The value of a debt free company has to be substantially more than the amount of debt it can comfortably service. It's a principle which was first laid out by Ben Graham in Security Analysis and he wrote about it again and again in successive editions and he produced examples in the annexure that this is a company, this is the valuations in the market, this is the amount of debt that it can comfortably finance, it is a debt free company -- why are the stockholders of this company valuing in this company at such a low price?


I'd like to give an example of a person who is in financial trouble and he goes to a pawnshop and tries to take a loan against his watch. The owner of the pawnshop when he gives out the loan against the security of the watch, wants to make sure that the money he lends is a lot less than the value of the watch. And that's exactly what happens when you go to any lender. If you are a good lender, then -- and if you are lending money to a business, then you want to make sure that the business to whom you are a lending money is worth a lot more than the amount of money that you want to lend to that business. But the stock market doesn't always think like that. Let me give you some examples.


Here is an unleveraged company A. It's got no debt. It's an all equity finance company. And it has 5 years average profit before interest and taxes of say Rs. 100 crores per annum.





Let us say that A raises Rs. 250 crores by issuing 10 percent bonds and distributes the funds to its shareholders as dividend, which means we are recapitalizing the firm. You are borrowing money and giving it out as dividend. So the total capital in the company remains the same, it's just that the debt-equity ratio changes. Debt was zero, now it is there. Equity goes down, debt has gone up. Total assets remain unchanged.


Now come to think of it, this company which was a PBIT of Rs. 100 crores is issuing bonds for only Rs. 250 crores of 10 percent interest, which means the annual interest will be only Rs. 25 crores, which means the interest cover is -- if you look at it from the perspective of the income statement -- four times, which means it is very safe from a bondholder’s viewpoint. This means the bond fund managers will be pretty happy to give that kind of money to this company against the security of its cash flow and assets. So that's the kind of money this company can easily finance from its cash flow.


From where do the bond holders of this company derive their safety? Their safety comes from the same PBIT number of Rs. 100 crores. Because if this number collapses their bonds are in jeopardy. If this number remains big, the bonds are going to be serviced without a problem. So the bonds are going to enjoy a high credit rating because the interest cover is 4. And these bonds will have a market value of about 250 crores.


Then, what this principle that I have mentioned in the previous slide states is as follows:


The fair value of A before recap cannot be less than the amount of debt it can comfortably service.


It's a very simple mathematical principle which often breaks down in the stock market, providing very interesting opportunities which I will explain in a moment, but just think about it -- you will have to agree with this, that unleveraged company A's market cap cannot be less than this debt part of the leveraged company A, because both these companies are essentially the same companies. The total capital in the companies is the same. Debt is there in company A recapitalized, it was not there in pre-recapitalized unleveraged company A. That's the only difference.


So all that this principle says that it is mathematical impossible for an unleveraged company A to be less than the amount of debt that it can comfortably finance. And in this case we have done the calculation. It is coming to about to Rs. 250 crores.


Then, supposing this unleveraged company A is less than Rs. 250 crores. Now you are going to ask yourself a question, why is it less than Rs. 250 crores?


Because any bond investor, a rational bond investor - a bond fund manager, for example, will gladly subscribe to Rs. 250 crores bond issue of this company against security of only a part of its assets.


If the bond market will value only a part of this company for Rs. 250 crores, then the value of the entire company must be a lot more than Rs. 250 crores, because of the principles of prudent lending requires that kind of lending practices.


If the stock market continues to put a low value on this unleveraged company A, then its board of directors can magically create these own bonds by writing out these bonds and distribute them to the stock holders which they can then sell for Rs 250 cr., and still leave them with their equity ownership intact. Can they not?


Leverage can play an important role in aligning the interest of the stockholders with that of the management, but that's beside the point. I am not arguing about that right now. I ignored the tax factors and all those other things, what I am saying here is that you can't say that this unleveraged company A will be less than the amount of the bonds that the bond investment community will buy without hesitation of the same company. Let me explain. I will give you more examples in a moment.


This concept of distribution was actually given by Graham in his book, Security Analysis, first edition. He gave an example of a company called American Laundering Machinery and I think you should all go and read that example -- if they have this book over here -- it will be very interesting to see what he had to say. And he said that it's ridiculous to think that the bond market is willing to buy bonds of this company and give it Rs. 250 crores and the stock market values this whole company for less than Rs. 250 crores, which has no debt in it. And if that's the case then the solution of the problem has to be that the board of directors create these bonds on a piece of paper and distribute them to the stockholders in proportion to the shares they hold, in effect doing a leveraged recap, delivering to the stockholders of piece of paper that has a market value of Rs. 250 crores and they still have got the original shares with them which is also have a value. So you force the market to correct its mistake.


And I think some of the things that have happened in the U.S. are going to happen in India pretty soon, because I think a company should act when they find their stocks are battered or valued too low. And some of them might be doing that. I don't think that was the logic for the bonus debentures issued by Hindustan Lever, but I think that might have been the logic recently for Marico. If you read the report two days back they are planning to have a meeting where they will consider distributing bonus preference shares to their stockholders. And there have been others. Some years back if you remember NALCO did something like that. They converted half their equity share capital into bonds and distributed them to the stockholders. So this leveraged recapitalization could be a very useful way for companies to ensure that the stock markets don't undervalue them. This particularly applies to a debt free company because they can borrow money and distribute to stockholders and deliver them a value sometimes more than the market cap prevailing before the leveraged recap.


Here is a quote from Ben Graham's Intelligent Investor which describes what I have just explained:


"There are instances where an equity share may be considered sound because it enjoys a margin of safety as large as that of a good bond. This will occur, for example, when a company has outstanding only equity shares that under depression conditions are selling for less than the amount of the bonds that could safely be issued against its property and earning power. In such instances the investor can obtain the margin of safety associated with a bond with all the chances of large income and principal appreciation inherent in an equity share."


And this is what he said in Security Analysis:


"An equity share representing the entire business cannot be less safe and less valuable than a bond having a claim to only a part that of."


And this is what one of the partners of Tweedy Browne, a company which follows Graham's techniques of investment in the U.S. said:


"Our research seeks to appraise the intrinsic value of a share by estimating its acquisition value or by estimating the collateral value of its assets and/or cash flow. We believe the process is related to credit analysis as we are seeking collateral net worth in excess of the cost of our investment."


So, what in effect I am trying to say here is that when we are looking at debt free companies or near debt free companies and there are plenty of those around -- we should think of the stocks of such companies as stocks with bonds hidden inside them and we can value the bond component as we know what price the bond market will pay for those bonds. And if you can get the entire stock without the bond component in it for less than the amount of the bond component, then you have got yourself a bargain. Examples:


Example 1: Gujarat Mineral Development Corporation





Here’s a company that generates tons of cash whose stock had been languishing at Rs. 30-40 levels, has recently gone up in the stock market. Market cap before the rise was Rs. 140 crores and unutilized debt capacity was Rs. 260 crores. Which means that if you look at the numbers and you do an analysis, you look at the cash flow statement and you look at the P&L account, you can come to the conclusion that this company which is debt free and easily finance Rs. 260 crores of debt from its operations. But the stock market was giving you the entire company for Rs. 140 crores. So you buy such companies and put them in your portfolio because this satisfies this criteria of this theme -- stock price less than debt capacity in a debt free company.





Example 2: Zodiac Clothing


Market cap -- Rs. 13 crores, I am talking about a year back. Unutilized debt capacity -- Rs. 15 crores. Again the assumptions are given at the bottom, the company had nine years average PBIT of Rs. 7 crores. If you assume the interest cover of 4 and actually if you go to the bond fund managers, if you go to the bank they would easily lend this company money on the basis of and interest cover of 2 1/2 - 3. But I am talking about an interest cover of 4 here. Also, I am assuming an interest rate of 12 percent. Today, this company can easily borrow money at 9 or 10 percent or even less, but I am assuming 12 percent. My assumptions are based on the figures of that time, so I am giving you the prevailing interest rates at the that point in time. So, you have a situation where a whole company is available for Rs.13 crores and it can finance debt of Rs.15 crores. So it's a buy. And you just buy it and put it in the portfolio. You don't care what the analysts are saying, you don't care about how the industry is doing. You do know that the cash flow of the company are likely to be volatile perhaps, but they will be able to sustain, without problems a debt capacity of more than the market cap. And that's all that you need to know. At least in the context of the value investing that I am talking about





Example 3: Blue Star Infotech


This company, which was de-merged from Blue Star, the air conditioning, had a market cap of Rs. 30 crores but the unutilized debt capacity was Rs. 33 crores. Again a debt free company


Question: How much below cash should a stock trade before it becomes a buy?


Answer: What I am saying here is that you should buy companies that are selling below cash. You don't have to buy them selling at 30 percent below cash or 50 percent. Below cash is good enough. They may go down further still, you can never know how crazy stock market can be. So they can go down further still, which means you have to continue buying, but you have to stop when you think you have reached the exposure limits. You have to diversify. In that sense you are buying something extremely cheap. It's hard to lose money there. And what history shows that these stocks actually do tend to get valued up. Just think about it. When I talked about cash bargains what did I mean? See, there is a concept of book value, what is book value? Fixed assets plus current assets -- within current assets there is inventory, there is debtors, there is cash and then current liabilities are reduced. And then there is debt on the liabilities side. Now when you are talking about book value, you mean add up all the assets and deduct all the liabilities including current liabilities and divide by the number of shares outstanding, that gives you the book value. Now, cash value per share is a very small subset of that book value.


You know when some people say that a stock is selling for less than book value is a value stock. But, I don't agree with that. When I say that stocks selling for less than a very small subset of that book value (i.e. cash value) are value stocks is a very different thing to say. Because in that book value you are eliminating fixed assets. In that book value you are eliminating a substantial part of the current assets, which is the inventories and the receivables. You are only counting the cash and the cash equivalents. And you are using that small number on the assets side of the balance sheet and deducting the entire liabilities side. And then you are comparing that number with the stock price or market cap and then you are finding that the market cap is less than that number. I think you don't need to be more conservative than that. So, in that sense I am saying you don't need to say that I want to buy at 50 percent of cash. So you have already taken into account by saying that I don't want to buy discount to book, you are buying discount to cash.


Question: How long one should hold on to such stocks?


Well, I don't know the average holding period but you get paid for waiting. I will tell you why. What happens in these stocks is when you are looking at deep value stocks, you often end up with high dividend yields also. So when you end up with a decent dividend yield of, say, 10 percent, then you are being paid to wait. You can wait indefinitely because the cost of waiting is not there. So if you combine this theme with a high dividend yield theme you have got yourself a winning combination because you can then wait without feeling the pinch of waiting. But to answer your question, what is the average holding period? I think average holding period in this case would be no more than a year. I have looked at maybe about ten below cash stocks in the last 8 or 10 years you don't find very many out there, in the sense that what I am trying to say here is maybe more applicable for the individual investor and more applicable for smaller pots of money and most certainly it is not applicable for the Birla Mutual Fund because you can't put lots of money in these sort of stocks because of the amount of the money that you manage. But my point is that if you buy -- for an individual investor, if you just buy the shares and keep them in your portfolio, almost all your equity money is invested in deep value shares. Now the only thing that can go wrong is if the whole country tanks, which can happen.. After all you are investing in equities and the country goes down and equities market goes down with it. But those are risks which I think are worth taking. At least you will go down less than what the others go down. But the other point is that from my experience I think no more than one year is the holding period.


Question: Can you explain theme 2 again?


Answer: This second theme, I think, is hugely interesting to me in the sense that I find it very useful to look at a debt free company or a near debt free company from a bond holder’s perspective than from a stockholder’s perspective. Because if I can get the whole company for less than what a creditor will give this company on a conservative basis, I know I have got a bargain. Now I don't have to argue with anybody with that, I just buy the stock and put it in my portfolio and inevitably they it goes up -- at least till now I have not had a bad experience in any of these situations. But I have to admit that you can't put large sums of money in these sort of situations. But you can put fairly, you know -- small sums on maybe you know Rs.10-15 crores is pretty much the maximum amount of money that you can put in these sort of situations. So if you are managing lots of money, this is not going to work.


Debt pay down.


This is the third theme that I want to talk about and again the principle is very simple. It's an academic principle, coming from corporate finance -- it's very simple.


When a leveraged company selling for a very low P/E ratio starts paying down debt from its cash flow and/or asset sales, then the value of the equity in that company rises automatically and quite dramatically. It's a theme, it's a value theme -- you are already paying a low price of a highly leveraged company, so I am moving from one extreme to the other. I am moving away from value investing in debt free companies (theme 2) to value investing in highly leveraged companies (theme 3), which may be in financial trouble, which are in a debt trap, which are on the verge of default, but have got their act together. They sell off some businesses, they do some VRS, they restructure and they get the money to pay down their debt. Now because this stock is already selling for a low P/E or P/C multiple when they pay down debt, it will have a dramatic impact -- the sensitivity of the bottom line numbers to debt pay down will be very very large. And it will happen an automatic impact on equity valuations, eventually if not immediately reflected by the stock market.


And this is true even if the profit before interest remains unchanged. I am not looking at growth in the top line, I am not looking at growth in margins. I am only looking at reduction in the interest expense of a highly leveraged company, which should result in an increase in the stock price, over time - it's that simple. You think of a company as a pizza. Now the pizza's value is based on the cash flow before interest. Now that value should remain unchanged if you believe in Modgiliani & Miller regardless of what the debt ratios are. Now as debt is being paid down, equity is automatically going up, because the pizza remains the same. It doesn’t matter whether you think of it in terms of P/E multiple expanding because the company is becoming less leveraged, and therefore less risky, or the way I like to think of it as a pizza. When debt goes down, equity should automatically expand. And when you think about that you come up with some very investing companies once in a while. But in these kind of companies you got to be patient because debt pay down does not get immediately reflected in increased equity value in the market as the market is pretty skeptical about it. Because companies which have fallen on bad times, because of excessive debt did so because of managerial mistakes. And markets are very skeptical about these companies coming out of the problem they are in. So even though they are gradually paying down debt, markets may take some time to realize or rather to acknowledge that there has been a major improvement in debt pay down. So, the pizza is actually shrinking -- debt is going down, so the market value of debt is coming down, but equity is not expanding in the market as quickly. Which I think for value investors is actually an opportunity. Because if you have conviction in debt pay downs happening gradually, then you can take advantage of that.


And I will very quickly put up to 3 slides -- I will give you three different examples.




One was the case of SRF, a company which fell on very bad times some five or six years ago because they made a overpriced acquisition and financed it with short-term debt. But they got their act together. They sold off a lot of businesses, they refinanced debt, they made asset sales and paid down debt and they got lucky -- interest rates came down. And they didn't make any other mistakes after that and they did a phenomenal acquisition, acquiring a plant for virtually nothing -- the Dupont plant. And they have done a lot of good things and in the process they have allocated capital well, they have been able to pay down debt and if you look at the sequential interest expense over the last maybe 10 quarters, you will see every quarter, the interest is down by Rs.1 1/2 or Rs.2 crore. So you think of it like that if Rs.2 crore deduction in interest expense every quarter translates into say Rs. 10 crore of incremental profit in a given year and you have a 6 1/2 crores shares outstanding, you have an incremental EPS of Rs.2 - 2 1/2 and even if you give incremental EPS a multiplier of something like two or three, you have a Rs.6 or 7 increase in stock price every year. And for a Rs. 20 share, that's a phenomenal return to get. So in a sense this company is doing what you call in a "reverse LBO" A company has leveraged itself up to the hilt and it is gradually lowering the debt. And when it does that, the value of the equity has to automatically expand.



There are two other examples that I want to put up here. One is the case of Regency Ceramics, again a company which has been in the limelight recently. The stock price has just shot up but even at this price it looks cheap in relation to the profits that this company is generating. But the more important thing is how this company will paid down debt in the succeeding quarters. And you are able to visualize what is going to happen to the bottom line numbers when they do that.




The third company which comes in this is again counterintuitive. It is Hindustan Motors of all the companies. A company whose stock was selling at Rs. 5 at one time and again a highly leveraged company, but they sold a division for a lot of money. They sold their Earth Moving Division and retired high-cost debt.


In this theme what you need to do is to glance at the newspapers once in a while and look for transactions where highly leveraged companies are selling off assets and you know that once having learned the mistake of not having gone in that business in the first case and now getting out of it, may be for lots of money, and they are not likely to make the mistake out of diversifying, because that takes up more time. They will make that mistake maybe two years from now when they are becoming more profitable but right now debt is at their door. They have to pay off their creditors. And the moment they pay off their creditors, the value of the equity goes up. And it goes up in two ways. You see the interest expense of highly leveraged companies is already very high because it's a risky company from the lender's perspective, they charge a very high rate of interest. Now, when you are paying down debt, your interest expense goes down for two reasons. One, the principal itself has gone down and second, as you become more secure, you can refinance debt at lower rates. Combined with the situation where interest rates are generally coming down in an economy, you have got a triple factor in your favor.


But what, you may ask, about the management factor? You know, I am not at all happy about the way Hindustan Motors has been managed over the last so many years, but it doesn't matter. That's the key thing. I know it's very controversial what I am saying here because almost any investor that I talk to emphasizes the management factor a lot. Whereas if you read Graham's book carefully, he said I don't even want to know what the company is doing, I don't even want to know who the manager is. I want to go by the numbers. And I want to diversify a lot. So if I am wrong in some of them because I didn't check out the management and I did a check out the prospects, if something went bad, it's OK, because I have so many other stocks in the portfolio which are so dirt cheap and they are going to do well, it's OK. So every insurance company doesn’t do a check on your character, but if you have a bad character, you can swindle an insurance company. But those are acceptable risks which are taken care of with the principle of diversification.