Tag Archives: India

PC Jeweller & Anscor Position Size 10/2/17

PC Jeweller & Anscor Position Size 10/2/17

The company continues to execute with strong growth in showrooms leading to good growth in sales and profitability. PC Jeweller’s share price increased by 33% over the past four months leading to an increase in valuations. The company now trades on an NOPAT yield of 4.4%.


The fragmentation in the market points to a lack of barriers to entry. PC Jeweller’s gross margin similar to its competitors indicates its products are undifferentiated and customer are not willing to pay a premium. The company’s capital efficiency is also on par with competitors meaning capital efficiency is not the source of excess returns. Gross margin return on inventory tells a similar story. Meaning, operational efficiencies are the driver of the PC Jeweller’s excess returns. Its operating expenses averaged 4.1% of sales over the last five years lower than any other jewelry company analyzed.


Operational efficiency is replicable but it is very difficult as processes and values within an organization are difficult to change, therefore, PC Jeweller’s excess profitability should persist for some time. This is backed up by the ability of the company to maintain strong profitability during the latest industry downturn. Further, the organized portion of the segment accounts for only 30% of the industry so competition is currently primarily against weaker peers. Despite the likely persistence of excess profitability, a NOPAT yield of 4.4% requires a persistence growth over 10% into perpetuity with no working capital or fixed capital investment for an investment in PC Jeweller to meet the required rate of return of 15%. The PC Jeweller position is being sold.


A Soriano Corporation is also very illiquid. Reperio’s model portfolio has been purchasing shares since inception and it has only reached 0.5% of the portfolio.  There will be no futher purchases or posts until the position size changes. All recommendations will meet minimum liquidity requirements.

PC Jeweller FY2017 Results 6/1/17

PC Jeweller FY2017 Results Review June 1, 2017


PC Jeweller reported FQ4 2017 & FY2017 results. The company continues to perform well in a difficult operating environment due to regulatory measures. FY2017 saw demonetization and a stricter regulatory environment including high value purchases require a pan card, and imposition of an excise duty. The company also issued preferred shares to DVI Mauritus and Fidelity investments with a guaranteed dividend yield of 13.0% along with a conversion option. Despite, the regulatory environment PC Jeweller grew by 15.7%. Gross profit grew by 0.3% while operating profit increased by 12.1%.


The company’s gross margin declined as exports were a larger portion of sales. The table below illustrates management’s estimates of gross margin by geography and product within the domestic market. Based on the midpoint of the assumptions below gross margin should be roughly 13.37%.

The company improved capital efficiency with inventory only growing by 8.3% in the year. The slight decline in the company’s NOPAT margin combined with the improved capital efficiency saw ROIC increase to 24.7% from 20.9%.  A measure used commonly used in the retail industry is gross margin on inventory. Given the biggest investment within the Indian Jewelry industry is inventory, 57% of PC Jeweller’s 2017 assets was inventory. Since 2008, inventory has accounted for 58% of assets. The typical formula is gross profit divided by average inventory. We modify it slightly by subtracting interest expense from gross profit as the company purchases inventory using gold leases that comes with an interest component.


Unfortunately, the GMROI continues to decline. Compared to its peers, PC Jeweller is at the lower end of GMROI. This is particularly concerning when compared to Titan Company, whose GMROI is almost three times higher than PC Jeweller’s as the company generates a higher gross margin and pays less on interest.


The company’s declining and poor gross margin return on inventory points to a lack of pricing power.


PC Jeweller increased its showroom count to 75 from 60 in FY2017, while the square footage grew by 10% from 352,313 square feet to 386,923 square feet. The company’s average store size decreased to 5,159 square feet.


In FY2017, domestic sales per store and square foot decreased by 15.8% and 4.2%, respectively.


Since, the government took drastic measures in 2013 to stunt the growth of the gold industry, the primary growth driver for PC Jeweller is new showrooms.


The company trialed its first franchise operations and will continue to add additional franchises fueling growth with little additional investment requirements.


Overall, PC Jeweller continues to execute and is one of the most profitable and fastest growing companies in the Indian jewelry industry due to the strength of the company’s management and focus on efficiency. Management is one of the most innovative in the industry with many initiatives not seen in the industry. The company is trying to double its showroom footprint over the next five years. Despite the strengths of the company and management, government is continually bringing new regulation to the detriment of the industry. Additionally, the industry is fiercely competitive with evidence pointing to no barriers to entry. As discussed in a weekly commentary, the jewelry industry evolution in more developed countries points to no barriers to entry and a compression of profitability towards the cost of capital.


Given our research on industry evolution, our base case involves elimination of excess profits by the end of the terminal year as competition intensifies. PC Jeweller is able to grow by 10% over the next five years before fading to 0% terminal growth leading to an estimated annualized return of 2.6%.


The optimistic scenario assumes the company to grow its sales by 15.0% over the next five years inline with PC Jeweller’s target of doubling its store count over the same period. In the terminal assumptions, there is assumed to be continued grow of 2.5%. Also, the company is not impacted by competitive forces allowing the company to maintain its profitability leading to an estimated annualized return of 25.4%.


The pessimistic scenario assumes no growth and immediate decline in profitability as well as no excess profits in the terminal assumption as competition impacts the company.  The estimated annualized return under the pessimistic scenario is -4.0%.


At current valuation levels, the risk rewards is no longer drastically in our favor and a sustained continuation of the company’s excess profits is needed to justify much higher valuations. We will cut our position size to 2.0% as long as the share price is above INR450.

WEEKLY COMMENTARY 2/13/17- 2/19/17

WEEKLY COMMENTARY               2/13/17- 2/19/17









PC Jeweller report Q3 FY17 results over the past week. Demonetization impacted the quarter’s results with the company estimating sales were affected for three to four weeks. Post-demonetization, sales started improving in December and returned to normal in January. Gross margin were stable but the decline is sales resulted in a decline in profitability. Year on year sales declined by 3.4%, the number of showrooms grew from 58 in FQ3 2016 to 68 FQ3 2017, or 17%, and total square feet increased by 8% year on year from 346,855 square feet to 374,481 square feet. Year on year, the company’s operating profit declined 13.7%. Assuming during the four weeks that demonetization affected sales there was a 50% decreased in sales, no impact from demonetization would have lead to an increase in sales by roughly 16% year on year.


It is tough to tell how good or bad the quarter was due to demonetization. The company continues to increase its showroom footprint and sales barely declined despite demonetization. The company estimates 75% of the jewelry industry is unorganized dampening competitive pressures.


PC Jeweller is one of the most profitable and fastest growing companies in the Indian jewelry industry illustrating the strength of the company’s management and focus on efficiency. Management is one of the most innovative in the industry with many initiatives not seen in the industry. The company is trying to double its showroom footprint over the next five years. Despite the company’s strengths, it trades on an EV/NOPAT of 14 times and an EV/IC of 2.6 times. We will maintain our current position size.


In the past week, Grendene reported Q4 2016 and full year results. For the full year 2016, net sales declined by 7.2% with domestic sales falling by 1.6% and export sales falling by 16.3%.


Overall volume declined by 9.3% with domestic volume declining by 8.0% and export volumes falling by 13.0%.


ASP increased by 4.1% with domestic ASP increasing by 7.2% and export ASP falling by 3.2%. Gross profit fell by 6.7% as cost of goods sold declined by 7.6%.


Operating profit declined by in 7.5%. The company’s capital intensity did not change over the year with working capital at 47.9% of sales, fixed capital at 18.9% of sales, and invested capital at 66.8% of sales.


Grendene’s key value drivers are illustrated above. In 2016, gross margin reached a peak level of 48.7%. Selling expenses remain near its historical average relative to sales at 24.0%. General and administrative is at its peak at 4.8% of sales. EBIT margin remained at its historical peak of 20.0%. Working capital remains slightly elevated relative to historical averages. Fixed capital as a percentage is at its highest level over the past eleven years.


Grendene continues to struggle with economic weakness in Brazil and in export markets. The company operational efficiency allows the company to maintain its profitability during a period of declining revenue. In 2015, the company reiterated its growth targets of revenue growth of 8-12% and net income growth of 12-15%. The company continues to believe these targets are achievable but acknowledge risks of not achieving these results are increasing due to economic weakness in Brazil and in exports markets.


Given the new data, we update Grendene’s earnings valuation range. Grendene illustrated its ability to maintain profitability despite a period of declining revenues and increasing competitive pressures making earnings valuation the most appropriate valuation methodology.


Looking at Grendene’s earnings valuation, the company reaches our target return of 15% per year under the most optimistic scenarios. We would assume perpetuity growth only under scenarios when the company operates in an industry with barriers to entry and pricing power. Within the domestic market, there are clear barriers to entry with the company and its main competitor Alpargatas having economies of scale as they occupy over 50% of the market with large fixed costs in the form of distribution and advertising. Grendene also has unique capabilities in manufacturing plastic products as it modifies its own machines and can formulate plastics that are unavailable to other footwear producers. These barriers to entry do not transfer outside of Brazil. The company is a low cost producer with only China producing exports at a lower price.


The question is whether the barriers to entry within Brazil translate to pricing power. The barriers to entry within the segment means very few other players could sell products at the Grendene’s and Alpargatas’ price range meaning the company’s probably do have some pricing power in Brazil. Over the past ten years, the company average selling price increased by 3.8% per annum with the domestic selling price increasing by 2.6% and export selling pricing increasing by 3.9% in USD terms so there is a strong argument for potential pricing power. We assume 2.5% pricing power in our base case scenario. The company sales have grown at 6.8% over the past ten years with growth stagnating at 4.9% over the past five years. Assuming an inability to growth operating profit above sales growth a 5% growth rate seems appropriate for our five-year forecast period. Despite the company’s ability to maintain profitability during the recent industry weakness using peak margins seems aggressive therefore average margins are more appropriate. Our base case scenario is 5% forecast period growth, 2.5% terminal growth and average operating margins leading an upside to the 2021 fair value of 60% or 9.9% annualized return. Overall, the average return over the next five years under the earnings valuation is 59% or 9.7%.






How much is growth worth? (Musing on Markets)


Professor Damodaran breakdowns how to value growth, the key drivers of growth, and the importance of ROIC in determing whether growth is valuable or not. (link)



Narrative and Numbers: How a number cruncher learned to tell stories! (Musing on Markets)


Another post by Professor Damodaran explaining how narratives can be worked into your valuation to provide a better picture of how the market is valuing a company. (link) Professor Damodaran recently published a book Narrative and Numbers, which I have not read but is next on my list.



Diversification..again.. (Oddball Stocks)


Nate Tobik of Oddball Stocks shares his thoughts on diversification. (link) Our current thoughts on diversification and position sizing can be viewed here. (link) We have a similar thought process on the limits of one’s knowledge as an outside investor with valuation being the biggest tool to offset the limits of our knowledge.



Humility and knowledge (Oddball Stocks)


Related to his post on diversification, Mr. Tobik discusses how investors sometimes make the mistake of believing they know too much. (link)  We touched on a similar topic in our diversification post linked above.



Graham & Doddsville (Columbia Business School)


Columbia Business School put out another edition of Graham & Doddsville, which always makes for interesting reading. (link)



Buffett’s Three Categories of Returns on Capital (Base Hit Investing)


Base Hit Investing’s John Huber talks about how Buffett categorizes business by their return on capital and capital requirements. (link)



What Does Nevada’s $35 Billion Fund Manager Do All Day? Nothing (Wall Street Journal)


The Wall Street Journal profiles the Steve Edmundson, the investment chief for the Nevada Public Employees’ Retirement. (link)



Howard Marks’ Letters Sorted by Topic (Anil Kumar Tulsiram)


Anil Kumar Tulsiram complied all Howard Marks’ letters by topic. He has compiled other documents in the past and can be followed on Twitter @Anil_Tulsiram. (link)





Company News


PC Jeweller

PC Jeweller’s share price fell by 15.1% during the week bringing the total decline to 31.7% this month as the Indian government demonetized INR500 and INR1,000 notes in an attempt to fight “black money”. On the back of the regulation, the market is speculated that gems and jewelry companies would be one of the most impacted industries as gold and jewelry is thought to be a favorite “black money” asset. The Indian jewelry industry participants speculate a potential import ban on gold is also coming.


After the fall in share price, PC Jeweller is now offers a 9.1% NOPAT yield causing us to increase our position to 4.0%. While the company is in an industry with no barriers to entry evident by the thousands of competitors, PC Jeweller and Titan are far more operationally efficient than competitors creating excess profits through strong management. Our initial theory on PC Jeweller’s and Titan’s excess profits was associated with weaker competition from the unorganized sector, but the continued outperformance of PC Jeweller and Titan while listed peers continue to struggle points to operational advantage over organized peers.



The table shows the key value drivers within the industry as well as the financial health of peers. From 2012 to 2016, PC Jeweller has the third highest gross margin with the highest operating margin. Gross margin points directly to the customers’ willingness to pay while the difference between gross margin and operating margin point to the efficiency of management in running operations. In addition to the highest operating margin, PC Jeweller also has the fastest growth in the industry. PC Jeweller has the second highest ROIC leading to the second highest value creation in the form of excess profits. PC Jeweller and Titan are the only competitors that generated any significant excess profits over the period examined. The ability to continually generate excess profits in a period of raw material constraints and weak demand points to the strength of the management teams at PC Jeweller and Titan and an ability for sustained excess profits.


To get to an annualized return of 15%, PC Jeweller would have to fight margin pressures through stable operating margin and capital efficiency, while growing at 10% during the forecast period fading to a 0% growth rate in perpetuity. These assumptions do not seem too aggressive given, management ability to continue to create value despite points to sustained excess profits. New store openings and franchising should provide the 10% growth with the fade to 0% growth in year ten potentially being conservative. Our big concern with the above assumptions is competitive pressures lead to ROIC contraction rather than growth. If we change our profitability assumption to marginal excess profits from superior management (ROIC = 15%, Economic Spread = 2.5%), the five year would be 10%. This profitability assumption seems much more conservative and gives us sufficient comfort that if profitability declines there is still ample upside. It seems the risk reward is balanced sufficiently to increase our position size in PC Jeweller to 4.0%. We will be increasing our position size at a price below INR375.


Zensar Technologies

On November 17, 2016, Zensar Technologies reported FQ2 2017 results. Revenue grew by 2.7% and operating profit declined by 9.3%. FQ2 2017 was the third straight quarter where operating profit declined as the lack of growth on the top combined with continued growth in employee benefit expense leading to margin compression. The margin compression comes with an increasing average deal size and an increasing number of customers above 1 million, Zensar are unable to grow its top line as rapidly as its employee benefit expense leading to margin contraction. The weak top line growth may be temporary as the company’s backlog is strong at USD700 million up from USD500 million in the last quarter. Zensar is now offering a NOPAT yield of 6.5% despite being a business with no competitive advantage. With very aggressive assumption of a 12.5% discount rate, stable margins and capital efficiency, 10% forecast period growth, and 5% growth into perpetuity, Zensar offers 85% upside over the next five years. Growth in perpetuity is usually only assumed for companies with sustainable competitive advantages, which seems not to be the case for Zensar. Assuming a perpetuity growth rate of 0% decreases the potential upside over the next five years to 47%. Changing the growth assumptions to a 5% growth rate over the next five years, and a 0% terminal growth rate, there is only 19% upside over the next five years. Given the lack of upside, and lack of competitive advantages, we will be selling our Zensar position at prices above INR900.


Other Links


Why Moats are Essential for Profitability (Restaurant Edition) (25iq)

A fantastic essay at 25iq discussing the importance of moats. It also discusses the amount of research needed to understand the economics of a business. (link)


A Narrative Narrative (Polemic’s Pains)

A good blog post discussing how the current narrative on many topics is nothing more than speculation and subject to rapid change (link)


Expected Return (Research Affiliates)

Research Affiliates maintains expected real returns of different asset classes including Emerging Market Equities. (link) Given our view that the discount rate is an opportunity cost it may be more appropriate to view expected returns as the discount rate rather than historical returns. The appropriate discount rate for Emerging Markets would be 7.3% expect real return. Adding an additional 2.5% for expected inflation gets to roughly 10% discount rate. Adding an additional 2.5% as a margin of error gets us to 12.5%, our current discount rate. The idea that the discount rate should be tied to expected returns needs to be flushed out, but it seems interesting.


Predicting the Long Term is Easier than Predicting the Short Term (Intrinsic Investing)

An interesting article discussing how it is easier to predict the long term than the short term due and why this is one of the reason investing for the long term investing outperforms short term investing. (link)


Value Stocks vs. Value Traps (Old School Value)

Old School Value wrote an interesting article by discussing the characteristics of Value Stock and Value Traps. (link)


Chris Mayers on 100-Baggers (MicroCapClub)

Chris Mayers wrote 100-Baggers, an update on Thomas Phelps 1972 book 100 to 1 in the Stock Market. In this video, he discusses the key characteristic of 100-Baggers. (link) Below are the summary points.


  • Start small
  • Hold for a long time
  • Prefer a low multiple
  • High returns on capital
  • Owner operators


Fake News (Stratechery)

A good article by Stratechery on the subject of “fake” news, Facebook’s role in the delivering the news, and the dangers of who decides what news is deemed fake. (link) The discussion of fake news is interesting with the potential to leading us down a scary path. We must not forget the masses still receive their news from a small number of news outlets creating gatekeepers who deem some information to be newsworthy and other information less newsworthy. The existing gatekeepers already create narratives and form opinions among the population.


How the Brain Decides Without You (Nautilus)

It may not matter what the facts are, as the brain seems to decide how the world appears based on your existing views. (link) The best way to ensure, you are not missing anything due to pre-existing biases is to seek out the other side of the argument and understand it as well as you understand your side of the argument.


How Headlines Change the Way We Think (New Yorker)

Tied to the previous two articles, is an older article from the New Yorker discussing how headlines change the way we think about a story (link)

Credit Analysis and Research June 20, 2016

Credit Research and Analysis                          June  20, 2016

Ticker: CARE:IN

Closing Price (6/20/2016): INR993.50

1 Year Avg. Daily Vol. (USD): 530,269

Estimated Annualized Return: 8-9%

Credit Analysis and Research June 20 2016 RCR




Credit Analysis and Research is the second largest Indian credit rating agency in an oligopolistic market.  The three largest players in the credit rating industry have a significant brand advantage over smaller players and potential new entrants as credibility is crucial for ratings, a third party assessment to be valuable. The company is extremely profitable with personnel expense as a percentage of sales half of its peers and operating margins twice its peers in an industry with little to no capital requirements. Using conservative estimates, the company currently offers a base case expected return of 8.0-9.0% with potential downside of 28.0% over the next five years under the bear case and potential upside of 100% or more over the next five years under the bull case.  We will take a 2.0% position as the company is very high quality with a competitive advantage but is slightly undervalued to fairly valued.




CARE Key Statistics June 20 2016




CARE Factor Ratings June 20 2016





Credit Analysis and Research (CARE) incorporated in April 1993 as a credit rating information and advisory services company. It is promoted by the Industrial Development Bank of India (IDBI), other financial institutions, public/private sector banks, and private finance companies. It offers a wide range of products and services in the field of credit information and equity research including credit rating, IPO grading, SME rating, and REIT ratings. The company’s ratings are recognized by the Government of India, the Reserve Bank of India, and the Stock Exchange Board of India. In FY2016 (March 2015-March 2016), ratings services account for 94.8% of CARE’s revenue.  Rating assignments generates two types of revenue: rating revenue and surveillance revenue.  Rating revenue is generated at the time of the rating and surveillance revenue is generated as CARE continues to monitor the company over the life of the financial product being rated. Ratings revenue is dependent on the amount of credit outstanding and the company’s share of the credit rated.

CARE Volume of Debt Rated June 20 2016


Over the past five years, 60.9% of debt rated was bank facilities, 32.7% long term debt, and the remainder was short term and medium term debt.   Bank facilities are bank loans that are rated to determine the risk weights under the Reserve Bank of India’s (RBI’s) Guidelines for Implementation of the New Capital Adequacy Framework under Basel II framework. CARE rates all types of fund-based and non-fund based facilities including cash credit, working capital demand loans, Letters of Credit, bank guarantees, bill discounting, project loans, and loans for general corporate purposes. Credit rating for bank loans is not mandatory under Basel II, but the higher rating on the loan ratings the lower the risk weight and the less capital required for the loan.  If a loan it not rated, it retains a capital risk weight of 100%.

CARE Bank Loan Rating Capital Savings June 20 2016


The table above illustrates the capital savings by having bank loans rated under Basel II for an INR1,000 million bank loan. It assumes a 9% capital requirement under Basel I. Under Basel I, a INR1,000 million loan would require INR90 million in capital.  Under Basel II, if the same INR1,000 million loan was AAA rated only INR18 million in capital leading to a capital savings of INR72 million. Some of CARE’s larger bank loan ratings customers have significant volume allowing them to negotiate a rating fee cap making the bank loan segment much more price sensitive than other parts of the rating market.

CARE Credit Penentration June 20 2016


As illustrated above, India’s population is under banked relative to Asian peers leading to growth potential in the bank lending market.


Roughly 39.0% of CARE’s revenue comes from the non-bank loan ratings. These ratings include most kinds of short, medium and long term debt instruments, such as commercial paper, bonds, debentures, preference shares and structured debt instruments, and deposit obligations, such as inter-corporate deposits, fixed deposits and certificates of deposits.  Other rating products include IPO grading, mutual fund ratings, and corporate governance ratings.

CARE Bond Market Penentration June 20 2016


As illustrated above, India’s corporate and government bond markets are still underdeveloped relative to Asian peers.  It is not a given that bank lending and bond markets will develop to the potential of other markets due to idiosyncratic reasons, but there seems to be a relationship between GDP per capita and development of both bank lending markets and bond markets, as illustrated by the charts below.

CARE Domestic Credit vs GDP per capita June 20 2016


CARE Bond Market vs GDP per capita June 20 2016


Other than increased penetration of existing products other avenues for growth for CARE include increased market share, new products, and new geographical markets.  New products for CARE include SME rating, the MSE rating, Edu-grade, Equi-grade, Real Estate Star Ratings, Green ratings, and valuation of market linked debentures.  The company can also move into adjacent product market like research and advisory services.   CARE intends to move into new geographical markets and has a 75.1% interest in a ratings business in Maldives.


CARE does not have any shareholders classified as promoters. The company’s largest shareholders on March 31, 2016 are listed below.

CARE Shareholder Structure June 20 2016


IDBI Bank, Canara Bank, and IDBI Bank have all sold down their stake progressively and now own roughly 25% of the company.





CRISIL, the first India credit rating agency, was established in 1987.  ICRA was the second rating agency opening in 1991. CARE was the third rating agency established in 1993. ONICRA was also established in 1993. India Ratings and Research Private Limited followed in 1996. Brickworks Ratings India Private Limited (Brickworks) and SME Rating Agency of India Limited (SMERA) began their ratings businesses in 2008.


In 1992, credit rating became mandatory for the issuance of debt instruments with maturity/convertibility of 18 months and above. Subsequently, the RBI guidelines made rating mandatory for issuance of commercial paper. RBI also made rating of public deposit schemes mandatory for Non Banking Financial Corporations. Since then credit ratings have continually increased the number and value of instruments that have been rated.


In 2003, SEBI along with stock exchanges made ratings mandatory for debt instruments placed under private placements with a maturity of one year or more, which are proposed to be listed. Also in 2003, the RBI issued prudential guidelines on the management of the non-statutory liquidity ratio (SLR) investment portfolio of all scheduled commercial banks except regional rural banks and local area banks. These guidelines require such institutions to make investments only in rated non-SLR securities.


Similarly, non-government provident funds, superannuation funds, gratuity funds can invest in bonds issued by public financial institutions, public sector companies/banks and private sector companies only when they are rated by at least two different credit rating agencies. Further, such provident funds, superannuation funds, gratuity funds can invest in shares of only those companies whose debt is rated investment grade by at least two credit rating agencies on the date of such investments. Investment by mutual funds and insurance companies in unrated paper/non-investment grade paper is also restricted.


Barriers to Entry


The industry structure points to barriers to entry.  There are only seven competitors with the three largest competitors, CRISIL, CARE, and ICRA, dominating the market, accounting for an estimated 90% of the market.  The market share among the top three players since FY2006 is illustrated below.

CARE Top 3 maket share June 20 2016


CARE has steadily increased its market share to 29.5% in FY2016 from 20.1% in FY2006, at the expense of ICRA. Further illustrating the oligopoly is CARE’s share among the Business Standard’s top 1000 companies (45% share), the Economic Times top 500 companies (54% share), and the Financial Express’ top 500 companies (52% share).


The oligopolistic industry structure of ratings agencies in the United States points to strong barriers to entry in the industry. Although the credit rating industry is more mature in the US and idiosyncratic factors exist in each market, companies in both markets have similar business models and competitive advantages allowing the US market to be a potential roadmap for the Indian credit rating industry.


CARE is very profitable. Since FY2011, the company’s NOPAT margin averaged 45.3%, although the company’s margin is on a declining trend. The company requires no capital with an average invested capital of negative INR123 million.  The negative invested capital is driven by average working capital of negative INR632 million and INR509 million in fixed capital. The negative working capital and negative invested capital points to a barrier to entry and very strong bargaining power.

CARE Profitability June 20 2016


The rating agencies seem to lack pricing power pointing to no barriers to entry.  The largest bank loan ratings customers have been able to put pressure on pricing but in the rest of the market the rating agencies say they have pricing power.  The lack of pricing power among the large bank loan ratings customers is probably down to economic weakness rather than sustaining bargaining power as there is significant benefit for the customer from using rating agencies, often more than one is used, in the form of capital savings. Typically, cash gross margin is used to identify pricing power, but in the knowledge industry the key input is employees so employee expense/revenue is the key proxy for cost of goods sold.

CARE Employee Expense June 20 2016


CARE’s employee expense to revenue increased from 17.7% in FY2011 to 27.1% in FY2016 illustrating a lack of pricing power. Revenue per employee increased from INR3.6 million in FY2012 to INR4.9 million in FY2016 while personnel expense per employee increased from INR856,255 in FY2012 to INR1,336,628 in FY2016.


Brickworks and SMERA started in 2008. While these entrants point to the possibility of new entrants, it will take years for these new entrants to gain the reputation of the larger rating agencies.  ONICRA entered the market in 1993 and Indian Ratings and Research was established in 1996. Despite both companies entering the market over 20 years ago, both have nowhere near the scale of the three larger firms.  The ability to enter but not scale illustrates the low minimum efficient scale or lack of economies of scale and the importance of a brand.


Ratings agencies require a brand as a rating is nothing more than assessment of a complex instrument or product by an independent third party, therefore trust must be placed in the third party and its assessment.  If the third party lacks credibility the assessment is useless. Credibility is built up over many years and very difficult to replicate.


Economies of scale also exist in marketing, administration, legal, compliance, and software development costs. Economies of scale are nowhere near as important to as brand advantage as illustrated by the number of smaller players in the market.


Other Four Forces


The rivalry between competitors exists but is not a significant drag on profitability. Competition among the three largest rating agencies has increased recently due to weakness in the credit markets, lower government subsidies for Micro, Small, and Medium size enterprises (MSMEs), and weaker infrastructure spend leading to weaker margins over the past few years. Competitive rivalry is decreased as ratings account for a smaller portion of revenue at CRISIL and ICRA.  In FY2016, rating revenue accounted for 31.5% of CRISIL’s revenue and 57.9% of ICRA’s revenue.  Many times debt instruments are rated by multiple rating agencies further decreasing rivalry.


The credit rating agencies main supplier is employees. Employees are non-unionized and fragmented. As illustrated above under pricing power, personnel expense per employee increased from INR856,255 in FY2012 to INR1,336,628 in FY2016 or 11.8% per annum, while revenue has not been able to keep pace with the increases in personnel expense.  The steady increase in personnel expense illustrates the bargaining power of employees. Given the fragmented nature, the steadily increasing personnel expense seems to be due to a shortage of qualified talent in the labor market.  Since 2011, CRISIL’s personnel expense per employee increased from INR1,100,699  to INR1,863,188 or 14.1% per annum, while ICRA’s personnel expense per employee decreased from INR3,962,465 in FY2012 to INR3,436,615 in FY2016 representing a 4.6% decline.   CRISIL’s personnel expense per employee inflation confirms the trend at CARE, while ICRA’s personnel expense per employee is much higher so the decline does not necessarily counter the trend seen at CARE and ICRA.


The credit rating customers include financial institutions, corporations, municipalities, and others. Banks are CARE’s largest customers accounting for 60.9% of debt rated.  A bank loan facility are not required to be rated by regulation, but under Basel II, if the loan facility is not rated it receives a risk weighting of 100%. As illustrated below the higher the rating on the bank facility the lower the risk weighting and the less capital required for the facility. This creates a strong incentive for banks to have loan facilities rated decreasing their bargaining power.

CARE Bank Loan Rating Capital Savings June 20 2016


Given the volume of instruments rated, banks are an important source of revenue for CARE. Banks are much more price sensitive than other customers and have been able to negotiate a fee cap illustrating their bargaining power.  The volume of bank loan facility points to a much more sophisticated customer as banks have dealt with the process more often than non-banks. Other customers are less price sensitive given their fragmentation relative to the ratings agencies and the benefits associated with having debt rated.


The threat of substitutes is low. Banks can choose to not use ratings or use an internal ratings based system but the risk weight for an unrated loan is 100% so there are benefits in the form of capital savings.  Corporations and other customers of rating agencies can decide not to have their debt rated but a debt rating increases transparency on the instrument and/or company leading to a decreased cost of debt and a better image of the firm.  Additionally, as more and more investors use rating agencies, the value of having your debt rated goes up and the penalty of not having your debt rated also increases.





Operational Performance


Operationally, management has performed very well.  It is increased its market share among the top three rating agencies by almost 10% over the past ten years.

CARE Top 3 maket share June 20 2016


The company is also the best performing credit rating agency in terms of operating profit per employee.

CARE vs Peers Per Employee stats June 20 2016


ICRA generates the highest revenue per employee, while CARE has the lowest personnel expense per employee and the highest operating profit per employee leading to the highest operating margin. As mentioned earlier, the company is extremely profitable with very low investment requirements.


Capital Allocation


Management has done a good job on focusing on the ratings business.  CRISIL and ICRA have allocated capital to research, advisory, and consultancy businesses.  These businesses currently generate strong returns but have much lower barriers to entry making the businesses much more prone to competition. Both CRISILs and ICRA’s and rating businesses have negative capital employed while research, advisory, consultancy and other businesses require capital.  CRISIL’s research business generates very strong pre-tax returns on capital employed averaging 98.3% over the past four years.  ICRA’s non-rating business pre-tax returns on capital employed averaged 17.9% over the past three years. CRISIL has done a good job of generating strong profitability on its non-rating business while ICRA is barely generating its cost of capital illustrating the potential pitfalls of allocating capital from a business with strong entry barriers to a business is much weaker entry barriers.


The only other capital allocation decision made by management is whether to hold cash or payout cash.  Since its IPO in Dec 2012 (FY2013), CARE has paid out 87.4% of after tax net income in the form of cash dividends. The company has a net cash position equal to 3.29 times FY2016 net income. Given the negative invested capital in the business, no additional capital is needed to grow therefore management could pay out more cash in the form of dividends.

CARE Return on Financial Assets June 20 2016


Paying dividends make even more sense when CARE’s cumulative return on net cash since FY2012 is 1.1% lower than what can be received on a 1 year fixed term deposit (7.4% return on net cash vs. 8.5% return on 1 year fixed term deposit) over the same period illustrating the weak investing returns generated by the company.


Given the low investment requirements, the company did not need to IPO but it was owned by a number of financial institutions that wanted to gain liquidity on their investment.


Corporate Governance


There are no related party transactions other than management remuneration.   Management’s salary averaged 2.4% of operating income over the last four years, below CRISIL’s management salaries average of 2.6% of operating income, over the same period, and well below ICRA’s outrageous average of 11.5% of operating income.


There are no other corporate governance issues. The board has two members of the CARE management team and the other five members are either independent or represent outside shareholders.


Managers at CARE are compensated primarily with a salary with their shareholding and performance related pay being less than a third of pay in FY2015.





Given the asset light nature of CARE’s business model and negative invested capital, any asset based approach to valuation does not make sense.  The brand advantage in the industry makes earnings based valuation the most appropriate valuation. We use a blended average valuation of DCF/Residual Income/Earnings Power Valuation and an IRR approach.


Under the blended valuation, we use different scenarios to determine potential upsides and downsides.  The key value driver assumptions changed are sales growth and operating margin, while, the discount rate, the effective tax rate, working capital turnover and fixed capital turnover remain the same at the figures in the table below.

CARE Key Stagnant assumptions June 20 2016


Sales growth and operating margin are changed to determine upside under different scenarios.  The scenarios and assumptions for both value drivers are listed below.

CARE Key Variable assumptions June 20 2016


The estimated intrinsic value per share under each scenario and upside from June 17, 2016 closing price is listed below.

CARE Scenario Valuations June 20 2016


The average FY2017 earnings valuation per share is INR1,035.80 representing 4% upside and the average FY2021 earnings valuation per share is INR1,378.91 representing 39% upside.


The bear case valuation assumes 0% perpetuity growth and trough margins leading to the FY2017 intrinsic value per share of INR616.26 or 38% downside and a FY2021 intrinsic value per share of INR722.82 or 27% downside to the FY2021 downside.  The bear case assumes a no further development of credit markets and a slight decrease in margins from competition.


The base case valuation assumes 5% growth into perpetuity with current margins leading to a FY2017 intrinsic value per share of INR1,107.35 or 11% upside and 45% upside to the estimated FY2021 intrinsic value per share of INR1,436.62. The base case is conservative on the growth side as it assumes growth slows down but banking and credit markets continue to develop, while margins compress due to the bargaining power of employees is also conservative given margin weakness has followed economic weakness.


The bull case valuation of average growth, average margins, and 5% terminal growth leads to 40% upside to the FY2017 intrinsic value per share of INR1,393.43 and 97% upside to the FY2021 intrinsic value per share of INR1,955.08.


Using a conservative IRR valuation, the current FCF yield is roughly 4.0% with estimated growth of 5.0% leading to an estimated annual return is 9.0%, which is almost equivalent to the estimated annualized return from the base case under the blended valuation.  The 9.0% is a conservative estimate given where in the life cycle, banking and credit markets are in India.  Additionally, the last few years saw margin compression due to economic weakness and slowing growth in the credit rating industry as growth returns margins should expand.


CARE seems to be slightly undervalued to fairly valued.





The biggest risk to CARE’s business is reputational.  After the 2008 financial crisis, the ratings agencies in the United States had their credibility questioned from apparent conflicts of interest due to poor analysis and ratings that did not properly reflect the risks of instruments being rated.  During the U.S. housing boom, the ratings agencies inflated mortgage bonds ratings to generate fees allowing rating sensitive investors to purchase the securities for their portfolios. The bonds later plummeted in value.  S&P was frozen out of rating mortgage bonds after admitting a flaw in their CMBS models.


Many investors are restricted to purchasing higher rated debt instruments in the domestic bond market that are rated by multiple rating agencies. If investors are no longer required to purchase rated bonds or if the ratings from multiple rating agencies are no longer required there is a risk of loss of revenue.


Accessing the overseas debt market by Indian borrowers is regulated including restrictions on raising debt in overseas markets. If accessing overseas debt markets was permitted, many borrowers could search for lower borrowing costs leading to decreased reliance on Indian debt markets and lower rating revenue for ratings agencies.


There is a risk that banks will use an internal rating based approach for credit risk. In a circular dated July 7, 2009, RBI advised banks they may request approval for the using of an internal rating based approach to use their own internal estimates to determine capital requirements for a given credit exposure. Bank loan facilities accounted for 60.9% of CARE’s revenue in FY2016.


Despite strong brand advantages that will take new entrants years to replicate. There is always risk of increased competition with rating agencies like Brickworks and SMERA recently entering the market with operations starting in 2008. Given the low fixed costs in the industry leading to a low minimum efficient scale, smaller players ONICRA and India Ratings and Research have survived over 20 years with minimal market share.


After the Amtek Auto default to JP Morgan some investors are calling for strong regulation of and increased accountability for ratings agencies as the rating agencies were late to change their ratings on Amtek Auto.


CARE is managed by external agents rather than owner operators.  If the board is unable to keep management’s incentives aligned with shareholders, management may make decisions in their interest over the interest of shareholders.


CARE investment thesis and price paid is based on the development of banking and credit markets.  If banking and credit markets do not develop, there may be permanent loss of capital.


CARE is more expensive than our typical investment opportunities, but with little or no investment requirements and underdeveloped credit markets, any growth is essentially free. If investors are unwilling to pay the current multiples for Indian equities in the future, there may be a permanent loss of capital.  To combat this risk, we are taking a small starting position.



Zensar FY2016 Results Review June 8, 2016

Zensar FY2016 Review June 8, 2016

We are decreasing our position size in Zensar Technologies to 4.0%.  Zensar Technologies continue to performing well with revenues growing by 12.8%, gross margin expanding by 170 basis points and operating profit increasing by 18.4%. The company has been a very consistent in its growth with revenue growing by 21.1% per year over the past five years and 21.3% per annum over the past ten years. Operating income has increased by 20.6% per year over the past five years and 25.3% over the past ten years.


The company is shifting its business model from traditional IT services to a digital strategy to drive further growth. Zensar is executing the shift with digital revenues at 27% of total revenues in FY2016 up from only 5% three year ago.  Digitial revenues are expected to continue to grow at over 20% for the next few years.  The company also continues to increase deal size with the number of large deals over 64 clients over USD1 million in FY2016 up from 51 in FY2013.  It also won USD130 million in contracts in FY2016 with expectations for a much higher number in FY2017.


Zensar expects margin expansion from increasing significance of digital and decreasing significance of product and license revenue. The company also is decreasing the number of low margin, low revenue accounts with the total number of accounts decreasing from 211 to 194.   Unfortunately, the industry suffers from an inability to grow margins drastically as more business requires more employees.  There are low barriers to entry leading to significant fragmentation within the industry as illustrated by the industry fragmentation.  Zensar’s top 60-65 clients have had a business relationship with company on average over 6 years pointing to a quality product and some switching costs.  Most smart customers will have multiple vendors allowing the customer to eliminate bargaining power of the suppliers and eliminating their pricing power with it as multiple vendors allows for continuity in case of switching suppliers.


Our initial investment was due to very cheap valuations along with strong profitability, strong growth, execution, and a strong culture.  The company continues to execute on all fronts but valuations are no longer extremely cheap and therefore we will be taking our profits and nearly halving our position size to around 4.0%.  The company is trading on an NOPAT yield of 6.6% and conservative growth of 10% over the next few years. While the company expected return is over 15%, the lack of barriers to entry leading to fragmentation within the industry and eliminating pricing power increases the risk to earnings.

Bajaj Auto

Bajaj Auto April 29, 2016

Bajaj Auto April 29 2016 RCR


BHIL Investment Thesis


Bajaj Auto is a stock we would not normally research but it accounts the majority of the value of Bajaj Holdings and Investments (BHIL).  BHIL is a holding company trading at a discount to the current market values of its investment holdings. Its main assets are a 31.49% stake in Bajaj Auto and a 29.15% stake in Bajaj Finserv. The Bajaj Auto position accounts for roughly 56% of the company’s total value and Bajaj Finserv accounts for another 27%.  The company’s remaining value is split between a large number of equity investments and fixed income investments.

BHIL SOTP April 29, 2016


At the end of March 2015, BHIL had no debt and a net cash position of INR4,514 million equal to 5.2% of its current market cap. BHIL is 54.4% owned by the Bajaj family and its associates with the remainder owned by the public. If Bajaj Auto and Bajaj Finserv’s market prices are a good approximation of fair value, there is significant upside to BHIL assuming a 30% holding company discount.  Unfortunately, the market often misprices securities and if Bajaj Auto and Bajaj Finserv are overvalued then the discount BHIL is trading at relative to the underlying investments may be warranted.  It seems Bajaj Auto is significantly overvalued therefore no position is taken in BHIL.



Bajaj AutoInvestment Thesis


Bajaj Auto is the second largest Indian and the fourth largest motorcycle manufacturer in the world. There seems to be brand advantages and economies of scale creating barriers to entry in the Indian two wheeler industry.  The company’s management is doing a good job operationally, and strategically.  There are minor corporate governance issues but nothing to eliminate Bajaj Auto as a potential investment.  At the current time, valuation is a concern.  The market is pricing in a very rosy picture with the company trading on a FCF yield of 3.3%.  Bajaj would be an attractive opportunity below INR1,300.


Bajaj Auto Key Stats 1 April 29 2016


Bajaj Auto Key Stats 2 April 29 2016


Company Description


Bajaj Auto is India’s second largest two wheeler manufacturer and the world’s 4th largest motorcycle manufacturer. It has been producing scooter and two wheelers since 1945.  Over the last decade, the company has successfully changed its image from a scooter manufacturer to a motorcycle manufacturer. The company now exports its products to over 50 countries. In 2008, Bajaj Auto demerged into three separately listed entities, Baja Auto, Bajaj Finserv Ltd, and Bajaj Holdings and Investment Limited.  These companies are all listed on the National Stock Exchange of India with an initial listing on May 26, 2008.


In November 2007, Bajaj Auto acquired 24.5% stake in KTM Power Sports AG (holding company of KTM Sportmotorcycles AG) for 98.4 million euros.  KTM is known as a high performance motorcycle brand.  The company is consistently Europe’s largest motorcycle brand and is a dominant maker of off road motorcycles with 260 World Championships and 15 consecutive Dakar victories. Bajaj Auto has since increased its investment by 99.7 million euros making its total investment in KTM equal to 198.1 million euros with the company’s stake increasing from 24.5% to 48%.  Bajaj manufacturers all KTM bikes under 600ccs in India lowering the manufacturing cost for KTM’s bikes. Bajaj also distributes KTM bikes throughout its distribution network. Bajaj distributes its products throughout KTM network as well as received technological expertise from KTM’s motors. KTM is listed on the Vienna Stock Exchange.   At current market prices, Bajaj Auto’s 198 million euro investment in KTM is now worth 595.58 million euros.


Bajaj Auto produces and exports motorcycles, three wheelers, and quadricycles. Its headquarters are in Pune, with plants in Akurdi and Chakan (Pune), Waluj (near Aurangabad) and Pantnagar. The Chakan plant produces Pulsars, Avengers, Ninjas, and KTM motorcycles and has annual production capacity of 1.2 million units.  The Pantnagar plant produces CT100, Platina, and Discover and has annual product capacity of 1.8 million units.   The company’s Waluj plant produces the Boxer, CT100, Platina, Discover, Pulsar, three wheelers, RE 60, and all exports.  It currently has annual production capacity of 3.06 million units.

Baja Auto Production Capacity


In the year ending March 2015 (FY2015), Bajaj Auto sold 3.81 million units. 2.01 million units were sold in India and the other 1.81 million units were exported.  Of the 3.81 million units sold, 3.29 million units were motorcycles and 0.52 million units were three wheelers.

Bajaj Volume by product and geography


Since 2010, the main driver of unit growth has been export volumes, growing at 15.2% per annum, as domestic volumes have stagnated since 2010 and contracted by 10.2% since 2012.


The company sells more three wheelers in export markets with 54.9% of three wheelers sold 0.285 million units exported.  In the domestic market, the company sold 0.234 million units three wheelers generating an EBITDA margin over 20% in the domestic market, holding 46% overall market share, 91% market share in the petrol and alternate fuel segment, and 62% market share in the small diesel segment.


Export markets have an EBITDA margin are greater than 20% above the company’s domestic EBITDA margin. Assuming a 20% EBITDA margin in the export market the domestic market’s EBITDA margin is roughly 16.5%.  The company’s exports by regions are below with the largest two wheeler export market is Nigeria, while Sri Lanka is the company’s largest three wheeler export market.

Bajaj Export Revenue by Geography


In export markets, Bajaj Auto has a unique model.  The company produces all motorcycles in India then the motorcycles are assemble locally.  Hero is taking another route of producing and assembling motorcycles locally, as illustrated by Hero’s USD38 million investment in a Columbian manufacturing plant with 150,000 unit capacity. Bajaj Auto is taking advantage of the company’s existing infrastructure and ecosystem (90% of part production is outsourced in India) as well as India’s lower cost of production. KTM’s CEO puts the cost of producing a motorcycle at 30% of the cost of production in Europe.  Bajaj Auto’s goal is to increase its share in the global motorcycle market from 10% to 20% through exports, primarily to developing markets.


The company’s main brands are the Pulsar, Discover, and Platina.  The Pulsar brand is the company’s largest brand selling 0.881 million units in FY2015 with 0.631 million units sold in the domestic market and 0.25 million units exported. In FY 2015, the Pulsar and KTM brand had a 43% market share of the domestic sport segment with roughly a 20% EBITDA margin in the segment.  The Discover brand was the company’s largest brand with 1.5 million units in FY2013. Unfortunately, the brand has not performed well and it only 429,000 units sold domestically in FY2015. 0.985 million units were sold in the domestic market and 0.191 million units were exported. The company’s third largest platform is the Platina.  Platina is a motorcycle for the entry segment, where the company has a 23% market share. In FY2015, Platina and the newer CT100 brand sold 0.518 million units in the entry segment.  Other motorcycle brands include the Avenger, which competes in the cruiser segment selling 44,000 units in FY2015. The KTM brand competes in the sports segment selling 23,000 units in the domestic market in FY2015.


Bajaj Auto’s marketing strategy is different than other two wheeler manufacturers.  Bajaj Auto creates a motorcycle brand and uses this brand across different engine sizes and customer segments. For example, the Pulsar brand has a youthful and powerful image.  The company manufactures Pulsars across many different engines sizes.  Bajaj Auto also does not use the Bajaj name on motorcycles as the company sees it as very diluted.  With the company’s Pulsar brand, it never advertised cheaper 135cc and 150cc models to avoid diluting the premium image of the brand even in the commuter segment.  A lesson learned from the marketing mistakes made on the Discover brand. Other two wheeler manufacturers use the company’s brand name such as Hero and then a model has a specific model name such as Splendor or Passion.  These model names are used on just one engine size.


Bajaj Auto believes its focus on brands over models leads to pricing power as fewer brands create less confusion among customers and creates better knowledge and intimacy with a brand.  Additionally, it is more cost effective as the company only has to market a few brand platforms rather than a number of different models brand platforms.


The company’s focus on brands is what Bajaj Auto calls the front-end, which thrives on differentiation.  Manufacturing is the back-end, which relies on synergies and economies of scale.


Bajaj Auto also has a marketing agreement with Kawasaki to sell motorcycles in ASEAN and South American markets.  The partnership started in Philippines and has spread to Indonesia and Brazil. The companies are complimentary as Kawasaki makes motorbikes mostly with over 650-cc engines at the upper end of the spectrum, while, Bajaj Auto is a mass player with bikes ranging from 100 cc to 220 cc.


Bajaj Auto’s market share by segment in H1 FY2016 is illustrated below.

 Bajaj Market Share by Segment


M1 is entry level mileage segment, which Bajaj serves with CT100 and Platina. The Sports segment is served by Pulsar.  The Supersport segment is served by Pulsar and KTM.



Bajaj Auto- Barriers to Entry


The first step is determining whether barriers to entry exist is to examine the evidence.  The evidence pointing to barriers to entry are listed below.


  1. The company consistently generates ROIC well above 15%. Over the past five year the company’s average ROIC is 359.2% and a FCF ROIC of 244.4%. The company has maintained its high profitability during industry downturns.


  1. The company has negative working capital. Negative working capital points to significant bargaining power and being the center of an ecosystem.


  1. The two wheeler market in an oligopoly. Hero, Honda, Bajaj Auto, and TVS are the four largest two wheeler manufacturers accounting for 90.9% of the market in FY2015. The Herfindahl index also points to significant concentration.

Bajaj Two Wheeler Market Share


Bajaj Auto has seen the largest decline in domestic market share as its Discover brand sales declined significantly as the brand position was diluted confusing consumers about its position. Bajaj Auto also exited scooters, a segment of the market that has grown the most over the past few years. Additionally, the company has grown significantly in export markets. Bajaj Auto’s management is focused on profitability over market share.


  1. Honda’s quick market share gains while smaller players have difficulty gaining meaningful share points to a well known brand being important in a customer’s purchase decision. Until 2010, Honda had a joint venture with Hero MotoCorp allowing consumers to have experience and trust the company’s brand. Since the joint venture ended, Honda has increased its market share from 12.7% in FY2010 to 26.6% in FY2015, while smaller brands have gained share but nothing meaningful. The average annual share gain by smaller players is 0.4% per year. Eicher Motors market share increased from 0.7% in FY2010 to 2.8% in FY2015, while the other gainer outside of the top four was Yamaha, which grew its market share from 2.4% to 3.7%.  Honda has had a much easier time increasing market share compared to smaller players due to its existing brand and infrastructure pointing to barriers to entry.


  1. Hero’s inability to gain share in the premium segment (150cc and up). Despite seven models in the segment, Hero only has a 6% share.  Hero is well known for its leadership in mileage and commuter segment. Given its position as a cheaper motorcycle that gives you good mileage, it may be difficult for consumers to view it at a premium brand that they are going to spend more on illustrating the importance of a company’s brand.


  1. There are significant fixed costs in the form of advertising and R&D. Of the top four two wheeler makers, three are publicly traded and report full financials.

Bajaj MES


The average gross profit of three largest publicly traded two wheeler manufacturers is INR12,888 per unit in FY2015.  Dividing the average fixed costs by that figure leads to a minimum efficient scale of 758,767 units or 4.1% of the market in FY2015.

Bajaj Expanded Market Share


4.1% is the minimum efficient scale required to compete as a generalist.  A company can take niche strategy similar to Eicher Motors attacking a specificsegment and just competing in that segment. The key to winning a niche segment in the Indian motorcycle segment is to create the segment.  Eicher Motor created the mid-size segment (250-750 cc) in India and holds 96% market share within the segment so smaller players can enter the market and compete but will have difficulty as a generalist.  Even large international companies such as Suzuki and Yamaha that can be subsidized by profitable international parents or local automobile companies such as Mahindra that can be subsidized by the automobile companies are having difficulty garnering the 4.1% market share required to be profitable under a generalist strategy.   Given the top four collectively hold 90.9% of the market and Eicher Motors hold 2.8% of the market through a profitable niche strategy, it would be difficult for many other players to be profitable with a generalist strategy.


  1. In the domestic market there are regulatory barriers to entry. There are high import duties with 105% import duty on new motorcycles and 100% import duty on used motorcycles. The motorcycles can only be imported through three ports. Motorcycles that are assembled in India with foreign parts have a 30% duty. The industry is fully deregulated with regard to foreign direct investment.


  1. Bajaj Auto outperforms its largest peers on almost all profitability measures.

Bajaj Per Unit Performance


Bajaj Auto has the highest ASP of its largest peers largely due to a higher focus on motorcycles and three wheelers.  Adjusting for the effect of other two wheelers and three wheelers, Bajaj Auto’s ASP (INR56,690) is still higher than Hero (43,934) and TVS (49,976) due to its lack of focus on the entry level segment, 75-110cc motorcycles, which is currently dominated by Hero with a 71% market share.  The next level up, the 125cc market, is also dominated by Hero with a 51% share.

Bajaj vs Peers product type


Given the higher cost of producing motorcycles and three wheelers, Bajaj Auto’s cost of goods sold per unit is higher.  The focus on premium products decreases the importance of price in the purchase decision.  Additionally, exports are almost half of the company’s sales.  Exports have higher margins than the domestic market. Both lead to a higher gross profit per unit relative to peers.  The premium pricing and higher gross profit per unit potentially points to Bajaj Auto having valuable brands.


Over the five year period, Bajaj Auto has been the most efficient on operating expenses.   Over both five year and during FY2015, Bajaj has used capital the most efficiently with the lowest capital requirements per unit.  The company’s management is focused on efficiency and profitability over market share. Overall, Bajaj generates the highest ROIC and FCF ROIC of its largest peers.


While there is evidence pointing to barriers to entry there is also evidence pointing to no barriers to entry.


  1. The poor performance of the Discover brand points to a lack of brand advantage. Discover brand was introduced in 2004 reaching 1.5 million units sold in FY2013. Since 2013, Discovers sales have halved with estimated total sales of 744,000 in FY2015.

Discover brand sales


If a brand advantage existed the company’s sales would not have increased as rapidly as it did from 2004 to 2013 in the face of a strong existing competition, which would have a brand advantage. If the company was able to build a brand, its sales would not have halved in two years time.


  1. Bajaj Auto’s gross margin volatility points to a lack of pricing power. If the company had pricing power it would be able to transfer raw materials cost increases to customers and gross margin would be consistent or increasing.

Bajaj Gross Margin


  1. The decreasing concentration within the top four players consistently losing market share to smaller players. From FY2007 to FY2015, the four largest two wheeler companies lost 4.1% with four firm ratio dropping from 95.0% to 90.9%.  It is still a highly concentrated market but the existence of barriers to entry should lead to the inability of players to enter the market.  Eicher Motors with its Royal Enfield brand is profitable and dominating a niche segment, the mid-size segment with 96% market share. It has increased its market share to 2.8% in FY2015 from 0.7% in 2010. Yamaha has also increased its market share to 3.7% in FY2015 from 2.7% in FY2007.  Suzuki has increased its market share to 2.0% in FY2015 from 0.8% in FY2007.  The share increases are not dramatic and it will take some time for smaller players to break the oligopoly.


  1. The lack of stability in market share among the top four players. The change in market share over the eight years among the top four players is significant. If any company had a competitive advantage, market share changes would not be as drastic. The average absolute share change over the eight year period was very high at 9.94%.  Honda’s market share gain should not be view as a new entrant but an existing player. Honda is a well known brand within the India market. Until 2010, it had a long standing joint venture with Hero. The prior existence of the brand in the market made it well known.  The quick market share gain by Honda and small market share gains by smaller players points to how a brand can influence a customer’s purchase decision.

Bajaj Two Wheeler Market Share Part 2


Overall, there is compelling evidence for and against the existence of barriers to entry in the two wheeler market.  Although there is compelling evidence against barriers to entry existing, the most compelling evidence is most often a company’s ability to consistently generate excess profitability. The ability to generate excess returns with the significant concentration in the industry, the presence of fixed costs, and inability of smaller players to gain significant market share over a long period outweighs the evidence against barriers to entry.


Given the evidence points to barriers to entry existing, the next question is what are those barriers to entry?  It seems the presence of fixed costs leads to economies of scale within the industry.  Economies of scale should lead to greater profitability with size, which is not the case as in FY2015. Including export volumes, Bajaj Auto is just over half the size of Hero yet is much more profitable on a per unit basis and overall ROIC basis.  Eicher Motors is just under a fifth of the size TVS yet much profitable.  There may be economies of scale in the industry stopping entry from smaller players but it does not drive profitability differences between the four larger players.


There seems to be a brand advantage as well. A company that gets the first mover advantage by creating a new segment retains the position in consumers’ minds as the leader in the segment. Hero is a leader in the commuter segment due to a combination of price, mileage, and resale value.  Despite others making motorcycles that are slightly more efficient Hero retains the position in consumers’ minds as the motorcycle that gets the most mileage.  Bajaj Auto created the sport and super sport segments with the Pulsar brand launch in November 2001. Before the introduction of the Pulsar, the Indian motorcycle market trend was towards fuel efficient, small capacity motorcycles (80–125 cc class) with barely any motorcycles above the entry segment. Despite competition, Bajaj Auto continues to dominate the segment with a 44% market share.  Eicher Motors created and dominates the mid-size segment (250-750 cc) with a 96% market share.  Bajaj Discover’s may provide evidence of lack of brand value within the market but it was a not the leading brand and too much like the Hero Splendor.  Bajaj Auto seems to have diluted the brand’s position confusing consumers.


In the export market, India has a large cost advantage over other locations and it has some of the largest motorcycle manufacturers in the world leading to an existing ecosystem. According to KTM’s CEO, it costs 1/3rd of the cost to produce motorcycles in India compared to Europe.


Other than economies of scale and brand in the domestic market and costs in the export market, there seems to be no other economies of scale.


Given the oligopolistic market structure, intensity of rivalry is also important to profitability. Prior to 2007, companies competed for market share leading to price wars and margin compression.  Since those price wars, industry competitors have been more disciplined on pricing.  The discipline is further shown by the invested capital growth of the three largest players.  Since 2007, total invested capital increased by 10.3% per year while domestic sales volume increased by 10.2% per year.





Since Rajiv Bajaj took over as managing director, management has done well strategically and operationally. Strategically, the company narrowed its focus leaving the scooter segment focusing on motorcycles and three wheelers allowing the company to become more efficient in marketing and manufacturing.  It also allowed the company to better exploit the global market through low cost manufacturing.  Within the domestic market, the company’s unique marketing strategy allows it to build stronger brands and greater efficiencies in marketing.  Although it has lost market share domestically, it is now a global company with almost half its revenues from global markets, primarily in developing markets.


Operationally, Bajaj Auto is the most profitable company in the two wheeler industry due to the strength of its strategy. Over the past five years, the company’s gross margin is slightly higher than it large peers due to the company’s premium products. Operating margins are well above peers due to the company’s strategic focus allowing for efficiencies in marketing and manufacturing.

Bajaj Margins vs peers


The company has not made any capital allocation missteps.  The company’s core operations continue to generate very strong profitability. Since 2011, total operating cash flow before working capital INR127,176 million.  Working capital generated an additional INR5,773 million.  The largest capital allocation decision was the decision to retain cash leading to an increase in cash by INR62,860 million. At the end of FY2010, the company had a net debt position of INR12,558 million. At the end of FY2015, the company had a net cash position of INR62,809 million.  The company only spent INR17,208 million on capex over the last five years so there is more than enough cash on the company’s balance sheet and it should return cash to shareholders.  At the current valuation, dividends would probably be the best option.

Bajaj Capital Allocation


In November 2007, Bajaj Auto acquired 24.5% stake in KTM Power Sports AG (holding company of KTM Sportmotocycles AG) for 98.4 million euros.  Bajaj Auto increased its investment by 99.7 million euros to 198.1 million euros with the company’s stake increasing from 24.5% to 48%.  KTM is listed on the Vienna Stock Exchange.   At current market prices, Bajaj Auto’s 198 million euro investment in KTM is now worth 595.58 million euros representing a 200% return on investment, a very shrewd investment.



Corporate Governance


In FY2014, Bajaj gave former Citi banker Nanoo Pamnani, an independent director serving on the board of four Bajaj companies, a Rs1.5 million bonus.  The additional payment puts into the question the independence of the Nanoo Pamnani. Proxy advisory firm Stakeholders Empowerment Services believes the bonus payment is unfair and recommended shareholders vote against it.


The company was the principal sponsor of the Positive Health Awards run by Mukesh Batra’s the proprietor of a chain of homeopathy clinics. Mr. Batra is a good friend of Bajaj Auto’s managing director Rajiv Bajaj, who is passionate about yoga and homeopathy.  The sponsorship does not seem to add much value and seems to be frivolous and not in the best interest of all shareholders.


Management does not extract too much value with directors and senior management renumeration remaining consistently around 1.0% of operating profit.



Management’s Language


Management’s language gives you strong understanding of how they view their business and the assumptions used in the business. Below are selected quotes illustrating management’s views and assumption of its business.


FY2011 Annual Report


“In other words, there was more to Bajaj Auto’s performance than riding with the tide. It was about combining a highly focused brand-centered strategy with production efficiency, quality, costs and logistics.”


“Discover and Pulsar do not ‘buy’ market share through eventually debilitating price competition. They gain share by their brand, quality and performance – so that customers are pleased to pay more for obviously better value.”


FY2010 Annual Report


“For the last few years, your Company has been working at developing a brand-centered strategy especially of its two key brands, the Discover and the Pulsar.”


“What pleases me is that Bajaj Auto is leveraging its key brands to maximize profits. Your Company’s performance has not been about ‘buying’ market share through various pricing deals. Instead, it is about gaining share through better quality and branding – thus having the customer willing to pay higher prices for better value.”


“Your managing director often says that while products may generate market share, brands            provide pricing power and create higher profits. I am increasingly tending to agree with him.”


Other sources


“Management believes its ability to build very strong brands is the reason for its above industry returns on invested capital.”


“Less of technology industry and more of a marketing industry.  More less all players have the same technology and quality.  It is all about being first to market. Second to market with no differentiation”


“Bajaj Auto Mass manufacturer not a niche manufacturer.”


“Three wheeler segment low barriers to entry no capital requirements to develop a three wheeler, no technology requirements to manufacture, no elaborate arrangements to distribute.  Absence of barriers to entry market will become commoditized.”


“At the base of all human problems lies ego. And every shareholder is human. We always have our moments when greed gets the better of us. But one must draw a line between growth and greed. Growth for the sake of growth is an ideology of a cancerous cell. This is how most companies destroy themselves. How does one grow without being greedy? We feel the best way to do that is to listen to your brands. If I want to be greedy, I can introduce a 100cc Pulsar.  It will grow for 6-12 months. But over a period of three years, it will diffuse the brand. The ill-effects take time to play out. If companies look back, whenever they have line extended in some way, it has not worked. We don’t manage our brand.

Our brand manages us.”



“Of the global volume of roughly 50 million two wheelers, 30-35 million are motorcycles. This year, we will sell around 3.8 million motorcycles. We have a 10% share, so we have no business to look at something like scooters. We should go up to 20-25%. In exports, there is a lot of headroom to grow. In the past five years, we have grown six times; today, exports comprise 35% of total sales. A day should come when 20% of our sales are in India and 80% outside.”


“By end of fiscal 2016, we should enter a dozen new export markets,” said Sharma, declining to give further details. This will help the firm report a growth of 13-15% in export volumes over the next 3-4 years”





Assuming a 15% discount rate, 5.0% sales growth into perpetuity, 18.9% operating margin, and historical average capital efficiency, there is 22% downside to the company’s FY2021 intrinsic value per share of INR2,039 per share.  Assuming 10% growth over the forecast period fading to a 5% perpetuity growth rate, there is 1% downside to the company’s FY2021 intrinsic value per share of INR2,595. Assuming 15% growth over the forecast period fading to a 5% perpetuity growth rate, there is 27% upside to the company’s FY2021 intrinsic value of INR3,314.


The company currently offers a 3.4% FCF yield assuming a 7% growth rate the company offers an expected return of 11.4% per year.


The ideal time to buy Bajaj Auto is when the share price is below INR1,300.




The biggest risk to an investment in Bajaj Auto is currently valuation risk as there is little to no margin of safety.


Domestically, the biggest concern is continued stagnation in demand.


Currently, the industry is undergoing a period of competitive discipline.  If companies shifted its focus back to market share over profitability, it could lead to price wars and margin pressure.


Dilution of the company’s brands is a concern.  While other two wheeler manufacturers have one model and engine per brand, Bajaj Auto manufacturers many different models and engine size in a brand creating the risk of diluting a brand’s position, which happened with the Discover brand.


Another concern is regulation.  The company has created a quadricycle to replace three wheelers.  The company has not been allowed to sell the product domestically or in Sri Lanka, the company’s largest three wheeler market outside of India, due to perceived safety issues.

2015 Reperio Model Portfolio Review 1/4/2016

2015 Reperio Model Portfolio Review 1/4/2016



2015 Portfolio Review 1 4 2016 Returns


Our primary concern is avoiding permanent loss of capital. Our secondary concern is absolute returns with a goal of 15% per annum for each investment.  Our final concern is beating our benchmark ensuring active management adds value.  In 2015, Reperio Capital’s Model Portfolio ended the year up 14.3% while the iShares MSCI Emerging Market Small Cap ETF declined by 9.1%.  We successfully avoided any permanent loss of capital and beat our benchmark by 23.4% but missed our target return of 15.0% as we are building our portfolio and our average cash position 67.5% in 2015.  At the end of 2015, our cash position is at 38.1% but is expected to increase by 15.6%, assuming no price changes as we are reducing our position in Peak Sport Products and Honworld Group.  We are attempting to find one idea per month, which will make us closer to fully invested.  Cash is a residual of opportunities but fully invested assumes a cash position between 10-30%.



PC Jeweller


PC Jeweller’s (PCJL:IN) share price appreciated by 80.1% with a 1.5% dividend yield, while the Indian Rupee depreciated by 4.5% against the dollar.  PC Jeweller grew its operating income by 25.8% over the past year with the remainder of the share price appreciation coming from multiple expansion with EV/ttm EBIT increasing from 8.5 at the end of 2014 to 10.5 times at the end of 2015.


2015 Portfolio Review 1 4 2016 PC Jeweller


PC Jeweller opened its first franchise in the previous quarter. Franchising requires little or no capital.  Franchises will be set up in locations where the company has no operations.  In addition, the company is going to open smaller locations to tap the middle/lower class markets, which the company does not serve.


The unorganized segment accounts for 80% of the market and in seven to ten years management believes the organized sector will reach 80% of the market with only 15-20 organized players. The company is targeting opening 15 showrooms in FY2016 and plans to add an average 100,000 sq ft per year over the next 5 years.  Assuming PC Jeweller reaches half of its expansion targets over the next five years, with similar profitability per square foot, the company will be trading on a 6.3 times EV/EBIT multiple. This is very conservative as it is half the company’s expansion target, assumes no improvement to profitability, and no franchises.  PC Jeweller is extremely profitable with an average ROIC of 38% since 2008 with stability during an industry downturn.  The company has a very strong financial position with net debt to EBIT of 0.55 times. The company’s management is strong operationally with no capital allocation missteps and there are no corporate governance issues. Despite, the company’s financial health, profitability, growth outlook and management, PC Jeweller is only valued at an EV/EBIT of 10.3 times.  We have sold more than our original investment but continue to hold our current 5.0% position given the company’s profitability, growth outlook, and valuation.



Zensar Technologies


Zensar Technologies’ (ZENT:IN) share price appreciated by 80.6% in Indian Rupee terms. The company paid a 1.8% dividend yield and the rupee depreciated by 4.5% against the US Dollar. Zensar’s FQ2 2016 trailing twelve month sales have increased by 15.9% and trailing month operating income has increased by 26.8%. While the company is growing its intrinsic value, there has also been multiple expansion with the company’s EV/ttm EBIT increasing from 8.4 times at the end of 2015 to 12.7 times at the end of 2016.


Zensar continues to execute well with the number of million dollar contracts continuing to increase.  At the end of FY2015, the company’s digital revenues accounted for 13% of revenues up from 5% in at the end of FY2014.  The company expects revenues to reach 20% at the end of FY2016.  The company also continues to increase the number of employees, revenue per employee, and profitability per employee. Since 2011, the company’s employee count grew by 6% per annum, revenue per employee grew by 10% per annum, and operating income per employee grew by 20% per annum.


2015 Portfolio Review 1 4 2016 Zensar employees


In December 2015, Zensar appointed Sandeep Kishore as the next CEO & MD. He comes from HCL where he is vice president and global head for the life sciences and health care and the public services businesses. He has over 25 years experience in the Indian IT Outsourcing industry and has a very impressive resume.


Zensar has one of the highest percentages of digital revenues among the Indian IT Services companies, and has aspirations to be a Tier 1 IT services provider. It continues to generates strong profitability with an average ROIC of 25% since 2005 with little variability.  The company believes it can continue to grow at mid to high teen rates for the foreseeable future.  The company has proven it ability growth with an average revenue growth rate of 23% since 2005. Despite, the company’s strong financial health, profitability, growth outlook, Zensar Technologies is only valued at an EV/EBIT of 12.7 times.



Peak Sport Products


Since our initial purchase in March 2015, Peak Sport Products’ (1968:HK) share price appreciated by 4.2%, paid a 7.7% dividend with no change to the Hong Kong Dollar US Dollar exchange rate.  Peak was initially a 9.1% cost base position. At the time, the company was trading just above its net current asset value and an EV/EBIT of 3.1 times. With the exception of a large cash position on the balance sheet, the company had not made any significant capital allocation mistakes. In July 2015, Peak issued 280 million shares or 11.72% dilution to existing shareholders. Insiders did not sell any of their shares.  The company sold the shares at net price of HKD2.43 representing an EV/EBIT of 4.8 times.  After the placement and during a period of significant stress in the Chinese markets, Peak’s share price fell to a low of HKD1.55 well below the company’s net current asset value of HKD2.15. Our initial position fell from 9.1% to 6.1%.  Given the discount to its net current asset value, we increased our position size by 5.6% to a 15.0% cost position.


The company continues to generate consistent profitability with a leading position in the niche segment of the basketball performance market. The company has growth opportunities in both the international and in new segments, tennis and running, where it is bringing its focus on performance and functionality. Despite the company’s strong balance sheet, three year average ROIC of 17%, and mid to high single digit growth, the company is no longer trading at a significant discount to its net current asset value but right above its net current asset value. We are adjusting our position to 5.0% as management credibility and capital allocation skills are in question making the investment a deep value investment rather than a quality value investment.  Our max deep value position is a 5.0% cost position given the inherent weaknesses of deeper value businesses.



Honworld Group


We started purchasing Honworld Group (2226:HK) after our initial recommendation in June 2015. The company’s share price has appreciated by 28.6% from our weighted average purchase price with no dividends and no significant change to the Hong Kong Dollar relative to the US Dollar.  Honworld is the largest cooking wine producer in China. The company is very regional with 88% of its revenues coming from the company’s key regions, which account for roughly 26% of China’s population. The company is still expanding its distribution channel within its key regions.  The combination of the company’s size and ability to garner premium pricing as it is the only one of the top four producers that uses an all natural brewing process for its condiment products gives the company a large gross profit advantage over its closest competitors. Honworld’s gross profit is 2.86 times its largest competitor, 4.81 times is second largest competitor, 8.89 times its third largest competitor, and 16.00 times its fourth largest competitor. This size advantage allows Honworld to significantly outspend competitors on acquiring new customers via marketing and building out its distribution channel and improving the company’s products through research and development. The company has pricing power given the company’s product quality and the low cost of the product.  Unit economics are fantastic with the four year average ROIC per liter is 79%. The company is also growing at 20% rate despite the concerns over the Chinese economy.  Management is passionate, owner operators with integrity although there are some question marks over capital allocation related to building inventories.  Management stated in its H1 2015 interim report that inventory is now sufficient for growth requirements so this may point to decreasing inventory levels. In November 2015, the primary owner charged his shares to receive a loan for his holding company.  Management honesty is evidenced by the donation of the primary shareholder’s cooking wine inventory, valued at RMB7.0 million to the company before its IPO.  Additionally, the primary shareholder sold his family’s cooking wine secret recipe to the company for RMB1.  His family also owned Honworld’s main brand before the communist revolution.  We believe the main shareholder sees the asset as his family’s heritage that he would not put at risk.  Despite the business quality and cheap valuation, EV/EBIT of 9.8 times, the charging of shares for a loan, the lack of few cash flow due to the misallocation of capital, and management unwillingness to have discuss the company all lead to lowering our position to a 5.0% position in our model portfolio.



Miko International


Miko International’s (1247:HK) share price has fallen by 27.4% since our initial purchase. The original investment thesis was buying a very profitable, rapidly growing business with a healthy balance sheet run by owner operators. The vast majority of the investment thesis still holds with the exception of the strong growth.  In the first half of 2015, Miko saw negative top line and operating profit growth.  The company put this down to a slowing economy as well as closing of many stores for refurbishment.  The favorable sign of the weaker growth in H1 2015 was Miko’s ability to maintain strong profitability.  Typically, when a retailer is hit by slowing growth working capital balloons and fixed costs become more prominent driving down profitability.  While Miko’s profitability took a slight hit in H1 2015, with ROIC falling to 26%, it was still well above the company’s cost of capital.  Miko is in the process of acquiring distributors and running the retail operations themselves as Miko has been selling products to distributors at 35% of final ASP.  Miko had full control of retail operations but this makes it more formal, allows for better contact with customers and brings the distributors margins in house.  As illustrated in our initiation report, the IRR on taking the retail activity in house is well above the cost of capital.  Despite continued strong returns, management are owner operators with no material corporate governance issues, Miko is trading at 78% of its net cash position and 58% of its net current asset value. It will remain at its current position size given its lack of liquidity.



Company 9/18/15


Company 9/18/15’s share price appreciated by 14.6% from our weighted average purchase price. The company is very strong at acquiring companies very cheaply without taking on debt, and improving their operations.  In all its business segments, the company has shown consistent success generating ROIC well above its peer group average.  The company has multiple unique activities with a tailored value chain that is not easily replicable.  The company’s latest results show it growing at 20% without any acquisitions and over the past five years the company has grow by 50% per annum. Finally, the company’s executives are very strong operators, capital allocators, owner operators, and are increasing their stake in the company. In 2015, the company’s chairman and main shareholder increased his stake from 45.14% to 51.66%.   Despite all the strengths of the company, it trades on an EV/EBIT of 4.9 times.  It is currently our largest and highest conviction position at a 14.5% cost position.



Company 11/19/15


Company 11/19/15 is down 7.0% in US Dollar terms since our purchase in November 2015. The company built multiple competitive advantages in the domestic market and the company is trying to replicate these advantages in the export market.  Within the domestic market, it is a low cost operator with scale advantage due to heavy investments in advertising, product development, automation, and process improvements.  It produces a low priced experienced good that is purchased infrequently combined with heavy spending on advertising the company has built a strong brand allowing for pricing power. In the export market, the company is at the low end of the cost curve ensuring the company stays competitive and profitable.


The company is run by owner operators with strong operational skills and an understanding of its competitive position who treat all stakeholders with respect.  It also has consistently generated stable, excess profit even during periods of industry stress and has a net cash balance sheet.


Despite the company’s strengths, there is upside to the bear case scenario of no growth and trough margins with the company trading on a 10.5% NOPAT yield and an 8.8% FCF yield. Using conservative assumptions, estimated annualized return over the next five years is 15-17.5%.  It will remain a 5.0% cost base position.

Reperio Capital Research’s Edge 11/6/2015

This is an excerpt from our October 2015 monthly review.

What is Our Edge?

At Reperio, we are firm believers that to produce extraordinary results, you have to do something different from everyone else.  What do we do different in an attempt to produce superior results?

It is something we think about a lot and we believe there are three key differentiating factors for our research.  First, we have a business owner mentality focusing on competitive position, management (not focused on by traditional research providers), corporate governance (not focused on by traditional research providers), absolute intrinsic value (not focused on by traditional research providers more focused on earnings momentum and companies beating expectations), and ensuring there is a margin of safety before recommendation (traditional research providers top picks are what is currently loved by the market due to earnings momentum are their top picks the opposite of our approach.)  We look for high quality stocks with poor sentiment.


Second, we have a long term investment horizon.  Jean Marie Eveillard once estimated that 95% of market participants are focused on the short term.  Given 95% of participants are focused on the short term; the vast majority of research providers will be catering to those participants in an effort to win their commission dollars.  Theses traditional research providers are obsessed with the next three to six months and companies with earnings momentum that can beat consensus. Our long term investment horizon coupled with our business owners approach gives us a tremendous advantage.


Third, we attempt to play a game where the competition is the weakest, i.e. Emerging Market Small and Mid Cap companies.  Just like any competition, if you play a game against very strong competition, it will be much harder than playing against weaker competition. When you are looking at US large caps you are competing against large buy side, sell-side, and hedge funds.  This is very difficult competition and while there are inefficiencies in these markets they are relatively small.  When looking at small and mid caps in Emerging Markets, competition is from the sell side, the buy side, and the public. Many of the names in the small and mid cap space have very little if any analyst coverage.  Analysts that do cover the names are more likely to be less experienced as most traditional research providers take the approach of trying to gain a small slither of a big pie and therefore put their best analysts on the bigger names.  The combination of short term orientation, and weaker experience leads to little competition. With buy side institutions, the vast majority has 100 or more names in their portfolio and has to know three to four times the number of companies.  This puts little emphasis on in-depth, independent research on smaller companies within Emerging Markets.  Additionally, 95% of buy side institutions are closet benchmark funds (over 100 stocks in the portfolio with big overweights and underweights being 1 to 2%).  This place a greater emphasis on the larger names that are in the index decreasing the importance of small and mid caps even more.  So buy side is very little competition.  The public typically are traders and have very little understanding of business so they are not much competition.


Our edge is illustrated by our PC Jeweller recommendation.  At the time of our recommendation in PC Jeweller, no large sell side institution covered the company and the smaller sell-side institutions were focused on the short term regulatory concerns leading to potential weakness in the short term and downside to earnings expectations. Our business owner mentality with a long term view saw a company that showed incredible resilience during an industry downturn (stable and high profitability) with a very strong balance sheet and innovative management with skin in the game.  There was short term looked uncertain due to regulation but the long term growth rate potential was tremendous given limited competition from organized retailers and a store opening target of 15-20% growth per year.  Despite the strengths of the company, it was valued under 5 times EV/EBIT.


Zensar Technologies is a similar story. It was a company that was coming off a period of indigestion after a large acquisition, which happens often.  Growth had slowed a bit which potentially put often the very few sell-side institution covered the company with no coverage from any big institutions.  The business owner with a long term investment horizon saw a company with very strong leadership in an industry with incredible profitability due to switching costs with industry low turnover due to a differentiated activity in an industry where the key resource is people and management was guiding 15% top line and operating profit growth for the foreseeable future. Zensar was also trading at under 5 times EV/EBIT eliminating a lot of the risk associated with the investment thesis but in the short term there were concerns putting off the sell-side.

Update on Macro concerns August 23 2015

Update on Macro concerns August 23 2015


Regarding recent macro concerns, we do not look at macro. While it is very important, it is extremely difficult to forecast due to the complexity of the economic systems. If the Fed and IMF with their armies of PH.D. economists have trouble forecasting the path of economies, we have very little chance particularly when my background is accounting and finance and not economics. Reperio would rather decrease the complexity of investing by focusing on buying high quality companies with good management, strong growth available at cheap valuations. With all that said, we are happy with all the companies mentioned and in our model portfolio as there is little evidence of macroeconomic concerns affecting our companies. The current macro concerns are increasing the number of companies meeting our strict criteria for investment.


PC Jeweller recently report Q1 FY2016 earnings. Sales grew by 14.2% with same store sales growth of 5% and profit before tax grew by 17.0%. The company opened four stores in the quarter remaining on target for 20 stores per year.  This illustrates operations are continuing unabated by any macro concerns. The company is also restarting its Jewelry for Less program in August which should increase affordability for customers.  The company agreed a partnership with Blue Nile, a US online jewelry retailer and is currently working on introducing smaller shops with a new brand for value segment of the market, where the company does not participate. In addition financing costs are starting to decline with the re-introduction of gold leases.  PC Jeweller proved its strength as an organization when the company withstood the recent downturn with very strong profitability while all other participants with the exception of Titan saw a significant contraction in profitability.  The market is valuing PC Jeweller on an EV to Profit after tax of 18.7 times. EV to PAT is appropriate given interest costs are such an vital part of the company’s business model. The company is spending significantly on growth depressing current earnings. The company has a huge opportunity to grow for the next five to ten years and maybe more.  The company is very well run and management continues to innovate, find was to maximize the future cash flows of the business and is trustworthy. We have sold more than my initial cost so we are happy to see how the company continues and do not expect selling any of the position any time soon. If we are lucky enough to see a significant fall in the share price, the position size will increase. A position size decrease would require a drastic run up in share price and even that may not do the trick.


Zensar Technologies reported Q1 FY2016 results as well. Revenues grew by 16.5% and operating profit by 34%.  Zensar has consistently grown its top line over the years (5 year rev. CAGR = 22%) and with larger and larger deals the companies is growing operating profit faster than revenues. The company is growing digital revenues rapidly and management is doing a good job with all divisions. Application management revenues grew by 19% and IMS continues to be volatile and despite a slight decrease in revenues operating profit grew by 96%.  Product and licenses is a small portion but it turn negative profit in Q1 FY15 to positive profit in Q1 FY2016 with a 3.0% operating margin in Q1 FY2016 from -0.4% in Q1 FY2015.  Overall, Zensar continues to grow at a mid-double digit pace yet the market gives it very little credit for any growth with the market valuing the company on an EV/EBIT of 11 times.


Peak Sport also recently reported H1 2015 earnings.  The company grew revenues by 7% and operating profit by 54%.  The company continues to provide highly functional performance products in basketball and is pursuing the same strategy in tennis with some good initial signs.  The company is trading at 1.1 times price to NCAV and 4.5 times EV/EBIT despite a record of continuous and strong profitability. The market is essentially giving the company no credit for its operations.  The position size is roughly 14% and is as large as we would like for a company which is more a deep value investment than a quality value investment.


Miko is valued below its liquidation and at the net cash level on its balance sheet, despite the strong growth in the company’s revenues, its industry and its profitability.  (Miko’s share price = HKD0.71, NCAV = HKD1.04, Net Cash = HKD0.68).  It is also trading on a PE of 3.  EV/EBIT is not used given the numerator is near 0. Miko does not seem to have any competitive advantage but is operating in a relatively immature industry allowing for strong growth and low competitive pressures supporting high profitability.  We will continue to increase our position size despite the lack of liquidity as it is a much better alternative to holding cash on a three to five year time period.


Honworld Group is a high quality business as it has potential competitive advantage from economies of scale and habit forming behavior.  It also sells a low price product which allows for pricing power.  The company should continue to grow at a rapid pace as the company shifts from a dominant regional business to a dominant national business.  Management is extremely passionate but the insistence on building inventory is a bit perplexing and a major drag on profitability.  Despite growing its revenues above 20%, the company is valued at a 13.7% EBIT/EV yield.  Add a very conservative 5% organic growth rate, the annualized return is around 19%. We will continue to build our position to a as long as prices remain around this level or lower as the company is a better alternative to cash despite management’s insistence on building inventory.