Value Pick - Betting on Biocon

What Would You Say to the Following?

• Despite growing at a blistering pace of over 200% the year before, company X grows its net profit by another 42%
• PAT margins, already among the best in the sector (at 25%), have improved to 26%
• Every one of its businesses is profitable and growing
• The company is cash flow positive and generates enough to comfortably manage its operations and have some left over to fund acquisitions as well
• Company X possesses a patent on an innovative fermentation process, one of the core capabilities required for the business
• The company has recently launched human recombinant insulin into the market, one of only four companies worldwide that has been able to do so
• X is recognized globally in the field of statins, the world’s single-largest drug segment with a market size estimated at USD 23 bn globally
• The management team is extremely capable and experienced and almost all have been with the company for over a decade. Attrition levels at the company are a mere 1%, well below industry average
• The company has a research pipeline extending well into the next 5-10 years, beginning with lower-risk generics and moving on to high-risk, higher-value products
• Entry barriers into most of the company’s businesses are high, demanding sophisticated technology and regulatory clearances
• It has a clear vision, has delivered on every promise made to investors over the past few years and is poised to become a globally-recognized biotech and pharma major

Do You See A Dog? Or a Star??

The company is Biocon (www.biocon.com).

Debuting on the Indian exchanges in April 2004 at an impressive 52% premium (closing the day at Rs. 483) over the offer price, the stock is currently languishing in the early 400’s. The only explanation could be the general weakness of the market and perhaps lower-than-expected earnings, both of which have combined to make this a great buy!

At a PEG (Price / Earnings to Growth) ratio of around 0.5, the stock is almost certainly undervalued, even though its EV / EBITDA is quite high (around 12-14). Considering that it’s a growth business in a ‘hot’ industry, this state of affairs can only last as long as the overall market correction. Once the sensex swings the other way, this stock is poised to take off like a rocket!

Over the long term, given a couple of good breaks on new molecules / drugs, Biocon has the potential to really make it big. And, touchwood, if any of its products should become a blockbuster, the sky is the limit!

Have confidence.

Current Market Price: Rs. 395

Real Estate - A Strategy for Apartment Purchase?

For some months now, I’ve been in the market to purchase a good apartment. Unfortunately, I find I’m not alone! Thousands of others have had the same thought – apparently at the same time – and, armed with cheap home loans, they’re driving up prices way beyond control.

Unfortunately, not only is a flat a major investment, it is illiquid and the price at any point is quite subjective. There are few, if any, guidelines to determine the value of a property accurately.

A Strategy for Purchase

Now, if you’re like me, you’d have taken a loan for the purchase, probably up to 90% of the value of the apartment. The remainder plus the registration amount would be financed through available cash and perhaps a personal loan as well.

In this scenario, there are two components to the investment we’re making – principal repayment (which is basically installment payments against the value of the apartment) and interest (which is the amount we are spending in addition to the value of the apartment). Since the principal is merely a payment for the property, we don’t have an issue with it – we got a flat and we’re paying off against it. The problem is with the interest, which is an additional, fairly substantial, amount that we will have to fork out over time. This is the part we need to take care of.

The plan I have is to ensure that the rent for the apartment takes care of the interest component (home loan + personal loan if any) at least. This way, I’m merely paying for the value of the property, which is not an issue.

The other problem is the down payment that we’ve made from our own cash resources. Given a choice we would like the cash to earn interest. Let’s assume that for a low-risk investment similar to property, we would want returns of 10-12%. The expectation would then be that the apartment being purchased must has enough scope to appreciate by an amount that would make such returns possible.

Thus, in summary:

• Principal payment (home loan + personal loan) gets set off against value of the house
• Interest component (home loan + personal loan) should be matched by the rent
• Capital appreciation in the value of the property should be at least enough to translate into 10-12% returns from the down payment made with our own cash

An an example, let's take an apartment of value 50 lakhs, of which the home loan is for 45 lakhs. Let's assume registration amount is 5 lakhs. The down payment required is therefore 10 lakhs, of which the buyer intends to take a personal loan of 5 lakhs and fund the rest himself. The interest component of all the loans works out to about Rs. 25,000-27,000, which needs to be covered by the rent. Further, the apartment must appreciate by at least Rs. 50,000 per annum to generate returns of 10% on the 5 lakhs paid by the buyer. This implies that the apartment should show capital appreciation of 1% per annum at a minimum.

If the buyer had been able to fund the entire down payment himself, the rent requirement would have been lower at about Rs. 18,000 and the capital appreciation required would have been 1 lakh per annum, or about 2%.

IPO - Gateway Distriparks

The Gateway Distriparks offer hasn’t quite generated the frenzy that generally characterizes Indian IPOs. Oversubscribed by 6-7 times overall, the retail segment has seen remarkably little action, remaining undersubscribed up till the close of the offer. Perhaps the fact that Punjab National Bank and Emami were also available at the same time had something to do with the lack of enthusiasm…

What Makes Gateway Distriparks Interesting?

The following points indicate the company is a good buy:

It's a mid-cap company with significant presence in a growing industry

The company is in the logistics industry, dealing mainly with packaging of goods into containers and storage of incoming and outgoing goods in company-owned facilities. They have a significant presence in major shipping hubs like Mumbai and Vizag, with plans to acquire a facility in Chennai. They also have a presence in Gurgaon, thereby catering to road transport. The company plans to expand its presence geographically as well as in different transport sectors.

The offer proceeds are to be used for business expansion and other strategic purposes

GDL aims to use the proceeds to retire high-cost debt, acquire a facility in Chennai and improve its facilities in Mumbai and Gurgaon, all of whicih will lead to profit growth in the medium term.

GDL has displayed strong revenue and profit growth over the past five years

The company has shown a CAGR of 55% in revenues, with no year recording less than 20% growth. Costs have shown a more gradual increase, leading to excellent profit growth.

RONW and ROCE have been consistenly improving over the past few years

RONW has improved from about 8.3% to 23.5% over the past 3 years and ROCE from 4% to 19% over the same period.

Debt components have been steadily declining

Overall debt to equity and interest liabilities have been falling over the past 5 years and current interest coverage is at comfortable levels, suggesting that the company will at least not go under on account of debts!

There's evidence of improving business efficiency and movement up the value chain

The primary income streams are rental for goods storage and service charges for packaging and handling. While both have been on the rise, the share of rentals in the overall revenue has fallen, indicating the company has been able to command premium rates for services, indicating a move up the value chain. Further, reducing dependence on rentals also reduces the need to constantly acquire storage facilities involving high capital investments.

Price Attractiveness

At the offer price band of Rs 60 – Rs 72, the PE Ratio (using diluted EPS) is between 24 and 28, which is a tad high for a company that’s growing at an average of 30% year on year. However the overall business is attractive enough to buy at the price, especially at the lower end of the band.

Real Estate - Investing in Property

The first (and last) bit of investing advice most of our parents gave us – save, save, save and buy a house as soon as you can. You can never go wrong in real estate!

And it does seem like a good proposition. Just ask the people who’ve made millions from their ancestral properties or those who’ve recently made a killing in Bangalore or Gurgaon!

For many of us, buying a flat or a property is a big deal in every way. It is likely to be one of the biggest investments we ever make, it has a lot of sentiment attached to it and it does give a sense of fulfillment - I have a house, ergo I’ve arrived in life! Plus there’s the expectation of the property appreciating many times in value over time.

But is this expectation justified? Is real estate really an investment that defies the basic risk-return principle, yielding high returns for relatively low risk?

Consider This

Property purchases are fraught with uncertainty. For one, we never know what the ‘fair’ value of a property is. There are all kinds of intangibles determining the price, there is little or no flow of information and of course there are the buyer’s own biases involved as well. Further, during times of rapid expansion, ‘hot’ areas tend to appreciate to stratospheric levels (like parts of Gurgaon today) and there is rather inevitably a correction. Property prices, contrary to popular opinion, do not always tend northwards.

Further, as with any investment, one should consider the cost of funds and ongoing maintenance. In this context, we have tax breaks to consider, differing interest rates for loans, different payment schemes, stamp duties, property taxes, ongoing maintenance costs, brokerage…

In the following discussion, I propose to treat real estate as just another asset class in my portfolio and hence determine whether it compares favorably with other instruments. Of course, an underlying assumption here is that the purchase is purely for investment and not for personal use. In the latter case, just buy the best location you can afford - preferably in an area you’re comfortable with - and then forget it. Who cares what happens to the price? Your kids maybe, not you!

Some Basic Assumptions

In this discussion, I’ll focus on purchasing a house / apartment, not land. Land purchases, by their very nature, are speculative and the returns indeterminate. One buys land in the hope that it will appreciate in value but there’s no indication of what the appreciation might be.

In the case of an apartment, however, there is a clearly defined rental income that one can expect and I hope to use this as the primary basis for evaluating whether a property is a worthwhile investment or not.

Other assumptions (I’ve tried to take the worst case scenario) -

• The apartment costs Rs 10 lakhs, inclusive of stamp duty
• The property is bought on a 20-year loan @ 8.5% fixed interest rate working out to an EMI of Rs 900 per lakh or Rs 9,000 for the whole. I assume there’s no initial down payment required
• Inflation over 20 years will average at about 5% per annum. A higher inflation will be more beneficial by reducing the real interest rate on the loan
• The tax benefit on interest paid for housing loans does not exist.
• The rental yield on the property is about 4% per annum (about average for most cities in India, except Gurgaon, where the yield is higher), which works out to about Rs. 3,300 per month. This increases at par with inflation (usually the rental increases are higher)
• Ongoing maintenance costs plus applicable taxes are about Rs. 12,000 per annum (or about Rs. 1,000 per month), appreciating in line with inflation
• Tax on rental income is at 30%
• Post-tax returns on a low-risk bond are 6% per annum

For the above scenario, one could consider the property investment in two ways:

• As a pure investment: In this case, the buyer’s mindset would be of an investor looking to allocate his capital between various assets. The purchase of an apartment is incidental and the focus is on return on total investment
• As a mandatory purchase: In this case, the apartment price itself is above scrutiny and the focus is on determining whether the additional costs (interest, maintenance etc) are worthwhile in terms of returns.

Real Estate as a Pure Investment

The investor would only purchase an apartment if the returns (capital appreciation + post-tax rental income are comparable with other low-risk assets like bonds. Hence, the investor would consider the total cost to be the sum of the NPV of the total repayment over 20 years and the NPV of maintenance costs. This would be compared with the NPV of the rental income and the returns expected from a bond of similar cost in order to determine the capital appreciation required from the apartment.

In our example:

• NPV of loan repayment over 20 years = Rs. 13,45,920 (Rs. 1,08,000 per annum discounted at 5% rate of inflation)
• NPV of maintenance costs over 20 years = Rs. 2,40,000 (Rs. 12,000 per annum, rising in line with inflation)
• NPV of post-tax rental income over 20 years = Rs. 4,80,000 (Rs. 24,000 per annum post-tax over 20 years, rising in line with inflation)

Total investment in today’s prices = Rs. 13,45,920 + Rs. 2,40,000 = Rs. 15,85,920

Value of similarly-priced 6% bond over the same 20-year period = Rs. 50,86,250

In order to be an equally good investment, the ten lakh rupee property must appreciate to Rs. 46,06,250 (since the rental income is about Rs. 4,80,000) i.e. it must grow at a cumulative rate of 8.37% per annum.

One should purchase the apartment only if the expectation is for the property to grow at this aggressive rate year after year.

Real Estate as a Mandatory Purchase

The mandatory purchaser would not focus on the cost of the property, assuming that the price is a fair one. The only concern here would be to ensure that the extra cost of maintenance and interest is met by the rental income and the gain in apartment value so that the there is no loss incurred in the purchase.

In our example:

• NPV of interest repayment over 20 years = Rs. 7,47,730 (Rs. 60,000 interest payment per annum discounted at 5% rate of inflation)
• NPV of maintenance costs over 20 years = Rs. 2,40,000 (Rs. 12,000 per annum, rising in line with inflation)
• NPV of post-tax rental income over 20 years = Rs. 4,80,000 (Rs. 24,000 per annum post-tax over 20 years, rising in line with inflation)

Total investment in today’s prices = Rs. 9,87,730
Value of similarly-priced 6% bond over the same 20-year period = Rs. 31,67,790

In order to be an equally good investment, the ten lakh rupee property must appreciate to Rs. 26,87,790 (since the rental income is about Rs. 4,80,000) i.e. it must grow at a cumulative rate of 5.34% per annum.

One should purchase the apartment only if the expectation is for the property to keep pace with inflation year after year, a not unreasonable requirement.

Final Thoughts

The above analysis does not really throw up anything new other than the idea that real estate, as a pure investment, seems to be rather speculative. It’s not the sure-fire winner that people would have one believe. The best bet is probably to purchase apartments on the outskirts of growing metro cities or in B-category towns with the potential to scale up fast. It might even be a better idea to just buy land.

Buying an apartment for security and the feel-good factor seems to be a better motive. It’s also probably a good idea for people who currently stay in rented accommodation. Even apartments in mature parts of large cities should at the very least keep pace with inflation.

Returns could be juiced up a bit by holding for short period of time and selling out on substantial jumps in value, obtaining tax benefits on interest repayment, finding an apartment with a high and growing rental yield and perhaps reinvesting the rental income into interest-bearing investments.

When Does One Sell?

‘You hold on to stocks like they’re your babies and then sell when they are at their lowest!’ says my wife, making a point. Sound familiar?

A lot’s happened in the past month – the stock market bull run turned into a bit of a dream run, with stocks rising to dizzying heights. We saw record highs that even a year back few would have predicted. And I saw my investments generate over 50% in unrealized returns – man was I good!!

The key word in the fairy tale above of course is ‘unrealized’ returns – that's about the only realization I've had in the past month. It’s been only a few weeks since the record highs and the market index has fallen by around 10% or so, wiping out a lot of those gains. Stocks that had gotten ahead of their valuations have returned to more reasonable levels (though not to bargain prices by any stretch of imagination). Thankfully, I’m still profitable, though of course at a more modest level.

But why, oh why, didn’t I sell?

Kind of makes one wonder, doesn't it? Is a buy-and-hold strategy really a good idea? And if it is, how long should one hold? And when should one sell?

Is a Buy-and-Hold Strategy a Good Idea?

I think it is, at least for me. Look at the benefits – lower tax, less worry and no need to time the market except in a broad sense. On the down side, one tends to fall in love with one’s buys and live in a world of paper profits and ‘unrealized’ gains as I’ve just figured out. That, however, needs a mind-set change and acceptance of selling as an important aspect of investing. A bit of discipline (and a sharp jolt like the current downslide) should help sort it out. Not a problem, really.

When Should One Sell?

As with the choice of investment approach, there seems to be no single ‘best’ method for determining the selling strategy. Here are three options that have stuck in my mind and may be used as appropriate:

• In a rising market, set stop-losses at levels below the normal stock price fluctuation so they get triggered in case of unusual dips in the price. This has the advantage of being a mechanical method and hence creates discipline. The downside of course is that the stop-loss levels should be reviewed periodically (perhaps even daily) to ensure that they are relevant to the current stock price. Further, this approach will also lead to short-term corrections inadvertently triggering off the sale of a stock that should actually have been held for longer
• Peter Lynch’s investing approach is to find companies whose stocks have a good reason to grow manifold in the near future and then wait for the market to catch on. Hence the selling strategy would be to do so once the story has been fully played out, as per the investor’s opinion. The advantage of this approach is that it looks at the long term potential rather than at short-term price movements. The disadvantage of course is that the investor might be wrong in his / her assessment of the company or that the market may not bid the stock up in the near future. In the meantime the investor would hold on, accumulating losses in the hope of a turnaround.
• Another approach is to sell the stock when it reaches a price such that reinvesting the proceeds in a low-risk investment would still allow the investor to meet his / her financial goals. This is actually an intriguing idea – I think this is Warren Buffet’s - and it’s worth dwelling on this further.

Sell High and Re-Invest in Low-Risk Instruments

Let’s say you have invested Rs. 1,000 today in the hope of turning it into Rs. 10,000 in 10 years (you’re target returns are 25% compounded per annum). Now suppose after two years there is a major bull run and the stock reaches Rs. 5,000. Based on this philosophy, the investor could sell it and invest the proceeds (Rs. 5,000) into a low-risk bond at 8% let’s say. At the end of 10 years, the investor would have made approximately Rs. 9,500 with almost negligible risk.

This way, the investor meets his goals in the most efficient way by taking advantage of a bull run to jump-start the process. A capital idea (again no pun intended!), but would one be able to do this? Would it not take fabulous amounts of forbearance to sell a stock that’s doing well and put it into the boring ‘slow and steady’ bond that will get you to your goals but will not help you get rich quick? Would it not cause pangs of regret when the same stock scales even greater heights immediately after you sell? And what if it hits Rs. 10,000 when you’ve sold at 5,000 to take the scenic route to your destination? Whoa, that’s a killer!!

And do I hear you ask what I would do? I’d go for the rational and disciplined approach of selling high and investing in bonds, of course.

Or perhaps leave just a wee little bit in the stock just in case…

Actually, let me just wait till the next bull-run to find out.