Why focusing on a single metric can cost you a 6 bagger?

Case study – 1

Imagine your equity advisor told you to buy this pharmaceutical company’s stock in year 6. Considering that their cash flows aren’t reflecting the profits that are being declared by the company, would you still buy? (A consistent cash flow of below 8 bucks for every 10 bucks (80%) is generally considered not good)

And then you find out that cash flows are low because their receivable and inventory days have gone up 5x. Would you still consider buying, that too in the middle of a small/mid cap bear phase?

You decide to give the stock a miss, because the company’s working capital and cash flows aren’t looking good.

Much to your disappointment, the stock goes on to become a 6 bagger over the next 5 years, compounding shareholder wealth at a stunning 42% CAGR. What could you have potentially missed?

In my workshops I am often asked for a formula or an excel sheet that can help people spot life changing stocks. A related question that comes up rather frequently is how important is it to compare cash flow from operations vs profit after tax. And I am going to be deep diving into that aspect.

Note: This isn’t to pin point faults in any investor’s analysis. All of us are learning, and making mistakes is the tuition fee we pay to the market. And these case studies are vicarious experiences for normal mortals like all of us.

Case study 2 – Opto Circuits

In 2012, an investor wrote a blog about a very interesting fast grower called Opto Circuits. Here’s how Opto had been doing until then.

At 6 times earnings. This was a GARP investor’s dream come true. A 50% grower available at just 6 P/E.

Why was it trading at such low multiples? Perhaps it was because small & mid caps were in a bear phase or perhaps the market had doubts about the company’s cash flows or maybe it was a gold nugget waiting to be discovered.

In his blog post, this investor also mentioned Opto’s cash flows were worrying.

Yet, this risk was not given enough weight and this investor and many others who invested around that time, lost a big chunk because the market was right about the company’s shady accounting/business practices.

Investors who made a second mistake by not cutting their losses and stayed invested in Opto subsequently lost 98% of their capital.



The author subsequently accepted that his investment thesis had been broken at the hip, by writing another post mortem blog in which he reflected upon what had gone wrong. (To this person’s credit, not every blogger is bold/conscientious enough to do this. Unlike this blogger, some others just try to push things under the rug.)

Case 3 – Photoquip India

In another article published in a financial magazine, another investor talked about his experience with Photoquip India, which he picked up in 2011. Since this is a paid article, I don’t want to quote anything written in it. But the gist of the story is he trusted the management at face value, did a lot of scuttlebutt on the company/sector and yet ignored the fact that cash flows were lacking before, during and after he’d invested.

Now this was not some rookie investor. Instead he was the CIO of a PMS firm and somebody who’s experienced in many equity markets such as India, Sri Lanka, Bangladesh, Kenya, US, UK, Canada, Australia, and New Zealand.


And here’s the subsequent downfall in the company’s stock price. Even after a rare & phenomenal bull market like that of 2020-21, the stock is still down 70% after a decade.


So we have contrasting cases here. In case 1, the stock performed well despite low cash flows and in the cases of Opto & Photoquip, cash flow was the straw that broke the camel’s back.

Case 1 is that of Sun Pharma between 2005 (Year 1) & 2015 (Year 11).

In all 3 cases, cash flows were low and yet, the market was lenient towards Sun. So how were Sun’s lower CFO numbers different from Opto Circuits’ and Photoquip’s?

The answer lies in the following piece of wisdom from Albert Einstein.

In the case of Sun, a fanatic promoter drove cash flows back to high levels, from year 7 and Mr. Market said I am gonna be patient with this promoter for 6 years and I am not gonna count too much.

With Sun Pharma, the market believed in the promoter’s ability to eventually turn things around whereas Opto Circuits and Photoquip were cases of outright fraud. Mr. Market was perhaps smart enough to discount the fact that Opto & Photoquip would never grow their cash flows to sustainable levels.

The point I am trying to make is that one needs to look at the holistic picture, the grand scheme of things going on at a company. Perhaps we should not forego investing in companies if a single metric is out of whack, if other factors such as scuttlebutt feedback, management track record, competitive advantages available to the company are impeccable. Focusing too much on any single metric is the functional equivalent of paying too much attention to the scoreboard and not focusing enough on the playing field.

Yet, there are times, a single metric such as low cash flows become deal breakers, if other red flags start showing up. Perhaps some of these red flags would become obvious only after resulting in permanent losses of capital. As we can see, long term investing in equities will never boil down to a single formula, ever.

Case 4 – Laurus Labs in July 2020
Some investors were worried about Laurus’ receivables being high and chose to skip investing in its stock, at a time when it was available at one-fifth of it’s current price. In effect they were saying, Laurus’ future CFO would be impacted because cash would be stuck in receivables and some of those receivables would become bad debts and would therefore lead to cash flow problems for the co.

What they missed is that receivables in pharma usually don’t end up being bad debts and write offs because relationships between pharma cos and their clients are multi year and there is a lot of inter dependence. If one of Laurus’ large clients defaulted or delayed payments, Laurus could simply cut-off future supplies to that party and start recovery.

Besides who were these clients that owed money to Laurus? Were they some fly by night operators that would vanish into thin air some day? Or were these clients big MNCs that could potentially delay but not deny payments to Laurus? In my view, the answer was the latter and hence I took a big position despite their receivables being high, at 102 days at the time.

To conclude, like any other metric, a low CFO vs PAT can tell you there could be something getting cooked in the books. Yet, as the case of Sun Pharma shows, if the jockey is good, he can turn things around and a low CFO doesn’t become a problem then.

Too many times, we get stuck up on a single metric, and let go of some great opportunities, without looking at the grand scheme of things instead. If this isn’t analysis paralysis, what is?

Addendum – Case 5 – Zee TV during the TMT / Dotcom bubble phase

I was reading India’s Money Monarchs and this response by Mr. Samir Arora caught my attention, this morning (23rd Jan 2021).

Amazon.in: Buy India's Money Monarchs: Conversations with leading investors  Book Online at Low Prices in India | India's Money Monarchs: Conversations  with leading investors Reviews & Ratings

“If you look at our history, both the reason for success and the reason for criticism are the same, “You hold your stocks too long.” Zee, multiplied 160 times since we bought it. Every Rs 10 invested in the company had multiplied to Rs 1600. But we did not multiply our investment to that extent because by the time we sold, it had already fallen to Rs 700. So, we basically ended up multiplying our investment 70 times. I remember having said in an interview with one of the business magazines that our year-end target for Zee was Rs 250 when the price was around Rs 100. However, the stock had multiplied 10 times by the time the year had ended and we did not sell during the year. Even if I had sold at Rs 300, I would have tripled my money in a year and that would have been considered as a great job. While some might say that not selling at Rs 300 was a good decision, others might criticize me for not selling at Rs 1600.”

And then I looked at the numbers for Zee TV during those years and what I saw blew my mind.

Zee had a net cash flow of below zero while the TMT bull run was in progress. And the reason it’s insanely high receivable days. Zee was taking an average of 6 months to recover due owed to it by its customers.

Yet the market wasn’t worried because Zee went on to become a 100 bagger. Now I doubt how many people would have actually made 100x their money but we can at least get a rough idea of how things went.

Maybe the market was inefficient, back then. Or perhaps, it had a good enough reason because Zee’s profits had been growing at a very fast clip.

So yet again, we have a case where the market prioritized growth over balance sheet quality and cash flows and hence it makes sense to keep an open mind about all these metrics.

Disclaimer – Not SEBI registered. Not a recommendation to buy/sell any of the above mentioned stocks. Don’t hold any of the above either.

Barath Mukhi
7-Jan-2022

Selling before it’s too late- The delusion of paper profits in a bull market

Selling stocks is exponentially more difficult than buying. If you sell a winner at the wrong time, you could have the financial regret of a lifetime. On the flip side, there were times I ended up kicking myself for not having sold losing stocks in time, thereby magnifying the somewhat inevitable smaller losses I would have otherwise had.

It takes quite a few trials and errors before one figures out how to sell stocks in time. And even after one thinks he’s got it, could still go wrong.

The context is that like a lot of my peers, I was anxious about how this current bull run will play out. Will we experience another bull market like the one we experienced between 2009 and Feb 2020? Or will the market correct from here? If yes, then I shouldn’t be repeating the mistakes from the last cycle and convert paper profits to cash.

Bear markets sneak in when most poor mortals aren’t expecting them and not when there is a lot of debate on Twitter about whether it will crash this week or the next or the one after that.

While I am no expert at timing the markets or the macros, let me give this a shot anyway. In the aftermath of the 2008 housing bubble, the US Fed’s balance sheet expanded multi-fold and all those newly printed dollars chased equities and markets, the world over, shot up. Will the same story play out yet again over the next decade or so? A layman’s guess would be yes.

And here’s what somebody who has a good handle on macros, said about liquidity. Stanley Druckenmiller (left), one of the guys who famously broke the Bank of England, along with his mentor, the legendary, George Soros (right), in a highly leveraged bet, once said,

“Earnings don’t move the overall market; it’s the Federal Reserve Board. Focus on the central banks and focus on the movement of liquidity. Most people in the market are looking for earnings and conventional measures. It’s liquidity that moves markets.”

With liquidity, earnings and the several moving parts that work in the background to keep the market engine running, it is hard to make a sure shot prediction about market direction. Think about how many people got out in time before the March 2020 crash and whether the same set of people had the nerve to get back in time before the markets ran up so suddenly.

I don’t think there are easy answers to when a bear market will come or if at all it will be in the near future. While I have been dealing with this uncertainty in my mind, I’ve simultaneously been reading How to make money in stocks by William O’Neil. For somebody like me, who loves reading financial history, this book is an absolute delight.

O’Neil is a genius. He collated fundamental and technical data of historical multi baggers, as early as the year 1885. And he put them into his mainframe computer in the 1960s to analyze what works on Wall Street. So this guy got his hands on a mainframe (remember there was no Windows then) to analyze stocks much before Bill Gates was famously dozing off on his desk, working on computers, in 1968. Woah!!

How O’Neil collated and analyzed so much data at a time when computers used to work like the ones below is quite fascinating.

Anyway, like a lot of other things in life, one naively ignored idea is that of looking at history and seeing how others solved the same problem I am facing today. And here’s how O’Neil solved the problem of being able to sell winning stocks in time. He wrote –

“Have you ever analyzed every one of your failures so you can learn from them? Few people do. What a tragic mistake you’ll make if you don’t look carefully at yourself and the decisions you’ve made in the stock market that did not work. You get better only when you learn what you’ve done wrong. This is the difference between winners and losers, whether in the market or in life. If you got hurt in the 2000 or 2008 bear market, don’t get discouraged and quit. Plot out your mistakes on charts, study them, and write some additional new rules that, if you follow them, will correct your mistakes and let you avoid the actions that cost you a lot of time and money.”

Hmmm.. so he looked at his past trades and so should I. I have this excel sheet where I note down all my buy/sell trades. And here’s what I figured out by doing a post mortem of my past trades from that sheet. There is a bit of hindsight bias here but we’ll just need to work with what we have.

Relaxo Footwears

  • I initially thought the stock will not do better than 15% returns per annum, and did not buy.
  • Big opportunity loss due to not averaging up. I was anchored to low valuations or my cost price perhaps.
  • Position sizing was not sufficient. Should have bought a lot more.

Nesco

  • Prematurely sold due to fear of losing out gains already made.
  • Did not apply second level thinking. Should have trusted management would fix the issue, because they would have solved the problem with their business sooner or later.

Kitex Garments

  • Should not have bought the stock in the first place. I wasn’t looking hard enough.
  • Averaging down did not help.
  • Should have sold when EPS fell down. Did not cut losses quickly enough.

Bajaj Finance

  • What worked – Buying when others were fearful.
  • What didn’t – Process gap. Not adhering to my stop loss.

Alkyl Amines

  • What worked – Experimental bet although it was outside my circle of competence.
  • What didn’t – Not following up. Not averaging up.

The way I look at it is, my journey has been through 3 phases.

Phase 1 – Where I was neither buying nor selling correctly
Phase 2 – Where I was buying somewhat correctly but not selling correctly
Phase 3 (Hoping I am in phase 3 today) – Where I am buying correctly [High allocation bets like Alembic Pharma (exited), Laurus & RACL have done well since March 2020] and hoping to sell correctly.

It is foolish to keep repeating mistakes and I now have pre-determined stop loss prices for all my long term bets and I am hoping this kind of a process allows me to convert paper profits into real currency. Having pre-determined stops also helps get rid a lot of bias and inaction that comes when the stop price actually arrives. I am hoping this helps me to transition from phase 2 to phase 3 smoothly unless I figure out there are more holes in my process.

Perhaps there is a phase 4 too, that I can’t visualise today. Having said that, I am glad to have made it this far, the future seems exciting and there’s a lot more yet to be accomplished.

Note to self:

  • Not backing up positions with enough capital, is a costly mistake. How many of your bets go right is less important than how much you allocate to the ones that go up. To quote Jeff Bezos, “Big winners pay for several failed experiments.” I seem to have fixed this mistake, by allocating 25% of my portfolio to Laurus Labs, last year.
  • Avoid slow or non-growth businesses altogether. Just doesn’t work for my investing personality type.
  • Not cutting losses quickly is a lacuna to be avoided.

Barath Mukhi
26th July 2021

The growth story of Laurus Labs & it’s promoter

Let me start with a story of a fanatic who creates a 20 thousand Crore company from scratch. How does he do it? Where does he start?

The story begins at Andhra, which by the way has produced quite a few successful first generation entrepreneurs in the Pharma space. The ones I know of, are Dr. Reddy’s, Divi’s & Laurus. I don’t know if it is plain randomness or there was something in that environment that led to creation of multi billion dollar pharma companies by people starting from scratch. I speculate, one of the factors, may have been the way chemistry was taught in those colleges, was better than other places.

Or maybe it was about being in the right place at the right time with the right skills. Maybe, in an alternate universe, the same set of entrepreneurs may not have done as well as they have. Too many things needed to fall in place for this kind of, what some people may call, coincidence. Reminds me of the experiment which is widely known on the net, through the article about Justin Timberlake.

One of the key ideas in this article was that too many things need to fall in place, and more importantly, at the same time, for a knockout success story to happen. For example, imagine what would have happened if the exact same set of people were to start Infosys today. Would they be nearly as wildly successful as they have been? Or what if Bill Gates was born just 5 years later? Would we nearly have another giant monopoly like Microsoft or anything close? You get the point.

Will Laurus (20k Crs Market cap) follow the same trajectory as Dr. Reddy’s (75k Crs Market cap) & Divi’s (1 lac Crs Market cap)? In my biased view, chances are it will.

So after finishing his education, Dr. Chava,

  • Joins Ranbaxy as an R&D management trainee.
  • Moves to Veera Laboratories in 1995 and runs the R&D dept.
  • Moves to Vorin Labs which merges with Matrix Labs in 2001.
  • Becomes Chief Operating Officer of Matrix in 2004.
  • Starts Laurus Labs in 2005 due to differences with the chairman of Matrix.

How Matrix Labs strengthened it’s R&D – From Matrix Labs 2000 Annual Report

In 2000-2001, Matrix entered into drugs that treat the deadly AIDS disease. Here’s a snippet from Matrix’ 2001 annual report.

Matrix Labs 2003 Annual Report

Matrix Labs 2004 Annual Report

And here’s what happened at Matrix Labs during Dr. Chava’s tenure. Back then, this kind of growth might have been possible due to a mix of factors such as a growth in the overall industry + the management team driving the company’s focus on to the right products in the right markets, at the right time.

Now, let’s get into the current and future state of Laurus’ business.

In the past, growth was driven by sales of Antiviral APIs. This is the division that sells APIs for AIDS drugs, primarily in low and middle income countries through the Global Fund, PEPFAR and the WHO. A majority of ARV API sales growth came from 4 HIV/AIDS products – Tenofovir, Lamivudine, Efavirenz and Dolutegravir.

As per their latest concall, doubling sales in the HIV segment (APIs + Formulations) is going to be impossible. Having said that, they also mentioned, they should be able to deliver growth in their overall API business in FY22 as well. Based on whatever little info I could find, the largest player in ARVs seems to be Mylan (which acquired Matrix Labs in 2007), and has a 40% market share, in this space.

The other 2 therapies that management is bullish on, are Cardiovascular and Diabetes.

Some part of the growth was also driven Laurus’ Custom Synthesis, CDMO & Ingredients businesses. Custom Synthesis is the segment that has potential to do well over the next few years because the total sale from this division over the last 4 quarters is a minuscule 491 Crs.

Transforming into a full fledged Pharma player

Formulations / FDF showed up for the first time in 2020 Annual Report.

Q3 FY 2021 Concall – “See, if you look at the evolution from 80% to ARV APIs, in the five years we moved to 38% of ARV APIs. Similarly, our revenue dependency on ARV formulations currently is very high. But in the next five years, we will also diversify our revenues coming from non-ARV formulations significantly and the dependence on ARV will come down. Because there are no new formulations to be developed in the ARVs, we are almost done with developments. So, development focus is shifting from ARV to non-ARV. And also, we are adding very large capacity in Vizag and we have taken land for formulations expansion in Hyderabad as well. So if you want to look at where we will be in say, three, four years down the line, I am sure we will be discussing on non-ARV in five years from now. If you look at the calls one and a half year back, half of the times people were asking questions on Efavirenz. Now nobody asks questions on Efavirenz. Two years from now people will not ask questions on ARV APIs. And maybe another two years from then people will not ask about ARV formulations, people may talk about what is we are doing in our Laurus Bio?, what growth we have in Laurus Bio?, what other therapy areas we will be focusing?, what kind of delivery dosage forms we are doing?. So, company s in the transformation phase, so we need time and we are very confident to expand our portfolio beyond just ARV.

The SMILE pattern

This is a pattern noted by the famous investor, Mr. Vijay Kedia. He believes multibagger companies exhibit the following characteristics – Small in size (at least it was small when I started investing in this co.), Medium in experience, Large in aspiration and Extra large in market potential. I am of the opinion that the company has all 4 ingredients and is likely to scale up to the next level, from here.

Regarding aspiration, here’s a person who starts with a salary of a few thousands, moves on to lead the R&D division of another co. and goes on to create a $2.5 billion business in less than 2 decades. If this is not aspiration, what is?

Disclaimer: I have stayed invested in Laurus Labs from lower levels. These are my views and are not to be construed as investment advice. As always, please do your own research before proceeding to buy/sell.

Barath Mukhi
26th-Feb-2021

Quarterly earnings tracker

We will be using this page to update names of companies, which have shown good traction in their latest quarterly results. I may have positions in 1 or more companies. Please do your own due diligence before investing.

Last updated – 3-Feb-2021

Showing latest quarterly results for Q3 FY2021 – Dec 2020

CompanyDate updated
5Paisa Capital18-Jan-2021
Bhansali Engineering Polymers18-Jan-2021
GTPL Hathway18-Jan-2021
Indiamart Intermesh18-Jan-2021
Mindtree18-Jan-2021
Tata Elxsi18-Jan-2021
Tata Steel Long Products18-Jan-2021
Tata Steel Long Products18-Jan-2021
Alembic Pharmaceuticals28-Jan-2021
APM Finvest28-Jan-2021
Apollo Tricoat Tubes28-Jan-2021
CEAT28-Jan-2021
CG-VAK Software & Exports28-Jan-2021
Cosmo Films28-Jan-2021
D P Wires28-Jan-2021
Gujarat Ambuja Exports28-Jan-2021
Hatsun Agro Product28-Jan-2021
Hatsun Agro Product28-Jan-2021
ICICI Securities28-Jan-2021
India Grid Trust28-Jan-2021
InfoBeans Technologies28-Jan-2021
Mangalam Organics28-Jan-2021
Mold-Tek Packaging28-Jan-2021
Natural Capsules28-Jan-2021
Navin Fluorine International28-Jan-2021
Poly Medicure28-Jan-2021
RPG Life Sciences28-Jan-2021
Sagar Cements28-Jan-2021
Shree Digvijay Cement28-Jan-2021
Shri Jagdamba Polymers28-Jan-2021
Sportking India28-Jan-2021
Titan Biotech28-Jan-2021
TV18 Broadcast28-Jan-2021
Udaipur Cement Works28-Jan-2021
Welspun India28-Jan-2021
AAVAS Financiers3-Feb-2021
Add-Shop E-Retail3-Feb-2021
ADF Foods3-Feb-2021
Ajanta Pharma3-Feb-2021
Angel Broking3-Feb-2021
Avantel3-Feb-2021
Bajaj Healthcare3-Feb-2021
Cipla3-Feb-2021
Dixon Technologies (India)3-Feb-2021
Finolex Industries3-Feb-2021
Geojit Financial Services3-Feb-2021
Godawari Power & Ispat3-Feb-2021
Granules India3-Feb-2021
Greenpanel Industries3-Feb-2021
Gulshan Polyols3-Feb-2021
Indus Towers3-Feb-2021
JK Lakshmi Cement3-Feb-2021
L T Foods3-Feb-2021
Larsen & Toubro Infotech3-Feb-2021
Laurus Labs3-Feb-2021
Mastek3-Feb-2021
Neuland Laboratories3-Feb-2021
NGL Fine Chem3-Feb-2021
P I Industries3-Feb-2021
Pioneer Embroideries3-Feb-2021
Punjab Chemicals & Crop Protection3-Feb-2021
Route Mobile3-Feb-2021
Shree Cement3-Feb-2021
Sun Pharmaceuticals Industries3-Feb-2021
Tata Consumer Products3-Feb-2021
Tata Steel BSL3-Feb-2021
Vaibhav Global3-Feb-2021
Vaishali Pharma3-Feb-2021

Is low cash balance a red flag for Laurus Labs?

The idea for this post started with a Tweet which claims Laurus Labs’ cash levels are too low for comfort. How can Laurus have just 2-4 Crs of cash at the end of each financial year, despite a healthy TTM topline of 3682 Crs?

Laurus LabsMar 2014Mar 2015Mar 2016Mar 2017Mar 2018Mar 2019Mar 2020Sep 2020
Cash Equivalents23592943322

I think there was room for more deep diving. This analyst from Twitter had more room for giving more weight to other data points that disconfirmed his notion about low cash levels. I have tried to cover those data points below.

Let’s start with the assumption that the guy’s hunch is true. If a business is running low on cash, what are the things you’d typically see?

  • The co’s suppliers would be squeezed for credit, leading to lower operating margins, because suppliers would charge the co. more, for raw materials supplied. In turn, the co’s margins would shrink due to an inability to pass on the increased cost unless they have huge pricing power, which is scarce in the Pharma industry. But surprise, surprise. Instead of margins declining, the co’s margins expanded.
OPM% Chart from Screener.in
  • Given the co’s high sales growth, inventories would have reduced, due to an inability to fund incremental raw material demand. Did inventories decrease? No.
  • Assuming the management was cooking it’s books in order to inflate it’s stock price, what would you see? They would try to maximize profits now, and try to push the expenses to a later date. But here the co. is doing just the opposite. It is taking a hit on current year’s P&L and expensing 100 Crs of R&D before hand. This tells you the accounting practices are not too aggressive. Whereas a stock price focused promoter would do all the things in the world to inflate his profits. This promoter didn’t.
  • Did the co. inflate it’s capex? Did auditors miss to check something important? No, lease agreements were verified by Deloitte. This is in addition to other basic checks and balances on the auditor’s side.
  • Sales would not have grown at this pace, without an increase in debt. It would have still grown, but not at the scorching pace it has. That the co. grew it’s sales at a rapid pace without taking debt in the same proportion tells us something. No?
  • One of the things about most of the crooked managers is they take on a lot of debt. If you are a crooked manager, why would you have an all equity capital structure? Wouldn’t you want to maximize funding the business from others money than your very own? You would want gullible banks to lend you all the money they can and put up very little of your own money into the co. If I was a crooked promoter, why would I screw just shareholders and NOT cheat banks too? Higher debt would lead to an increase in debt to equity. In my view, debt free co’s are more likely to be honest than not. If debt to equity is decreasing, it is possibly a step in that very direction. That being said, being just debt free does not guarantee a totally honest promoter. There are no guarantees in equity investing.
  • If we were to look at past patterns of fraudulent companies, one thing that stands out usually is CFO stays low in comparison to PAT. Again, this co. clears that hurdle without doubt.
  • Auditors would have flagged concerns about cash. After all, bank balances at the end of the year, are one of the easiest things to check, even for an untrained eye. And here we are talking about Deloitte, one of the reputed “big four” and not some mysterious unknown auditor.
image
  • Without cash balances there would be bounced cheques in the company’s current account. Any evidence of that? No.
  • There are smaller things like employees not getting paid on time, not getting increments, etc. I can’t get into those because I can’t find evidence on either side. And, absence of evidence does not necessarily mean evidence of absence. We’ll just have to wait for more evidence to come by.

All of the above points prove low cash levels are not a valid data point to look at, unless additional red flags show up in the future, that confirm the opposite view.

What could the plausible reasons for low cash in bank possibly be?

Imagine you own the only store selling daily necessities in a small town. Every year, your next door auditor sees more and more customers in your store. He decides to investigate if you are doing some hanky panky. He sees there is no cash in the cash box at the end of every year. There is no cash because you have paid salaries to your employees, paid back your suppliers / distributors for stuff you bought from them, paid the tax man, bought more merchandise so you can sell more next year, perhaps added another floor on top to accommodate all that extra merchandise, besides paying dividends to your partners.

Now, you have this next door banker friend who offers, hey Laurus, you can use my credit card (Cash Credit facility in Laurus’ case) whenever you are falling short of funds to repay any of your stakeholders. Laurus happily obliges, because his sales is growing at 26% whereas his return on equity is only about 15%. So he has to fund the scorching growth somehow.

The overdraft facility has been validated by the rating agency. I found this, thanks to a superb post on Valuepickr by somebody who worked in credit on banking side and has a better handle on this aspect. Here’s what he says.

Another thing to note is that this Valuepickr member is not invested and hence his opinion is more likely to be unbiased than not.

Instead of looking at one data point, one should look at the holistic picture because vested interests (perhaps) will torture numbers and get those numbers to confess anything. Why did the guy choose cash on the balance sheet instead of something like CFO to PAT or debt to equity, which is a much better indicator than actual cash itself? Because low cash was perhaps the only data point that confirmed his notion.

For those of you who already understand how Cash Credit facilities work, you may choose to skip the below video. In simple terms cash credit is a revolving credit facility given to companies by putting up inventories, receivables or assets as collateral. Co’s can use this to meet their working capital requirements whenever they are falling short of cash. Why is there no cash? Because all of it is being invested, back into the business.

With working capital loans, it doesn’t make sense to keep funds in your bank ac. Who in his right mind would keep cash in his bank ac and not pay back his lender asap, given the huge difference in interest rates between a loan and a bank ac?

In the quest to find red flags, sometimes we forget to see the green flags, thereby missing the forest for the trees. We also need to get on the other side of the fence sometimes and back up managements of companies that are executing well, and try to put in a good word and keep them motivated. A promoter who could have been relaxing in his farm house, chose not to do so and took most of his life’s savings and put them into his firm. He took risks and pursued growth. I don’t see why he would put so much at stake if he simply wanted to cook books. We should appreciate the fact that doing business in India is challenging indeed and despite all hiccups, and despite being called bogus, here’s a management team that just keeps executing.

Show me one multibagger out there which did not have a single red flag. Pharma co’s by their very nature (sometimes rightly so) keep investors worried all the time that they stay invested. Take Ajanta Pharma’s 120 bagger journey for example. Elsewhere, I have written about the gut wrenching roller coaster ride it’s investors had through their journey while experiencing the joy of a 120 bagger.

Does that mean we close our eyes? No. But we do need to separate the signal from the noise. Personally, I have a neutral view and would look out for more red flags, if any. Meanwhile I continue to stay invested.

PS: Ideas in this post have been collated from Twitter / Valuepickr / Whatsapp and based on my own personal investing experience. I have tried to put everything in one place to try and get a holistic picture. I sincerely thank everybody’s contributions / ideas.

I could be wrong on one or more ideas articulated above. I rank myself as moderate when it comes to doing forensic accounting and acknowledge there are much better forensics guys out there. I may change stance on this business as and when new facts present themselves or whenever I start looking at old facts in new light. And hence, I reserve the right to be wrong. The best thing to do for you would be to do your own due diligence and build your own conviction.

Barath Mukhi
4-Nov-2020

Momentum investing strategies from The Next Apple

$10,000 invested in Apple in 2003 were worth about $1.5 Million in 2015.

In 2003, Apple was a $10 Billion co. Today it is worth a massive $1.8 Trillion. In the book, The Next Apple, the authors, Ivaylo Ivanhoff & Howard Lindzon, discuss ideas to find the next big winners, the next Apples of the world. Although, they discuss many factors, I will stick only to some points that I felt, formed the core of this book.

Despite some very scary recessions in financial history and gut wrenching volatility in stock prices, the market has consistently provided opportunities to invest in hundreds of stocks that went up 1000% or more.

This was also the key lesson from the below book, a book that hit me like a train when I first read it a few years back.

Thomas Phelps convincingly argued, that between 1930s and 1970s, 365 American stocks went up a hundred fold. (You read that right, 365 stocks went up a 100x!!). And these were spread across a 40-50 year time period, which means there were a few stocks available every single year, which went up more than a 100x, over that time period. Just the names kept changing.

To quote some examples from the list, these were some stocks that went up a 100x across different time periods.

  • Anheuser Busch (Budweiser Beer) – 1935 to 1971
  • IBM – 1948 to 1971
  • Kodak – 1933 to 1971
  • Polaroid – 1955 to 1971
  • Development Corp. of America – 1967 to 1971
  • American Laboratories – 1964 to 1971

But what’s in it for us? Why is it important to study financial history? Because history is (sometimes) a reliable resource to make educated guesses about the future.

Mr. Buffett agrees.

30 Best Warren Buffet Quotes On Investments, Business & Life

What history tells us is that there are multi baggers in every single year. The good news is that over the next 10 years, in any 10 year period, there will be multiple stocks that will advance 10x, 50x, 100x or more.

Could Apple, become the next Apple, for us, the investors of today? If history is a guide, it’s very unlikely. As a co. becomes big, the law of big numbers catches up and co’s fail to maintain their growth rates. Fro any co. it is relatively easy double it’s customer base from a 100 customers to 200 customers than it is to go from 10 Crore customers to 20 Crore customers.

This means that the names of big winners change every 3 to 5 years, sometimes more often. But the good news is they take similar paths. Studying their identical patterns helps us in finding the next Apple, Infosys, Page Industries, Symphony, Titan or any other multi bagger stocks.

So how do we identify such stocks?

The author of The Next Apple rightly insists that the vast majority of big long term trends start with a breakout to new 52 week highs from a proper base, with each trend having varying underlying reasons. A proper base is something I am still working to figure out. But from the author’s description, seems like he means, 52 week highs with good volumes + consolidation.

Look at the 52 week high list

  • Look at the 52 week high list. It is often a shortcut to the minds of smart investors. It could also be a reflection of people’s ignorance and stupidity. It takes some practice to learn to how to use it properly.
  • Once you have identified a stock/sector from the 52 week high list, follow the thoughts of people with domain experience. You don’t need to know any people with domain experience personally in order to benefit from their wisdom as an investor. The beauty of the Internet and social media is that anyone has access to everyone’s brain for a marginal cost.

If you learn to do both, you are likely to catch quite a few of the biggest stock market winners.

The beauty of the stock market is that you don’t need to be the first or the original, to identify a trend. As the example of Apple & similar other stocks shows, you can be a bit late and still ride the trend by becoming a minority partner in wonderful, fast growing businesses.

Understand why the stock hit 52 week highs (52WH) or All Time Highs(ATH)

Now, hundreds of stocks hit 52 week highs every year. It doesn’t mean we go buy all of them. It means we become curious as to why a given stock hit a 52WH. If a trend is obvious (like the current pharma pack), and there is more steam left, then consider buying the stock. Hence, understanding the story behind the moves becomes critical.

Understanding the triggers behind a price move will give you the confidence to raise the stakes to meaningful levels.

“Sometimes, being a contrarian means staying with the trend.” – Steven Spencer

No one knows which ATH is the beginning or an end of a trend. No one knows how far or how long a trend could go.

Past performance could be an incredible source of investing ideas. Past performance, means 2 things:
1. Momentum – Stocks that outperformed in the past 3 to 12 months tend to continue to outperform in the next 3 to 12 months.
2. New 52WH – All long term stock market winners spend a considerable time on the 52WH list, if not the ATH list.

Why the 52 week high list is so important?

  1. We don’t want to be first. We want to be in stocks that move, and being on the 52WH list attracts a lot of attention.
  2. It is an important benchmark followed by many investors.
  3. You cannot make a cent before the market agrees with you. The market’s way of agreeing with you is sending your stock to the 52WH list.

Take the example of Avanti Feeds, starting from March 2011, a stock which went from 3 bucks to 950 bucks, a 300+ bagger, at it’s peak in Oct 2017.

The arrows in the above charts show how many times this stock hit ATH, in it’s 300x journey.

Now you may ask why did this happen? What triggered the very first ATH in this stock?

The answer is that the co. went from making a loss in 2010 to a fast grower. It’s profit zoomed like a rocket, thanks to all the tailwinds this shrimp feed business experienced.

Now even if one was late to the party by 4 years, and bought the stock a good 4 years later, in March 2014, he could have made a 10+ bagger (even after factoring the stock price crash in 2018.

Now, one could have validated the story from Avanti’s 2014 annual report and then taken a call. Despite the massive run up, the co. was still available at a market cap of 473 Crs, trading at 7 times FY 2014 earnings.

The same pattern played out in Ajanta Pharma.

Take the charts of any historical wealth creator and you’ll see the same pattern playing out. Multibaggers show up on the 52WH & ATH lists, time and again.

What about hindsight bias?

But isn’t all this hindsight bias and seem to be prone to judgemental errors? Prof. Bakshi once articulated nicely about how people overdose on being rational.

I think the point Prof. was trying to make was sometimes you have to decide whether you want to be rational or you want to be rich.

When it comes to learning from the past, it is ok to take a balanced approach and not overdose on hindsight and survivorship biases, while at the same time acknowledging the limitations of using historical data.

Should you go out and buy all the stocks on the 52WH or ATH list?

The answer is NO. But what it means is this should become your hunting ground for the next big winners in the market. It means you dig deeper into the catalysts that led to the stock showing up on that list. And if there are strong reasons to believe the story is likely to last a while, consider pulling the buy trigger.

When you’ve found out a good candidate amongst the 52WH list, other common sense rules of investing well, still apply. The main ones being business strength, management intelligence & integrity and buying growth & quality at a reasonable price.

Having a fundamental catalyst like a big earnings surprise behind a breakout to new 52WH improves substantially, the odds of finding a big winner.

What if you buy at the highest 52WH before the co. goes into oblivion?

Most trends last only a few quarters, but knowledgeable investors know how to take advantage of them and protect profits when the inevitable drawdowns come.

Assuming all other rules of common sense investing have been followed, if one still finds themselves in a falling stock, it is better to acknowledge his fault, cut losses quickly and move on to the next ATH or 52WH stock. At such times, it would be logical to follow the advice of the world’s smartest businessman.

Relative strength

Another good idea in the book is that of relative strength. Particularly during market corrections, it is important to pay attention to stocks that exhibit relative strength. It is a simple concept. Look for stocks that go sideways, or even up, while the indexes bleed. Once the markets start recovering, these stocks tend to outperform.

The importance of this idea has been categorically highlighted by Ivan Hoff in Chapter 7 – “If you remember only one principle from this book, it should be the concept of relative strength.”

The below charts of Hero Motocorp, HUL & Glaxo speak for themselves.

Summary

  • 52WH and ATH lists are an all important tool for idea generation.
  • We cannot make a penny without Mr. Market agreeing with us and his way of agreeing with us it by sending our stocks to the 52WH & ATH lists.
  • Big winners are found in every single year, every single bull market and every single bear market.
  • All other rules of common sense investing still apply to buying at 52WH and ATHs.
  • Don’t overdo rationality. Understand the trade-offs between being rational and being rich.
  • Cutting losses rapidly is a given when buying 52WH stories. If gap downs happen, god help us.
  • Relative strength is another very good tool to have in an investor’s toolkit.

-Barath Mukhi
-29th Sep 2020

Will investors lose money by buying stocks of Alembic Pharma, Aarti Drugs & Laurus Labs?

Is the current rally in Pharma stocks like Alembic, Aarti & Laurus (current sector leaders & market favorites based on growth in sales & profits) being driven by supply chain disruptions due to Covid19 or is this a secular growth story we investors are looking at?

Will investors lose money yet again, chasing hot stocks of a sector, everybody’s talking about?

To the answer this question, lets look at the sales data for all 3 companies.

Alembic Pharma

Aarti Drugs

From Aarti’s Q4 FY2020 Concall

Laurus Labs

Conclusion

The consistent growth in quarterly sales of sector leaders from the API segment is suggesting that certain tailwinds are helping the API sector (Laurus & Aarti), and this is more likely to be a long term trend rather than a one-off jump in performance due to Covid19 disruption. As the above charts depict, both Aarti & Laurus started doing well, at least 2 quarters before Covid19 disrupted API supplies.

Meanwhile, Alembic started doing well (Most of Alembic’s sales come from Generic drug exports), due to it’s focus on R&D and strategizing well, much before Covid19 tailwinds came by.

I believe, (and could be wrong), all 3 companies are likely to do well over the short to medium term because of the reasons mentioned above.

Disclosure – I and my clients have substantial positions in Alembic Pharma and Laurus Labs and my views are certainly biased. As of 19th August 2020, I do not have a position in Aarti Drugs. This blog is not to be construed as an investment advice. Please consult your investment advisor before investing.

Disclaimer: This is NOT investment buy/sell/hold advise. I am not SEBI registered. May change stance on above businesses anytime with new developments and/or new insights, and/or overall market conditions. May NOT be able to update periodically. Please do your own diligence and/or take professional advise, before investing.

-Barath Mukhi

-19-Aug-2020

Should you be worried about Pledged Shares & a lack of Free Cash Flows in Laurus Labs?

Firstly, I have been invested Laurus Labs since 600 odd levels and added more on the day this company declared Q1 FY2021 Results. Currently this co. forms a little over 10% of my portfolio.

Here’s how I thought about the company before investing.

Firstly, sales had been growing well.

I love straight lines, particularly the ones that are goin’ up and indicating there’s something nice cooking there.

Q1 FY2021 Revenue sources

Cumulative cash flows vs Cumulative profits are good.

Quarterly Sales were showing a nice uptrend. The co. had been on my radar since Mar 2020 because it had shown 2 quarters of growth in sales as well as Profits. In retrospect, I could have bought it a little earlier.

Anyway, the below increase in sales and profits should be seen in the context of the current Covid19 situation where every other business is struggling.

But see what was happening here, at Laurus.

5 quarters of increasing sales and profits in an environment where lockdowns and job losses are the norm, at least temporarily. Wow!

What got me worried though, was the trend in receivable days. Almost a third of the companies sales are being done on credit and not cash.

So, I came across a superb thought by another investor who said, receivables in the pharma sector usually don’t end up being bad debts and write offs because transactions between the seller and the buyer are usually over several years and customers are likely to be dependent on Laurus for future supplies. A data point to validate this would be the company’s sales growth. So there seems to be good demand for the company’s products and write offs seem unlikely.

High debt

Debt is 3 times cash flows generated by the co. If good times continue, then the co. may be able to pay off their debt in due time.

Debt to Equity at 0.6x. The cost of debt as per the company’s latest concall is 6.6% which provides some comfort because it is way lower than the Return on Equity of 15% delivered by the co. in FY 2020. And this ROE was delivered despite a significant amount spent on Capex.

Free Cash Flows – From the company’s FY2020 Annual Report

Changing Revenue Mix

Booming Generic Finished Dosage Forms Business (FDF)

In Q1 FY 2021 alone, the company’s Generic FDF division delivered sales of 351 Crs compared to 46 Crs in all of FY 2019 and just 6 Crs in all of FY 2018.

Growth expected to continue in FDF as per Q1 FY2021 Concall

Booming Contract Manufacturing / CDMO / CRAMS Business

Growth in CRAMS expected to continue as per Q1 FY2021 Concall

Pledged Shares

There are concerns that promoters have pledged shares and this combined with the fact that this co. is based out of Hyderabad (rings a bell, fellow investors?) seems to make a lethal combination. Doesn’t it?

So as per a recent disclosure the 3 promoters who have a cumulative 1 Cr shares pledged out of their total holding of 3 Cr shares, recently got 25 lac shares released from Axis Finance Ltd.

The below graph shows the 3 promoters still own a lot of unpledged shares in the company. Besides, promoters of fast growing manufacturing companies are often expected by lenders to pledge shares to ensure skin in the game. So the promoters pledged a third of their stake to do capex and grow the business, which is fine, in my view.

I bought the stock at a little below 20 times FY20 earnings. For a fast growing co. with a reasonable ROE of 15%, and with tailwinds due to global supply chain disruptions, this is an attractive valuation in my view.

Free Cash Flow vs Growth

Some investors recently raised a red flag about the company lacking free cash flows, on Twitter. This is the typical debate that occurs between a value investor and a growth investor.

Growth investors want the co. to keep reinvesting as long as there are good opportunities for high return on capital growth.

On the other hand some value investors look for companies with cash on their books. I counter that by saying that the markets reward companies that can reinvest all that money and keep the ROE above the critical threshold of say, 15%. Mr. Market doesn’t like companies keeping cash in the bank and I have a ton of such examples.

Promoters

Day to day affairs of the co. seem to be headed by Dr. Satyanarayana Chava. He started the co. in 2007 by investing Rs. 60 Crores of his own money.

Dr.Satyanarayana Chava, @Economist India Summit 2017

It is a phenomenal achievement to have reached 3000 Crs + Revenue in a span of 13 years. So, the gentleman certainly knows what he’s doing. In the past, he was the COO of Matrix Laboratories and has a few decades of experience in the Pharma industry. It always excites me to partner with first generation businessmen who’ve come up the ladder despite all the challenges they might have faced in their entrepreneurial journey.

Risks

  • Around 15 to 20 Crs out of Q1 FY2021 profit of 172 Crs came from Forex gains. So Forex gains contributed about 10-11% of last quarter’s PAT. This may or may not continue depending upon currency movements.
  • Increase in interest rates could lead to pressure on margins, if debt is not reduced.
  • If demand tapers off, then Capex cost may not translate into profits.
  • Who succeeds Dr. Chava in the future will decide the growth trajectory of this co. whenever the time comes from him to step down.

Disclosure – I and my clients have substantial positions in this company and my views are certainly biased. This blog is not to be construed as an investment advice. Please consult your investment advisor before investing.

Disclaimer: This is NOT investment buy/sell/hold advise. I am not SEBI registered. May change stance on above business anytime with new developments and/or new insights, and/or overall market conditions. May NOT be able to update periodically. Please do your own diligence and/or take professional advise, before investing.

Barath Mukhi

5th August 2020

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