The Last Attendant

The scrips traded on BSE have been classified into various groups.

BSE has, for the guidance and benefit of the investors, classified the scrips in the Equity Segment into 'A', ‘B’,'T', ‘S', ‘TS' and 'Z' groups on certain qualitative and quantitative parameters.

The "F" Group represents the Fixed Income Securities.

The "T" Group represents scrips which are settled on a trade-to-trade basis as a surveillance measure.

The "S" Group represents scrips forming part of the "BSE-Indonext" segment.

The "TS" Group consists of scrips in the "BSE-Indonext" segment, which are settled on a trade-to- trade basis as a surveillance measure.

Trading in Government Securities by the retail investors is done under the "G" group.

The 'Z' group was introduced by BSE in July 1999 and includes companies which have failed to comply with its listing requirements and/or have failed to resolve investor complaints and/or have not made the required arrangements with both the depositories, viz., Central Depository Services (I) Ltd. (CDSL) and National Securities Depository Ltd. (NSDL) for dematerialization of their securities.

BSE also provides a facility to the market participants for on-line trading of odd-lot securities in physical form in 'A', 'B', 'T', 'S', 'TS' and 'Z' groups and in rights renunciations in all groups of scrips in the Equity Segment.

With effect from December 31, 2001, trading in all securities listed in the Equity segment takes place in one market segment, viz., Compulsory Rolling Settlement Segment (CRS).

The scrips of companies which are in demat can be traded in market lot of 1. However, the securities of companies which are still in the physical form are traded in the market lot of generally either 50 or 100. Investors having quantities of securities less than the market lot are required to sell them as "Odd Lots". This facility offers an exit route to investors to dispose of their odd lots of securities, and also provides them an opportunity to consolidate their securities into market lots.

This facility of selling physical shares in compulsory demat scrips is called an Exit Route Scheme. This facility can also be used by small investors for selling up to 500 shares in physical form in respect of scrips of companies where trades are required to be compulsorily settled by all investors in demat mode.

I came across this very unpopular book "Why smart people make big money mistakes and how to correct them" by Gary Belsky and Thomas Gilovich, so I thought that I should try to concise the book so please bear with me...

Here are the principles:---
1)Mental Accounting - is a term used to describe the way people tend to treat money differently depending on where it comes from,where it's kept or how it's spent. It can be useful habit when it leads you to treat savings for college or retirement as scared. But it can be dangerous when it cause you to spend money from some sources- such as gift,bonuses or tax refunds - more quickly than your might otherwise.Think about it and you will realize that you are caught with this bias.

2)Loss Aversion - One of the central tenet of prospect theory - a bedrock principle of behavioral finance - is that people are loss averse . The pain people feel from loosing Rs1000 is much greater than the pleasure they experience from gaining the same amount. this helps to explain why people behave inconsistently when taking risk.. For example the same person can act conservatively when protecting gains ( by selling successful investments to guarantee the profits.) but recklessly when seeking to avoid losses(By holding on to losing investments in the hope that they will become profitable).

3)The sunk cost fallacy - one of the most common behavioral finance mistakes, results in financial decisions that are based on previous investments or expenditures. Such a tendency is harmful for the simple reason that past mistake shouldn't lead you to make future ones.The past is past and what matters is what is likely to happen from now on .Well this is one of the tendency why so many government projects fail in the first place or took too much time for completion.Because once started they can never be closed because so much money has already been spent.

4)Number Numbness: This is the one which haunt most of the people and is again very dangerous . I have been a victim of it before I read something about it in Prof. Bakshi's blog. People give too much importance to big numbers an too little importance to smaller one. This is one of the reason value stores are still lagging behind kirana stores, though the saving potential in value store is more than general corner kirana store.People never thought that these small costs are the main criminals in there financial planning.Bigness bias is another term for this.This can also lead you to pay more than you need to, for the brokerage commission and mutual fund expenses.One common example is, many between us think that investing in a small mutual fund will lead you to greater returns but this is not at all true. Below is an example of sundram Tax saver recently noted No.1 tax saver fund and SBI Magnum Tax gain , both growth. Now both these funds have beaten the sensex since long(SBI Magnum has beaten it since 1996) but SBI magnum has also beaten sundaram since the start of sundaram I don't know why but high expense ratio is a surety.













5) Anchoring: The tendency to weigh certain facts , figures , and events too heavily and make your decision based on those. Example , you came to know that your friend has bought an antic for rs10000 then you will linger to that figure to buy one for you although it's not worth it. You can replace antic with anything : a fine buffet, buying a house, or anything.You just linger to the figure your friend has quoted and would always like to strike a better deal . After all you want to realize everyone your rationality.

6) Decision Paralysis : - Simple! most people never came to decision and keep on fighting with themselves to prove the points wrong. They seek lot of information , do thorough research and but are still skeptical about making a decision to buy any investment, buying a house etc.

Well these are some of the thoughts, Behavioral finance is a vast subject , once you overcame some of the biases, you will realize that you will get an edge towards so many psychological forces which are trying to beat you.

There is one more great book on Psychology :-- "Psychology Of Persuasion" By Robert Cladini,a great reads to.

Thanks,
Ashutosh
"Reading great books is a better concentration technique than doing Yoga :-)"

For this column, I am grouping institutions of all stripes -- be they money-center banks like Citigroup (NYSE: C), regional banks like BB&T (NYSE: BBT), or savings and loans like Washington Mutual (NYSE: WM), under the generic title of "bank." While there are differences among the types, that's a topic for another day.

The basics
Let's start off with a brief examination of what banks do. Simply put, banks buy and sell money. Banks purchase money through deposits like checking and savings accounts; CDs; and debt or equity financing, or both. Banks sell money by making loans or investing in securities, or both. Buy low and sell high -- value creation at its finest.

Most, if not all, banks also make money from a constellation of fees and service charges. Some will even sell off almost all of their loans shortly after origination. Furthermore, many banks also have other income-producing operations, like asset-management and insurance businesses.

Interest rates are important to banks because they essentially determine the price at which money is bought and sold. But it's not particularly Foolish to make sweeping statements like "rising/falling rates are bad." Good bank managers are neither stupid nor helpless, and they can adjust to different environments.

To a large extent, then, the more important factor is how interest rates behave relative to a bank's management's expectations. If managers are preparing for higher rates, and those higher rates don't materialize, it's likely that the business won't perform as well as hoped (and vice versa with falling rates). Unfortunately, there really isn't a handy ratio or formula to easily establish management's expectations. It requires paying attention to Securities and Exchange Commission filings like 10-Ks and 10-Qs and management comments during conference calls.

Growth
There are many moving parts to a bank. It doesn't really have revenue in the normal sense of the word, but you can look at the combination of interest income (minus loss provisions) and non-interestincome as a proxy. Clearly, you'd like to see these numbers going up.

Deposit growth and loan growth are also both important. If deposit growth is weak, other more expensive sources of funds might have to be tapped. Likewise, if loan growth is sluggish, it will be more difficult for the bank to earn a profitable spread on the money it controls.

Let's also not overlook earnings growth -- a growing bottom line is just as important to a bank as any other company. So, for all of the fancy or confusing concepts that follow, don't forget that income and per-share earnings growth are still important.

Profitability
As is the case with any business, profitability is paramount to banking success. Strong profitability can easily spell the difference between an average stock and an above-average winner.

Net interest margin is a good baseline measurement of the profitability of a bank's core lending and borrowing business. Net interest margin is basically the difference between interest income (loans, securities, et. al.) and interest expense (deposits, borrowed funds, et. al.). In some ways, I suppose you could think of it as a bank's gross margin.

When analyzing net interest margin, I'd suggest you do so in the context of similar banks and their strategies. Among banks in similar lines of business, higher margins can be a sign of great management. But it could the result of riskier lending policies. Narrower margins can suggest trouble on the deposit side and a higher cost of funds. Or it could mean more conservative lending practices. Context matters when comparing numbers.

The efficiency ratio is another useful metric. There are different ways to calculate this number, but the fundamental underpinning is the same: It is designed to measure the ratio of non-interest expense to income. Ideally, you want this number to be as small as possible -- the smaller the number, the less being spent on things like marketing, salaries, and branch expenses, and the better the earnings.

Assets
A bank's capital structure, asset quality, and liquidity are all important. Because the spreads on borrowing and lending money are relatively narrow, banks employ considerable leverage to pump up their earnings power. To make sure that banks don't overdo it and imperil their solvency, bank regulators impose limits.

To be "well capitalized," a bank must have a ratio, expressed as a percentage, of risk-based total capitalto total assets of 10%. ("Risk-based" refers to certain adjustments that are made to reflect that some assets -- like cash and treasury securities -- are less risky than others.) Likewise, shareholders can examine the ratio of shareholders' equity to assets to get a grasp on whether the company is increasing or decreasing its leverage.

Asset quality is important; if people don't repay their loans, the bank in question will have some problems. Numbers to look out for include net charge-offs, the percentage ofallowance of loan losses to total loans, and the percentage of non-performing loans tototal loans. Watch their trends to see whether asset quality is going downhill.

Liquidity is also important in the banking world; it basically reflects how easily a bank can lend money. If a bank is very liquid and has a lot of cash on hand, it can respond very quickly to new opportunities. Of course, there is an opportunity cost associated with keeping cash on hand -- you may lose out on what you could make by lending it out. So if a bank is too liquid, it's leaving money on the table. There are two quick ways to check liquidity -- the percentage of assets held in cash and treasury securities and the loan/deposit ratio. Ideally, this latter number should be near 100% for most well-capitalized banks.

Performance
All other things being equal, it's generally a good idea to invest with the folks who've proved that they can make the most money with a given amount of capital. One way to make that judgment is to look at a company's return on assets and return on equity. In a sense, these metrics capture the end result of a management's decisions on liquidity, leverage, credit quality, and other operational options.

The one note of caution I'd sound on return on assets is that you should make sure you're comparing banks with similar business models. Banks that generate a lot of non-interest income, like Bank of New York (NYSE: BK), can sometimes require less assets on a dollar-for-dollar basis than more lending-focused banks. So comparing across these lines can give you misleading results.

Return on equity is also highly useful for me. I like that you can break it down into net margin, asset turnover, and financial leverage and study how and why one bank may be better than another. Moreover, I've found that banks where management has consistently produced above-average return on equity are often above-average performers in the stock market.

Know the business
There is no such creature as a "typical bank" -- each has its own nuances and individual risk factors. Take beleaguered DoralFinancial (NYSE: DRL), for instance: While it looked good by the numbers and had a heck of a run, there was a ticking time bomb in the way the company valued aspects of its mortgage operations. Had you simply relied on the numbers and not dug into the 10-K, you could have easily been fooled into thinking the bank was safer than it really was.

Knowing the business is also important when you compare banks. Comparing a huge money-center bank like KeyCorp (NYSE: KEY) with a regional bank like Bank of theOzarks (Nasdaq: OZRK) just doesn't make sense. So the more you know about the business, the more likely you are to understand what the numbers are really telling you.

Don't overthink this
We have offered this brief treatment on bank stock analysis to help you with your evaluations of these stocks. But as is always the case, numbers tell only a certain side of the story. It's important to do your own due diligence and strive to really understand the policies, strategies, and expectations of the company in question before buying a small piece of it.

True, the banking sector has some unusual ratios and metrics for measuring performance, but don't get bogged down in the details. Ultimately, the pattern of success behind a bank stock investment is little different than that for most any other company -- a pattern of consistent growth in earnings, dividends, and assets, skillful and honest leadership, and expectations of further growth.

United Spirits Ltd:--
Equity -2009.32 cr
debt :- 1162.08 cr
at 12.5 or more expensive 13% interest rate 152 cr interest annually which is fully supported by the 5 year average PBDIT of the company. So it is well withing it's debt capacity.


Same is the case with United Spirit Breweries so no problem.

Now coming to KF airlines:---
Now let Mr.Mallya keep saying that losses has been reduced to rs 5 cr. Even if we don't give any heed to this let see what is in the hands of lenders and shareholders infect I don't care about KF airlines shareholders because they have put there money in a bad business, But still for United Spirit let's see how it's lenders' money is secured by the assets alone.(I don't know if lending has been completed or is in the talks but still see to the figures):----

KF airlines:--
Equity 192.87 cr
Debt 934.38

Final figures:--

equity 192.87cr
debt 1934cr (After rasing debt)

This debt has to covered by assets for lenders to restict themselves from exercising pledged shares.

Now the fleet of KF airlines include A319/A320/A321, ATR etc and around 71 in service flights.

Lowest Model ATR costs around 12-16mn but I'm considering only 10mn USD. it has a fleet of 27 ATR so the value is Rs 1188Cr.

Lowest model Airbus it has A319 costs around 44mn USD so it has a fleet of around Rs 7700Cr.

Moreover it can make money in trading in aircraft delievery slot. Search internet to get what it really means.

so Infect it is covered well by it's assets even if you take 50% margine of safety. And I don't think any lender will exercise the shares even when it's sure to get it's entire money,from asset sell.


I find no reason that investors should dump this stock. Well let some do but let the others more considerate ones, be aware of the facts and then take decision. These conditions are very rare and investors should take full advantage of this. I don't see any problem with US Business but I do am concern about there airline business which as always been a wealth eroding business but if Mallya can do a turnaround of KF airlines I'm sure this will be a good sign for KF Shareholders.Till then happy investing.

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.

After reading a lot by Phil Fisher he has become my second favorite after Mr. Warren Buffet. His unique sense of business and that too in manufacturing industry is commendable. I don’t know why but he is not so popular like Benjamin Graham. The most important learning these people share with us is there Business knowledge in different industries. Where Buffet is more inclined towards industries which have simple business and have really long term capital generation power and which took very less extra cash infusion and which gives good dividend (read his letters for more knowledge about his dividend theory it’s exceptional) , Fisher is more inclined towards manufacturing companies which infuse good amount in R&D and bring out extraordinary capital appreciation for share holders but then doing fisher like investing is very tough where he depend less on companies balance sheet but more on the outcome of his research about the company which invlove more of a field work. Although I have tried to do his kind of research using many public forums, company employee forums and one thing is for sure scuttlebutt is not an easy task becasue I can not directly go and talk to key people as far as my current situation is concerned.
So I’m now working with a new philosophy and it has given me exceptional results. I’m using a mix of philosophy of Buffet and Fisher. First I’ve drawn geographic boundaries around Bangalore and currently I’m not thinking of crossing them. Well in future I’ll cross them that's for sure. But the ease of analysing the company and its employees and talking to them has never been
this easy for me where I use different public websites and groups. Moreover ,apart from IT Bangalore is becoming a hub for many great companies which are not at all related to IT(I usually restrain myself from investing in this industry although I understand the criticalities of the business but if you find a management at par with Infosys try your luck). I have divided my available fund depending on where there is more upside and spend them entirely on some great business’ which are growing here. And obviously I have done thorough research of these companies and in due time, have learnt there businesses too.
Almost daily I’m reading different advices by some market experts, about buying some stock or in some sector. Well I have already tested there mettle before start on my own. There are people who are running different blogs advising about future multibaggers on the basis of some daily news papers or magazines, but they very much forget the hidden business economics which is generating or not generating cash for the business.Take for example Satyam about which one of the blog from some hyderabad based investor was advising about buying the stock,he is even recommending that while businesses which are in nich sectors it's useless to even look at the annual report.Well I pity them wheren instead of looking at the actual cash on the table for satyam they were looking at the earnings report. I suggest you all to remove all the other's and non cach charges or income while calculating the yearly earnings. It's your money and don't be emotional while spending your money as most of the well wishers of Mr.Raju has done,and they are repenting now. Read about American Express Salad oil Scandal and Enron Scandal where to get a better picture.

Finally for business Insight Read these lines from Buffet’s Letters:---
Businesses – The Great, the Good and the Gruesome

"Charlie and I look for companies that have a) a business we understand; b) favorable long-term economics; c) able and trustworthy management; and d) a sensible price tag. We like to buy the whole business or, if management is our partner, at least 80%. When control-type purchases of quality aren’t available, though, we are also happy to simply buy small portions of great businesses by way of stockmarket purchases. It’s better to have a part interest in the Hope Diamond than to own all of a rhinestone."
"A truly great business must have an enduring “moat” that protects excellent returns on invested capital. The dynamics of capitalism guarantee that competitors will repeatedly assault any business “castle” that is earning high returns. Therefore a formidable barrier such as a company’s being the lowcost producer (GEICO, Costco) or possessing a powerful world-wide brand (Coca-Cola, Gillette, American Express) is essential for sustained success. Business history is filled with “Roman Candles,” companies whose moats proved illusory and were soon crossed."
"Our criterion of “enduring” causes us to rule out companies in industries prone to rapid and
continuous change. Though capitalism’s “creative destruction” is highly beneficial for society, it precludes investment certainty. A moat that must be continuously rebuilt will eventually be no moat at all."
"Additionally, this criterion eliminates the business whose success depends on having a great
manager. Of course, a terrific CEO is a huge asset for any enterprise, and at Berkshire we have an abundance of these managers. Their abilities have created billions of dollars of value that would never have materialized if typical CEOs had been running their businesses.
But if a business requires a superstar to produce great results, the business itself cannot be deemed great. A medical partnership led by your area’s premier brain surgeon may enjoy outsized and growing earnings, but that tells little about its future. The partnership’s moat will go when the surgeon goes. You can count, though, on the moat of the Mayo Clinic to endure, even though you can’t name its CEO."
"Long-term competitive advantage in a stable industry is what we seek in a business. If that comes with rapid organic growth, great. But even without organic growth, such a business is rewarding. We will simply take the lush earnings of the business and use them to buy similar businesses elsewhere. There’s no rule that you have to invest money where you’ve earned it. Indeed, it’s often a mistake to do so: Truly great businesses, earning huge returns on tangible assets, can’t for any extended period reinvest a large portion of their earnings internally at high rates of return."

Stock Market rallied since last three days and everyone is getting a call from there most preferred brokers.”Buy this buy that" ,but there is one very interesting call I got from my icicidirect account(I prefer it because it's a plain portal and does not flash stock tickers for you every one second or so, more about ticker experience later). Well there call was buy HUL above Rs.238. Confused, well anybody can get confused, that why the hell are they asking me to buy HUL above so or so price. Is this some kind of joke from icicidirect , i don't know but that's for sure if you can get something for Rs.10 and your neighbor offers you to sell it for Rs.11, in most of the cases you will deny. I though a lot about this call and was not able to digest the fact. So people don't get caught in such kind of calls.
About experience with tickers: Earlier whenever researching about any company I give a lot of thought to the moving averages and prices and which impacted my decisions. I researched a lot about the company, always remaining very conservative in my valuations but in the end was moved away by rising prices. And this was the cause of my failure. But I never lose hope and one day I got the answer from my buffets letter. I changed my philosophy and now I started analyzing companies first, Note all the good points in xls , do scuttlebutt and note these too in xls, do conservative DCF valuation (DCF valuation should be your last destination and I have read this from all great investors and it’s true also because you should always valuate a good business not a sub standard one.) I note the valuation also in xls and how I did it.

On Agriculture Business: I’m really bullish about agriculture and renewable energy business in India, more specifically agriculture because it’s one sector which has great potential and has been left unnoticed since long although our economy is based on agriculture. And I think it’s not Indian railway which is the world’s largest employer but it’s Indian Agriculture. Read this http://www.fao.org/docrep/u8480e/U8480E0w.htm Karuturi Global has already reached Africa, Advanta is into hybrid seeds making and Jain irrigation is into drip and sprinkle irrigation technology and tissue culture there is lot and lot going to happen in this sector but why I’m betting on karuturi and jain irrigation because they have see one complete business cycle and have come up really well. They have tasted success and can repeat it year on year, if the current management remains intact. Moreover these are owner managers who have made fortunes, investing in such off track businesses and became market leaders.

I’m constantly reading Warren Buffet letters and would like you to read and discuss with me, I’m always open for discussion because it has always helped me learn new stuff and hope it will help you also.

These points are mentioned by Philip A. Fisher in his book "Common Stocks and Uncommon Profit" and he called it Scuttlebutt. But are these points really helpful? Well before starting with scuttlebutt make sure you understand the business and the company and whose data you can easily find. You can apply scuttlebutt in newly listed companies also. But it'll be better you apply it on already listed companies whose 5-10 years data can be easily obtained. Also you know that bargains can be only found in second hand products so why to invest in new products.

Also it is not important that company complies with all the 15 points and 9-10 points will give you the indication/intuition about whether to invest or not. During Fisher's days he himself has to go and meet people but in today's Information Technology world you can very well take the use or several applications like orkut, face book yahoo groups or Google groups, also just Google about the company and get each and every bit of information you can get about the company, like news, future prospects, interviews of the managers etc.

Now let's me write all the 15 points of scuttlebutt:-----


1) Does the company have products or services with sufficient market potential to make possible a sizable increase in sales for at least several years?

2) Does the management have a determination to continue to develop products or processes that will still further increase total sales potentials when the growth potentials of currently attractive product lines have largely been exploited?

3) How effective are the company's research and development efforts in relation to it's size?

4) Does the company have an above average sales organization?

5) Does the company have a worthwhile profit margins?

6) What is the company doing to maintain or increase it's profit margins?

7) Does the company have outstanding labor and personnel relations?

8) Does the company have outstanding public relations?

9) Does the company have depth to its management?

10) How good are the company’s cost analysis and accounting controls?

11) Are there other aspects of the business, somewhat peculiar to the industry involved, which will give the investors important clues as to how outstanding the company may be in relation to its competition?

12) Does the company have a short-range or long-range outlook in regard to profit?

13) In the foreseeable future will the growth of the company require sufficient equity financing so that the larger number of shares then outstanding will largely cancel the existing stockholders’ benefit from this anticipated growth?

14) Does the management talk freely to investors about it’s affair when things are going well but clam up when troubles and disappointments occur?

15) Does the company have a management of unquestionable integrity.


These were the 15 points of scuttlebutt. It’s true that no one method is enough to find great company. But in my view the best start will be know what the company does and if you see that company’s business has a great growth potential and can grow itself like a tree with many businesses connected to the main business of the company. Scuttlebutt is difficult but in today’s internet age NO WAY!!!!!. Just think about Mr. Fisher where he had to directly deal with company people and customer , but today even using orkut communities of almost all of the companies you can get any information you want.But yes you have to be careful not to ask something which is internal to the company.

"If it’s not going to go forever, it will eventually stop”. A great saying but I read it in Warren Buffet Letters to shareholders. Well it applies to our water also which is used by us as if it will never end. Recent example is rented house where I was staying and later I was forced to move out because the boring which was serving around 10 houses in the building dried and owner was infrequent in providing water from external source. He tried to dig the boring again and again but the result was wet mud and only that even after spending lacs on the boring. Well while things were going fine nobody in the entire building including me thought about such a scenario and everyone was extravagant in spending water. Now I moved to a new well furnished house where there are two water sources, a municipal one and a boring. But I’m still wondering what if one day I will have to face the situation that people are facing in Delhi(Many of them) or Mumbai, and you know what I’m referring to.
Scientists expect water scarcity to become more common in large part because the world’s population is rising and many people are getting richer (thus expanding demand) and because global climate change is exacerbating aridity and reducing supply in many regions. What is more, many water sources are threatened by faulty waste disposal, releases of industrial pollutants, fertilizer runoff and coastal influxes of saltwater into aquifers as groundwater is depleted. Because lack of access to water can lead to starvation, disease, political instability and even armed conflict, failure to take action can have broad and grave consequences. The condition of our major rivers like Ganga is worsening and can be catastrophic in the years to come if measures are not take. Well there is lot to tell about the water problem and there is no limit to think where it can lead to.So let's finish up with this and come to point as a true chemical engineer and company analyst to discuss about the solutions and the companies working on them (Well offcourse listed and unlisted both):-

Solving the world’s water problems requires, as a start, an understanding of how much freshwater each person requires, along with knowledge of the factors that impede supply and increase demand in different parts of the world. Malin Falkenmark of the Stockholm International Water Institute and other experts estimate that, on average, each person on the earth needs a minimum of 1,000 cubic meters (m3) of water per year—equivalent to two fifths of the volume of an Olympic-size swimming pool—for drinking, hygiene and growing food for sustenance. Whether people get enough depends greatly on where they live, because the distribution of global water resources varies widely.

Providing adequate water is especially challenging in drier, underdeveloped and developing nations with large populations, because demand in those areas is high and supply is low. Rivers such as the Nile, the Jordan, the Yangtze and the Ganges are not only overtaxed, they also now regularly peter out for long periods during the year. And the levels of the underground aquifers below New Delhi, Beijing and many other burgeoning urban areas are falling.
Well I read a lot about the ways to limit water waste but they are not looking feasible in my view. Like increasing price of water which will only cause trouble to poor people and farmers and as usual indian middle class will adjust with it. When the goal is to save water, another key strategy should be to focus on the largest consumers. That approach places irrigated agriculture in the bull’s-eye: compared with any other single activity, conserving irrigation flows would conserve dramatically more freshwater. To meet world food requirements in 2050 without any technological improvements to irrigated agriculture methods, farmers will need a substantial rise in irrigation water supplies (an increase from the current 2,700 to 4,000 km3), according to the IWMI study.I think what Jain Irrigation(BOM:500219) is doing can be of tremendos help to farmers.I was reading an article in forbes asia about jain irrigation and came to know about the tremendous management team with Mr. Jain and his three sons taking charge of everything and have brougth the company from getting bankrupt in 2002 to a billion dollar company. I have studied a lot about this company and was waiting for the opportunity to invest in it and Mr.Market gave me my price.They have a future model of renewable energy which will be a combination of solar bio fuel and wind.Well while doing my analysis (extracting details from all possible magazines the one I personally love is SME world. It contains some of the possible future multi baggers (even if it is not listed) you can keep a watch on them . From these gems I have found Permionics(http://www.permionics.com/ . Check out the website and find yourself what it does,well it's desalination of sea water using membranre technology and is a market leader in it. Even Ion exchange tried to buy the company but there founders rejected it.Google it and find it what it is. Ion Xchange is another company which is working in waste water management but due to very tight profit margings of the company I'm not yet interested in it.
Finally there is a very interesting article I read while browsing internet and that is of virtual water. On the first go it was kind of difficult to get the crux of what it really is.The term relates to the amount of water expended in producing food or commercial goods. If such products are exported to a dry region, then that area will not have to use its own water to create them. Hence, the items represent a transfer of water to the recipient locale and supply them with so-called virtual water.Provision of goods—and the virtual-water content of those goods—is helping many dry countries avoid using their own water supplies for growing crops, thus freeing up large quantities for other applications. The virtual-water concept and expanded trade have also led to the resolution of many international disputes caused by water scarcity. Imports of virtual water in products by Jordan have reduced the chance of water-based conflict with its neighbor Israel, for example.
Well here I'll end my discussion becasue the topic is too vast to discuss in one go .The main motive to give you details about the water crises and give some idea of the companies which are working well in these area. With Indian economy still largely dependent on agriculture . The provision of providing water and in a managed way can inccreas the productivity of our land many folds. Also with depleting natural resources of water companies coming up with best and the cheapest ideas will thrive and continue to grow.


Note:- I have read many different magazines before writting this article still I have restricted myself in directly copying the materials from these magazines. I am only presenting those ideas which I liked the most.For any discussion about anything leave a comment.My motive is to create a community where people of different circle of competency advise each other in analysisn businesses.

1) On investment banking
"What are they doing ? Shifting money back and forth without creating value.Most mergers don't work, but Wall stree trumps them up, and the CEO agrees because he wants to run a bigger operation. And some of those wrap accounts are terrible for clients - fees on fees"
2) On business scale :-
"Staying small is simply good business .it wouldn't be fair to out customers if we had to spread our ideas too this.There aren't that manu great companies."

3)On the new economy :-
" Ben Graham said to be careful of the good idea because it is apt to be terrible overdone."

4)On Market Crashes:-
"You have stocks at inflated levels for a long time ,just as they were at deflation levels from 1974 to 1982.

Now some definitions of IIP I found on internet and I’m pasting here….Hope they help me in future :--( Note : Treat IIP just like any other stock market indices whose base here is 100)

In Investopedia:--

Industrial Production Index - IPI

An economic indicator that is released monthly by the Federal Reserve Board. The indicator measures the amount of output from the manufacturing, mining, electric and gas industries. The reference year for the index is 2002 and a level of 100.

Production data is often received directly from the Bureau of Labor Statistics and trade associations, both on physical output and inputs used in the production process. Each individual index is calculated using the Fischer index formula.Investors can use the IPI of various industries to examine the growth in the respective industry. If the IPI is growing month-over-month for a particular industry, this is a sign that the companies in the industry are performing well.


In WIKI:-

The Industrial Production Index (IPI) is an economic indicator which measures real production output. It is expressed as a percentage of real output with base year currently at 2002. Production indexes are computed mainly as fisher indexes with the weights based on annual estimates of value added. This index, along with other industrial indexes and construction, accounts for the bulk of the variation in national output over the duration of the business cycle.


http://www.forecasts.org/index.htm :- This link will provide you with the current trends and forecasts.

http://mospi.gov.in/welcome.asp : This is the Ministry of statistics and Program Implementation web site browse it for monthly IIP data of various sectors.


I think this much detail is enough for IIP which is nothing but a trend and trends can be misleading sometimes so be careful and invest in businesses with proper business analysis . This is a thought straight from Buffet and it very important and I’ll advice you to apply not in stock market but in any investment you make. I can see so many people are investing in LICs and ULIPs without understanding the details of the policies and they end up filling pockets of the asset management company and the Insurance agents. There is an interesting story which I got from Mr. Sanjay Bakshi’s blog (BFBV course) :-

1) 1 burger = Rs 10
2) You have 100 Rupees then you can have 10 such burgers.
3) Now let’s assume instead of buying burger you think that time has come you should invest some money. So you invested Rs 100 instead of buying burger.
4) Now let’s say after one year you made 112(including principal) which is infact a 12% return. Now your burger man thought of increasing the price of the burger as raw materials(like onion and tomato and potato) are costly now and his calculation make the price of the burger to be Rs 12.
5) You went to your burger man to buy burger from your return and burger from your principal for your family.
6) Well he will say “Sir Commodities are costly and so we have increased the price of the burger to Rs 12 ”. Confounded you bought the burgers (10 burgers) and came back. You gave some thought about what just happened to you and you found that your IRR was zero and you had never thought about the return which you need to get to buy some extra burgers from your return.

Well average compounded annual growth rate of Indian market is between 16-17 %( Think about reversion of the mean). In my view if you can’t give time for research and reading then stick to index fund. Well this is from Benjamin Graham and it’s really true. I validate most of the best funds ,yes using ww.moneycontrol.com , and found that maximum number of funds are finding difficult to beat or even meet the market. Instead of that people are constantly investing in those funds giving 2.5% of there hard earned money. Some times these funds also charge exit load. But just check the Entry load of the Index fund (Which you can easily buy from you www.icicidirect.com (all the funds) ,it just 1% with no entry load . I never made an investment in one but for people who are locking there money in FD or bonds, GO FOR INDEX FUND!


[Note: My Thoughts are only for my tutorial purpose. I read and search a lot of interesting material and put in my blog.For anyone disagreeing with my thoughts, I would like him to leave a comment or mail me at ashutosh.nigam37@gmail.com . I love arguing about stuff and will love to talk to people who are pointing out errors in my writings. ]

http://businesstoday.digitaltoday.in/
http://www.businessworld.in/index.php/Archive/http://www.businessworld.in/index.php/Magazine/
http://money.outlookindia.com/
http://business.outlookindia.com/

http://www.sanjaybakshi.net/
http://www.ibnlive.com/
Economic Times
Times Of India
http://www.moneycontrol.com/
http://www.sciam.com/sciammag/issues.cfm
http://www.forbes.com/
http://www.officialwire.com/main.php?action=posted_news&catid=865 One of the best of it's kind
Putting all the links here so that I can navigate these sites quickly.

In this Web exclusive, we present further excerpts from his talk with the students, in which the megabillionaire offers his insights on judging managers, buying businesses, what metrics - if any - he relies upon, and why he views his job as similar to painting the Sistine Chapel.
Q: You said before that one of the things you look for in businesses you're buying is good managers who are honest, capable, and hard-working. To me, that's a hard judgment to make if you haven't known him for long on a personal level. How do you go about figuring that out about somebody, and how long does it take you to make that evaluation?
WB: Well, almost always, we're buying businesses where the managers come with it, so I do have a record [I can judge]. If I had to pick out the five people in this group here who would be the best managers, I wouldn't know how to do it. I mean, you all have great IQs, you have great academic records. You've all shown the energy to get into school and push hard and all that. So you'd have all these attractive qualities.
Can I pick out the five best? I don't think I can do it. What I can do, when I've seen somebody run a business for 20 years, is decide whether they're going to keep behaving in the future as they have in the past, if I keep the conditions that caused them to behave that way in the past. So when I buy a business - it's the biggest question I ask myself if I decide it's a good business - is "Do they love the money, or do they love the business?" Now, if they love the business, we can do business. If they love the money, we can't.
Now, let's say they love the business, as our managers do. They sell me a business for a billion dollars and can hardly wait to get to work in the morning.
In that situation, I'm the only guy that can mess it up. I can take that out of them. I can't put it into them. But I say to myself, "Why do I go to work in the morning?" I've got enough money. I've got Social Security now, even. [Laughter] I'll make it, you know? The kids won't get much, but that's their problem. So I say, "Why do I go to work in the morning?"
Well, there are two reasons. I love painting my own painting. I come down to the office, I get on my back, and I start painting. And I think I'm in the Sistine Chapel. It's my painting. Now, if somebody says, "Use more red paint instead of blue. Paint a seascape instead of a landscape," I would hand them the brush in five seconds and I'd say-I'd say a few other things, too - but I'd say, "Do your own painting. I'll go paint what I want to paint." I get to do my own painting. And then I get applause - if I deserve it. And I like that. I like having the painting admired, and I like to get to paint my own painting. That's so much more important to me than getting my golf score down three strokes or beating somebody at shuffleboard or something. I mean, it is the ultimate pleasure.
Now, if that turns me on, why won't it turn on these people who have built their own businesses? They have spent their life creating a wonderful painting. Now, for one reason or another, maybe tax reasons, maybe sibling reasons, who knows what, they need to sell it, they need to monetize it.
They come to me, and they know that at Berkshire they're going to keep the brush, they're going to keep doing the painting, and I have to look at them and decide whether they are people that really care about their painting or care about the money. [One giveaway is] if they auction the business. We've never bought a business at an auction. Never. Anybody that wants to auction off their family or auction off the creation of a lifetime, that's not what we want.
I tell people you've got two choices. You've spent a lifetime building this business. Or maybe your father built the business and you carried it on. Maybe your grandfather. You've given up vacations sometimes. You worked on weekends and all these things to create this really incredible painting that you're bringing to me. Now, if they want to auction it, they're not for me.
I tell them they have two choices. They can sell it to us, and it'll be in the Metropolitan Museum of Art. We'll have a wing for their painting. People will come and admire it, which they do. And they will say, "That's one hell of a painter." And you get to keep painting. Or you can take this marvelous painting and you can sell it to a porn shop. [Laughter] And he'll take the thing and he'll make the boobs a little bigger, something like that. And put it in the window. And a guy will come over in a raincoat a few years later, and he'll buy it, post it in his window, and it'll become a piece of meat, basically. We get the ones who care about having in it the Metropolitan Museum.
I got a fax almost three years ago on a Wednesday from a fellow I'd never met about a company I'd never heard of. This fellow named Peter Liegl ran Forest River over in Elkhart, Indiana. He sent me a couple pages, and said, "This is the sort of thing it looks like you're generally interested in."
I called him up that day. I said, "Pete, send me the last few audits. FedEx it, and I'll call you tomorrow afternoon." Never met him, never heard of the company. (It's a recreational vehicle company.) So I got in on Thursday morning, and I called him that afternoon. I said, "Pete, here's what I'll do. And if it works for you, fine." I'd never met the guy, but I could still tell by just the way he presented it and his thinking on it. And he said, "Fine. I'll come over next week with my wife and daughter, who own the stock."
And they came over late in the afternoon. I said to him, "Pete, what kind of salary would you like"; this is a company that did a billion seven last year. That's not the way they teach you to do it in business school, but I don't want anybody working for me that has a compensation system they're unhappy with. These people don't need me. They've got all the money they need. I'm going to [invest] hundreds and hundreds and hundreds of millions of dollars [in their businesses]. And he said, "I don't know." And I said, "Well, just tell me because I want you to be happy. You have to run this thing." "Well," he took a little while, "Well," he said, "I looked at the proxy statement, you make $100,000. I wouldn't want to make more than you do." So that became his salary.
Then I said, "You should get paid for exceeding the figures [on which I'm basing the decision to buy the company]. So," I said, "I want you to have a percentage interest in future earnings above this level," which we worked out. But he offered $100,000 and I offered the percentage above that. He has run the business magnificently since then. I've never been to Elkhart, Indiana. I've never seen this place. I hope it's there. [Laughter] Pete may have some 11-year-old kid in there that says, "What figure shall we send Warren?" [Laughter] The guy has done a remarkable job.
If I told Pete whether he should build a new plant, whether he should bring out a new model, whether he should change dealer firms, he'd tell me to take a hike. You know, why shouldn't he tell me to take a hike? He doesn't need the job. As long as that thing is a lot of fun for him, he's going to keep running it. And he'll run it for a long time.
[I get offered all] kinds of deals from LBO operators. I would just love to bet against the projections of every one that they give me. They hand me these books, which I don't even want to look at, but they hand me the books, and of course they always just project like that [points upward like a graph that only increases]. I would just love to make a career out of betting against the figures presented in those books, but I don't get a chance to do that. If you ever get a chance to short investment banker books, that would be a great activity.
Q: When you purchase a subsidiary, you've mentioned that you allow them to reinvest capital if they're able to go above a certain hurdle rate. So I was wondering how you decide what the cost of capital should be on a risk-adjusted basis.
WB: Well, we don't think about cost of capital or risk-adjusted. I mean, we don't want to take any risk, and we don't. That doesn't mean we don't do things that are wrong and all that, but we are not doing anything that risks real losses.
You know, GEICO spends 800 million on advertising. I may spend $200 million that's wrong this year at GEICO or something. But I recognize the things that I can't further refine. What we do with capital is we just look for the best thing we can do at any given time. I mean, in the end, we're going to retain everything.
We don't want to do anything that doesn't create more than a dollar's worth of value for every dollar expended. And we'll do the best we can. And as I said earlier [regarding stock holdings], we would have sold the thing to do something that offered even better opportunity. We won't do that with businesses at Berkshire. That's a pledge I make to people. If they sell me the business, it's going to stay in the Metropolitan Museum forever. I may make a mistake.
If it's going to permanently lose money, I reserve the right to sell it, and if it has labor problems, I reserve the right to sell it. That's in the back of the annual report every year. They've been there for 20-plus years, those principles. But we believe in them. We follow through on them. So we won't dump a business that way. But about 200 million a week comes in to me every week. I like it, too. [Laughter] And it's my job to figure out how to allocate that.
The smaller capital expenditures, or even fairly large ones at the subsidiaries, they just do them themselves. They don't need me, because if some guy comes in to me and talks about something in the yarn plant or something in Georgia, what the hell do I know about it? I mean, they can always present it in a way that makes it look good. If I say the internal rate of return we demand is 15.83, it'll be 15.84. I mean, you just can bet on it. I've never seen a project that doesn't meet your hurdle rate, you know, if they really want to do it. We don't go through those charades. And it saves my time, saves their time.
If we get into bigger deals, then I get involved. Buying businesses of any size and things of that sort. But we just look for the most intelligent thing. And our cutoff point is where we don't think we're creating more than a dollar of value for every dollar we lay out. Marketable securities, to some extent we just look for the things we think have the best expectancy, but we're not buying - there isn't one security that I've got in the portfolio that I look at as-in terms of risky - in the sense of permanent capital loss. They can go down 50%.
Berkshire Hathaway (BRKA, Fortune 500) stock itself has gone down 50% three times since I bought the first stock in at 7 3/8. In 1974 it got cut in half. In 1987 it got cut in half. In 1998, 2000 or so it got cut in half. So that doesn't make any difference. I mean, I just don't worry about it. I worry about permanent loss of capital. I worry about making the right businesses. I worry about keeping the managers happy. Everything else pretty much takes care of itself.