lot, investors know there is no more room to use leverage to boost growth. This reduces the valuation investors are willing to assign the shares. The cut-off point varies by industry, but when debt starts to exceed equity, investors begin to get nervous. Companies whose debt is only a small fraction of their capital still have a lot of room left to use debt to fuel growth.
• “Cash in the balance sheet” is often an easy and safe investment criteria. For example, suppose a company having zero debt is quoting at 15 Rs and has cash @ 5 Rs/share in the balance sheet. Then investor’s risk is up to an extent of 10 Rs/share as each share is carrying 5 Rs cash and the balance business is available at 10 Rs /share. When the gap between market price of the share and cash/share in the balance-sheet gets narrowed down it becomes an exciting and safe investment opportunity. A Company may have cash in the balance-sheet due to just completion of a successful IPO or may be due to disposal of non-core activity and these companies should be seen as an exception. There are companies, which have significant “cash-hoard” in the balance sheet but do not distribute the same among the shareholders ( in the form of buy-back/dividend), although they do not have any plan for diversification / capex – these companies should be seen with suspect as “shareholders interest” comes last in their wish-list.
• We will pursue “bottom-up” approach in stock selection with very little importance on the economic indicators. As we will be mostly pursuing long term/medium term investment strategies, too much focus on the economic indicators will result in short term decision making. A good business will certainly do well in the longer term. There will be winners in a bear market as there will be losers in a bull market. Our sole objective will be to buy a piece of easily understandable business at a significant amount of margin of safety.
• We will look for companies with regular dividend record and stock buy back track records. These will ensure that excess cash is being returned to the shareholders. Buy-back has another advantage in the sense that an investor will hold a larger share of the business (assuming that he/she is not tendering its stock in the buy-back). Companies with a declared dividend policy should be a good bet.
• We will look for companies with good franchise. Colgate, P&G and Rayban {which got delisted last year} are examples of businesses with strong franchise. With virtue of its strong franchise mode, these are more or less insured against any downturn in the business. Let’s consider Colgate. Its low capital intensity (ROCE of 100% plus), 60 day negative working capital cycle and ad spend of near 20% of sales has won market share of 50% plus. Hence the 27% per annum return to shareholders which the company has generated over the past thirty years. With only 7% of the Indian population brushing their teeth more than once per day (some 500 million don't at all) sales could be a multiple of the current USD350 million. Is 21x expensive? It certainly never has been in the past.  These are the businesses with a durable competitive advantage – we will call this as “moat”. As Warren buffet has said “the key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products and services that have wide, sustainable moats around them are the ones that deliver rewards to investors”

On the basis of the above parameters (may not be all), I feel Panasonic Carbon India Limited (BSE code: 508941) is a great value buy. It’s into manufacturing of carbon rods which are used in dry cell battery. The business is easy to understand and this company is a consistent performer.

Panasonic Carbon India Limited (PCIL) is not a growth story but it is a consistent generator of free cash flow. I prefer this type of companies. In last five years sales has moved from Rs 25 crore to Rs 37 crore. Net profit has moved from Rs 5 crore to Rs 6 crore on an equity base of Rs 4.8 crore.

The important aspect of this company is that it does not require any capital. It yields 5% at the current price of Rs 140.

Now let’s have a look at its balance sheet. It is “Size Zero” and does not have any excess flab. It works on negative working capital which is really commendable, given the nature of business. As on 31.3.09, it was having 46.5 crore cash, i.e. approx 97 Rs cash/share. Fixed assets are almost depreciated with almost no addition in capex in the last three years. PCIL does not have any long term loan and working capital loans. The present production capacity will take care of any incremental growth (upto 20% from the present level) in offtake in output.

As a result of the above, the company will continue to generate free cash flow and “cash in the balance sheet” will increase.

There are a couple of negatives about PCIL:

• Japanese Management -> Though there are a couple of advantages with Japanese management as they are generally extremely conservative, they are not very liberal in sharing the wealth.
• Product -> The product is a commodity one and there is a growing talk of replacement of present dry battery cell with Lithium cell. Although it’s not very clear but it may have an impact on the PCIL’s business

Given its current year’s profitability,  PCIL should be able to earn 15 Rs to 18 Rs per share in 2009-10 and as on 31.3.10, expected cash per share should be approx 113-115 Rs per share. As a result, the core business will then trade at a market capitalization of Rs 12 crore which is actually dirt cheap given the core business’s ability to generate free cash flow.

I think we need some activist shareholders to shake up the current management and the company should either distribute the cash in form of one time special dividend or can opt for an aggressive share buy back. The business does not require cash and the management should distribute the excess cash lying in the balance sheet to the shareholders.

PCIL is an appealing value buy at the current price and may return 100% (including dividend ) over the next 1-2 years.

Happy investing!

( Dipak Sen is the CFO of UshaComm  ( www.ushacomm.com ), India. Views expressed herein are entirely his own. He can be contacted at dipak.sen@ushacomm.com / dipaksen@yahoo.com . Any suggestion/views are welcome. )

30^th November,2009