Guru Mantra 16- Competitive Advantage: Racing for Uniqueness (The Second Part)

Business to accounting

It’s the business which drives accounting not the other way round. So when we start with an annual report I felt lot of times building of a business story in mind in tandem with financials disclosed in accounts/AR. For example, once I saw purchase of trading goods is a big number in financials, but when I red the business and look at peers I wasn’t sure why this fellow is indulged in trading. It turns out to be jacking a big number of revenue to catch some eye brows, off setting the massive losses that has resulted from key revenue streams with trading of goods (with 60% plus related party transactions).

The inverse thinking or reverse engineering is once you develop a business understanding build an accounting framework. It’s bit tiring for non accountants, but easily doable. I would like to highlight few old posts which talked about meaning and definition of financials including key accounts and disclosures, principles etc.

Example and disclosure remains same, Maithan Alloys.

First the “seedhi” soch (straight thinking):

  1. Maithan needs raw material to produce alloys.
  2. Requires plant & machinery, land/building for production facilitation.
  3. The key ingredients other than raw material for production, quality check i.e. power, labour.
  4. A logistics system to deliver the alloys to customers.
  5. Corporate office for book keeping, HR, strategy and all other corporate function.
  6. Sales and marketing office to manage direct marketing if any.

If you see strategy canvas earlier we discussed, absolutely in line with key attributes. If you see the competitive landscape you will realise some competitors are doing differently. Their accounts will not be same as Maithan Alloys like trading in raw material (a big chunk of trading profit/loss you will find along with operational revenue). Now I leave a question for you on peer comparison. :slight_smile:

Second the tedhi such or reverse thinking:

  1. what was the preliminary expenses that were written off to build the plants (difficult to get old ones, new plants like Maithan’s vizag should be easy.
  2. heavy hand of management, what is the opportunity cost foregone to build the business.
  3. advertisement and marketing expenses spend over the years which yielded results or non results (not expecting much being an intermediate products).
  4. was one time benefit like tax, fixed asset subsidy heavily build into business making? this would have developed a biased financials with incentive.
  5. few others like quality defect etc difficult to get, I am ignoring.

Third and last yeda such (orthodox thinking):

  1. How company is funding fixed assets and working capital?
  2. what are trade off available against key drivers (say for power buy vs own and generate)
  3. how I am managing margins short fall if any (absence of pricing power)? (say paid through additional capital?)
  4. are my asset maintenance heavy?
  5. have I ventured out like acquisitions and subsequently written off a great deal of money? This is actually positive, it could have impacted badly but management wont repeat again!
  6. am I subjected to high skilled employee requirement and why?

As I mentioned in my post, don’t worry about completeness. When you build prototype (meaning all dynamics infused and again challenged) likely gaps should come out before final product.

Now think about financials of Maithan Alloys:

Enforced activities (no choice, must to do):

  1. Raw material, power, labour, sales, logistics accounting.
  2. Asset funding, working capital funding accounting.
  3. Support/corporate expenses to the reasonable extent.

Voluntary activities (optional):

  1. Trade off decisions
  2. Business restructuring decisions (amalgamation, consolidation etc)
  3. One time decisions (discontinue product/operations)

Possibility of non disclosure:

  1. Expenses written off on various accounts (advt, preliminary expenses, R&D, promotion etc)
  2. Unsuccessful business restructured
  3. All wrong one time decisions
  4. Convention other than historical cost and other accounting practice (like land at cost value, decision not to write off inventory/debtors). This is what we need to hunt from creative accounting practices.

Non disclosure of information is the most difficult part to achieve. Don’t blow your head off for accuracy and completeness. An intellectual estimation or guess is all required than absence of estimation.

Can you spot some of the impact of these things:

  1. All the ratios you are calculating can be terribly wrong. For example inventory turnover where 25% of raw materials are obsolete and disclosed but not taken to financials. We must identify and adjust these big ticket numbers and that’s why I said earlier the objective is to find “adjustments required to financials”.
  2. Either over stated or under stated book value (land bought in 1967 never revalued) leading to gross mistakes in reproduction value of assets.
  3. Serious errors committed by management like failed business restructuring (I would like to see if it’s a hired hand he should be asked to march out).
  4. Auditor’s reluctant disclosures. Auditors are always caught between integrity and profit, they don’t want to upset client ; at the same time can’t compromise on certain auditing standards. Most of them they choose a middle path i.e. disclosures and note to accounts. These two unearth wealth of information.

Fair, lets get back to our work.

Now we know what Maithan’s account should have, lets get into 2015-2016 annual report and peep into it.

Maithan Alloys Balance Sheet and Profit & Loss

Share capital and reserves: nothing usual, a bonus issued in 2015. Long term borrowings: a foreign currency loan on mortgage of Vizag plant for the sam plant ( I guess cheaper cost of capital). Deferred tax liability (accounting treatment of taxes due to tax books and financial books).
Long term provision- employee benefit for gratuity. Short term borrowings - a working capital loan against hypothecation of goods, plant and other fixed assets (combination of rupee and foreign currency loan). Accounts payable- business as usual.

Other current liabilities- maturities of long term loan (why?) and others payables of 103 Cr (not known). Short term provisions- again employee benefit (may be bonus).

Fixed asset- a lots of tangible (land, building, plant, vehicle etc), intangible includes software and good will (indicating an acquisition of company). Point to note, these good will again are accounting treatment, seldom have no reproduction value.

Long term loans and advances include deposits , Current investments- mutual fund investments

Inventories- again big raw materials, spare parts etc.

Trade receivables, Cash and bank balances, short term loans , other current assets, revenue (only sale of products), employee benefit, power cost, finance cost, depreciation, other expenses (big ones include stores, repairs, freight, export expenses).

At first look nothing unusual to business but as they devil is hiding in fine details. The reverse thinking and orthodox thinking is a combination of business performance and creative accounting practices to unearth. Creative accounting practices, lets tackle it separately. I will rather focus on visible things for now, key points for consideration:

1. Bonus issued in 2015 (capital allocation decision)
2. Amalgamation somewhere and good will account
3. Foreign currency loan to minimise cost of capital?
4. Probe further on break up of other payables and classification of long term maturity within current liabilities.

That’s a very short and sweet list to start with. The possible financial adjustments will come by reading notes, directors/auditors report, and accounting policies. Lets cover that off in creative accounting practices.

For now, I will jump to Risk side.

Risk Profile of Company

Well these are business risks emanating from decisions taken on area of financial reporting, strategy, compliance to rules and regulations and operations of business. This has nothing to do with stock price risks.

A very good tool to know the risk profile is application of ERM or Enterprise wide risk management. But at same time next to impossible for a retail shareholder to do an ERM assessment sitting outside with minuscule information when company themselves are struggling to implement ERM. But an mindset towards ERM will help to have again best estimate on available information on the risk management capabilities.

Under ERM framework the objectives of company are split to 4.

  1. Strategic- high level goals, aligned with and supporting its mission
  2. Operations- effective and efficient use of resources
  3. Reporting- reliability of reporting
  4. Compliance- compliance with applicable rules and regulations

To understand whether company has fulfilled or attempted to achieve these objectives one needs to understand eight components.

  1. Internal environment- tone of organisation and set the basis for how risk is viewed and addressed. This include risk management philosophy, risk appetite , integrity , ethical values etc.
  2. Objective setting- a process in place to set objectives which support mission and risk appetite.
  3. Event identification- internal and external events affecting the objective must be identified. This can create either risk or an opportunity.
  4. Risk assessment- risks are analysed , with likelihood and impact. Assessment of both inherent and residual risk.
  5. Risk response- avoid, accept, reduce or share the risk.
  6. Control activities- policies and procedures are established to help risk response being implemented.
  7. Information and communication- information is identified, captured and communicate to people to carry out their responsibilities against control activities.
  8. Monitoring- independent guys assess the effectiveness of ERM and suggest for modification.

(For detail google COSO-ERM).

Under claus 49 of listing agreement all our companies are suppose to identify risks, quantify them, build response and identify failures, report and audit. And COSO_ERM was a suggested framework. But this never happened in true spirit, risks are disclosed as style statements and copy paste than reality.

But not everything bleak and dark. There is a limited way to crack this unusually complex framework. Of course to the extent what we require and to do that we need to know how a ERM is performed.

  1. The risk you see in annual reports are not some sort of casual discussions within management members and then paste it to AR.
  2. Every company should carry out a formal risk management plan , establish risk appetite and all other components of ERM documented. The documentation is called Risk register and controls identified against it are tested regularly for effectiveness.
  3. Every failure that resulted in risk register must be reported a host of people including auditors and regulators.

Now the problem is a lot of risks are subjective, regulators do not have band width for a water tight implementation. That leaves the auditor to hold the quality, I hope recent IFC will enhance the process further though a long way to go.

How do we spot key points for risk management for OUR NEED?

First it lies within the strategy value chain. Lets give it a shot for Maithan and compare what management has written in AR.

1. The biggest risk for this company is assured production backed by sales to cover it’s fixed costs. Or else within few years it will vanish. We can call at “UNUTILISED CAPACITY”.
2. Quality of product is poor. “QUALITY RISK”
3. Next is if you can not fund working capital and fixed capital for a company with high fixed cost again net worth will erode quickly. Lets call it as “CAPITAL RISK”.
4. Moving on one must stay close to customers and vendors here. “LOCATION RISK”.
5. A substantial portion of company revenue is exports, need forex risk to be managed. “CURRENCY RISK”.
6. With so many operational efficiency requirements, back up to key management members is important. “SUCCESSION PLAN”.
7. Unavailability of raw material and power can jeopardise the operations. I will call rather “INPUT AVAILABILITY RISK”.
8. Compliance to labour laws, internal controls, and tax laws. “COMPLIANCE RISK”.

From a strategic perspective substitute products, tailor made value chain we have already analysed earlier. Not repeating them.

Now lets see what management is saying:

1. Industry risk (sector volatility)- nothing but unutilised capacity
2. Quality risk (poor quality)
3. Competition risk (no entry barrier)
4. Currency risk
5. Geographic risk
6. Liquidity risk (capital risk to fund operations)
7. Compliance risk (covered generally in audit report, directors report and notes).

Pretty much on same line what we are thinking, except probably to me succession plan and input availability risk.

Have they managed to mitigate the risks, that’s part of performance management. Somewhere down the line for us to explore!

Next step is to sniff the creative accounting practices and that’s fun as well.

Good wishes and happy investing.

The highlighted ones are the only portion gone to my stock refresh document which I am doing simultaneously. half of a page. :slight_smile:


An Important Note on Maithan Alloys

Yesterday Maithan has informed stock exchange regarding the AP floods and it’s impact on Vizag plant.

  1. Management states clearly the plant has been damaged significantly. The plant is insured. but question remains about business disruption.
  2. Management clearly says there would be again significant business disruptions.

As expected there is a knee jerk reaction to stock price, but I guess by the time I am writing this price has recovered. Anyway price is not our concern.

The reason I am writing is this is not stock proposition I am making to you, it’s part of a explaining a methodology i.e. a case study. Hence obviously no buy or no sell decision I have suggested. Saying that I do understand we spoke exclusively about business, competitive advantage, trade off which creates a differentiated value chain. More so I am yet to get into a proper bear case in this series, hence it appears more positive news for now. Hence important for me to clarify on a forum where people do rely other’s opinion with respect and regards.

  1. I bought Maithan Alloys around 170-180 (Feb 15 onwards) initially (pre bonus price, effective price now would be 85-90) and I stopped buying beyond 110. The price was paid basis purely reproduction value of assets discarding earnings growth to a large extent.
  2. Maithan went leaps and bound after bonus issue in fact went past 430. I sold off few post 360 basis a price excessive to reproduction value of assets.
  3. I still have no doubt on management, their edge. However needless to say this is what my analysis (not opinion!). The same reason again I started buying around 260-270 as the price looked good to me.

Important Point- the value add/niche experiment ,if part of Vizag plant with smaller production batch (this is my understanding) it will affect the competitive advantage temporarily as discussed.

  1. However considering a dud industry and natural calamity more so with management acceptance. Results may be affected and that’s what an indication from management.
  2. These days I am operating strictly on stop losses even for core portfolio with holding expectation. I will start off loading around 165 below till 140 if happens. But that would be nothing to do fundamentals of company and doesn’t mean I wont make another entry.

Last thing, have we not captured the risk, it’s part of location risk. But there is no way I could factor the impact to valuation for a natural calamities for the simple reason no company’s earning will look good if you factor a natural calamity (e.g. discount 70% of earnings in case of earth quake- you may wait 100 years with same assumption still earth quake may not happen and we need not get valuation). This is exactly the black swan we need to learn and manage part of behavioural finance.

Disclosure again: I am invested, now you know my buying and selling strategy. I hope my further declaration is in line with stringent requirement of the forum.

To reiterate my research on this company I am starting “creative accounting practices” now. By end of day will post, thanks.

@manish962 is this adequate?

1 Like

Dear All
I have just reached the stage of creative accounting practices, to complete the journey we need to go through 1. Financial metrics against competitive adjustment 2. Analysis of growth, profitability and financial health 3. Quality of management 4. Special situations 5. Valuation. This is minimum gamut I want to cover.

Post the incident in morning (flood in AP) I am disclosing the extracts of analytics done during initial assessment of Maithan, currently I am doing a yearly refresh. This would help readers why I took the call then to buy. Period- Jan to Apr 15.

  1. Has the company ever made an operating profit?

Last ten years company has earned operating profit every year.
2. Does the company generate consistent cash flow from operations?

During last ten 10 years the cash flow from operations has been positive on 7 occasions. Once during last 5 years, the cash flow has not been consistent.
3. Are returns on equity consistently above 10 percent, with reasonable leverage? (at least 4 out of years, 15 plus ROE with minimum leverage is a good bet. Cyclical firms may buck the trend).

ROE has been above 15 in last 4 out of 5 years. Financial leverage is 2.72 which is volatility on higher side.
4. Is earnings growth consistent or erratic?

Earnings growth are erratic. 2011- 72 Cr, 2012- 45 Cr, 2013- 43 Cr, 2014- 11 Cr, 2015- 52 Cr.

  1. Financial leverage above 4 or Debt Equity more than 1- stable business, debt to assets trend, nature of debt.

Financial leverage is 2.72. Debt Equity is 0.66. Not good but also reasonable. Debt is long term debt and working capital loan.
6. Does the firm generate free cash flow? (Free cash flow by sales> 5%), check in tandem with ROE.

FCF is very bad which is way off sales, around 0.5-1%.

  1. How much “other” is there? (one time charges)

Other income is less than 0.1%.

  1. Has the number of shares outstanding increased markedly over the past several years? (stock options, issuing shares)

During last five years there has been no increase in outstanding shares.
9. Spot the points from 10 year cash flow, profit loss and balance sheet.

Covered in detail in investment document.
10. Hole the risks, legal issues, competition.

Covered in detail in investment document.

And all other factors related to competitive advantage, tailored value chain remains same. You can see prior posts for detail.

Please let me know if you need a particular detail, the original working file and document is bit voluminous. If I paste everything it will run to multiple pages.

Few more important lines then for decision making:

Allocated capital which has not resulted above average cash flow or earnings. However the company has performed better than peers, with a cycle uptick it may be the front runner to generate earnings.

Maithan is managed by owner operator whose family has been involved in most of key positions. The management communication has not been consistent, heavily centralized management.

The hedging risk has not been mitigated. Customer concentration is not known. All macroeconomic risks like interest rate and inflation affects business. Cash flow has been terrible where operational outflow has been managed via capital inflow. Company enjoys high ROIC compared to peers but not in best league to other industries.

The company is valued 40% over liquidation bet; hence it’s not a knock out safety. However reproduction value is hovering around 40% more than market value. The earning power at higher WACC of 11% confirms a bit of superior management.

Dear suvi,
pardon me if my question is inappropriate, but I am a novice who has just joined this amazing world of valuepickr. This is the first thread I have started reading as this seems to be filled with immense experience and knowledge.

However, before going further the first post of yours where have mentioned that you were advised to stay away from sick type of business includes automobile manufacturers. Can you please explain/elaborate more on the same.

I do understand it includes-
“presence of multiple producers” and “organised labour” as mentioned by you, however it also is a part of the “consumption/growth” story that has been an integral part of India’s economy.

Or does it mean it is just a relatively shorter cycle, ie. 5-10 years as compared to a Bank/Financial institution where money will also be required to lend or to borrow till there is time

P.S- I could be biased towards the automobile industry as I have holding in some Auto manufacturers as well as auto ancillary manufacturers.

and thanks once again to share this invaluable knowledge!


This is an important question, and thanks for raising same. The quest hunted me so much I am going back to 10 years of Indian history to deep dive into winners of Indian stock market. Preliminary indications absolutely goes in line with what you were saying or what we call cyclical are clear winner. Rest you can read here:

But wealth creation or buying a stock is combination of business, management and valuation. Hence if we buy cyclicals at good valuation or at time of uptick trend it can create good wealth and that’s what has happened in India. So lets get a fact straight you can create wealth still by buying any type of stock.

The thesis here was made on “good business quality”. Commodity type of business will suffer from non-differentiated products, economic cycles (both up and down), lesser entry barriers. Now imagine a company with differentiated products with a brand can sustain earnings for a long time. Problem lies here in india is two fold 1. There are very few companies exist 2. the valuations are steep for such companies.

The best test for you is to see the valuation impact of auto and pharma during economic downtick. Though I would like to request don’t go by growth story much. Growth has to be backed up by economic profit (profit generated by operations minus cost of capital for funding such operations). If growth comes without economic profit it will destroy economics i.e. shareholders, company and banks ; everyone connected with value chain.

Hope it provides some clarity.

Also, the post “the jewels of India” where the mention of luck seems to be really important. have read only the 1st post and thanks for sharing the same. [quote=“The_Confused_Consult, post:74, topic:4814”]

The best test for you is to see the valuation impact of auto and pharma during economic downtick
this definitely makes sense.

Thanks for the clarity. This forum is amazing!

Creative Accounting Practices

Accounting is a reflection of transaction that is recorded by company having a financial impact (note here no financial impact no accounting). A transaction is recorded only when an activity of a business process is initiated, processed, recorded and authorised. Business process is a combination of tasks or set of activities lead to the product or services are delivered by company. So we are saying a lot of activities are grouped to a business process of homogeneous nature. All business process may not trigger financial transactions directly like HR or legal department. Some are directly linked like sales and marketing, procurement etc. The business processes can be out sourced or managed in house. To monitor business processes we need to have board, auditors, regulators and so on.

I spoke about a purchase transaction in past i.e. which stage it creates a financial entry and which stages are not. It also covered the difference between management accounting and financial accounting, who sets the rules for accounting, it’s principles and so on.

Not repeating them again let me get into the nuances of creative accounting:

  1. The mother concept of financial accounting is a journal entry. For every plus there has to be a minus. The nature of posting has created more complications:
  • with advent of ERP and other systems routine process like Sales, Procurement etc accounting entry is linked to business process. That means unless you create a PO and receive goods entry won’t be posted, with security features around direct manual entry is prohibited. But still I can create few similar accounts and post it directly bypassing all that PO/Goods receipt etc.
  • Some processes are still not linked to accounting as a single platform, like software revenue (project management tool, expense booking, billing/revenue) still managed through different systems. This results to lots of interfaces and again possibility of direct posting.
  • A bunch of journal entries are meant to be posted directly to the ledger like manual journals on adjustments, consolidation, provisions etc. There are suppose to be controls built around it but no guarantee though.
  • Balance sheet reconciliation and review processes is an evolving area for lots of companies more in the space of smaller and mid companies. This means account balance is reconciled with source and reviewed at different layers to ensure correct balances are appearing in financials.
  • Internal controls is an area by itself having a wider scope, things are improving but subjectivity and materiality drags down the assurance level. Same is the story with statutory auditor. For example for an auditor 50 Cr is a material amount for misstatement of financial reporting. Well I may not agree with it, but financial statement assertions (assurances) are build on auditor’s assertion not me and you.
  1. Second area is standardisation of accounting practices against business process.
  • Accounting standards are globally debatable and have no uniform approach.
  • Every business transaction is prone to multiple interpretation. One area of interpretation where management have the decision making power say like treating an expense as capital expenditure or not. This decision making comes either from the flexibility offered by standards as to what is capex and what is not which has open interpretations and of course the complexities of certain area like software revenue recognition (like fair value accounting).

Let’s discuss some areas which are prone to accounting harakiri and the places and tools where we can find them. Where there is a disclosure we can compare and estimate something. If no disclosure have been made only way left to reconcile, analyse different statements and information to sniff again best guess estimates!

First lets understand motive behind creative accounting practices, it’s two only. Either I overstate (inflate) earnings or understate(deflate) earnings. There is nothing else.

Rather than targeting bottom up lets do a top down. What are the scenarios when accounting can be manipulated or window dressed, do remember some of these may have been done with an intent to create a fraud as well. But as discussed earlier we need to investigate separately with management provided information, something not easy for retail shareholder.

  1. By applying inconsistent accounting standards due to the flexibility allowed.
  2. Reclassifying Profit & Loss to balance sheet or vice-a-versa (e.g. capex/opex decisions, patents charged off to PL directly).
  3. Reclassification within income or expenses account (one time sale shown as revenue from operations, actual expenses twisted as provision to improve above the line profit).
  4. Adjusting expenses with income or vice-a-versa (very common practice when multiple revenue practices are allowed. Say one company has project accounting and sale of services. Shift the expenses to project as its done basis percentage of completion which can be deferred!)
  5. Play around periodicity of expenses or income, assets or liabilities (shift a future expenses to current expenses like writing off R&D, amortise costs too slowly so that current expenses shifted to future).
  6. Use balance sheet to cover up (creating reserve and postpone profits to future) where it couldn’t be done under reclassification.

There are multiple ways to cross check and unearth. For a retail investor I could think of something which may be easy:

  1. Auditor’s and management notes: this should be our first place to see if there is confession if any. If management has identified with impact our job becomes easy. A lot of times I started without ignoring obvious, after 2 days I realised it’s already disclosed by auditor/management.

  2. Accounting Policies Comparison: Every company has to formulate it’s own accounting policies which is in line with the accounting standards issued by regulators. You can see them just after schedules in financials and first section of notes to accounts. Plot accounting policies for 5-6 years, it will open up if they have been applied correctly. If see inconsistency important to understand the impact of financials e.g. depreciation method changed from SLM to WDV.

  3. Common size balance sheet and profit & loss account: this is done by listing key items of PL and BS over few years and then calculating a percentage to a common base. Say R& D expenses was around 2% of sales and suddenly went up to 20% one year. This becomes an alert.

  4. Reconcile with cash flow: every balance sheet and profit & loss account have a relationship with cash. Unless we receive or pay cash it cant be shown in cash flow statement , subject to a big caveat the bank balance what appears is correct! (apparently for Satyam it wasn’t correct). So what we can do if accounts receivable has been rising faster than sales then sales are booked without cash being collected. Now this can be due to aggressive sales tactics by extending credit period to customers or over book billing as sales and then pass reversal entries next year. Every element of PL if paid /received as cash will have an impact on cash flow. You can reconcile same.

  5. Compare quarterly results: quarterly results are abstracts of financials and given quickly from reporting date. Apart from good earning member there is no sufficient time to do all the good window dressing. Add three quarter results and compare with annual figure proportionately. You will see the amount of sales and expenses that gets booked in last quarter, March quarter needs to be best quarter :). But a caution, this may not work for balance sheet, a good amount of entries like employee benefit provisions, estimates are done on a yearly basis.

The above are generally ways of hunting down, few specific example so that we know what is happening “normally”, meaning the areas where creative accounting practices applied. By using the methods mentioned above you should able hunt them down for quite a few.

Few practical experiences, please do read “Financial Shenanigans”, you will get most of examples. I am including a few customised to my approach.

  1. Check price per unit if sales are going down. There is a chance of rebates and discounts applied at an account level when prices are constant and rising.
  2. If related party transactions are high with high margin business big chances of revenue big over stated. Even cash flow comparison wont catch as bank transactions between known people are not a big thing.
  3. When we have high intangibles and reserves. Non cash entries get posted for bogus transactions to strengthen book value. Intangible I am not referring to purchased or developed software but more goodwill, patent types (not acquired).
  4. Loans included in related party transactions vis-a-vis revenue movement. Reclassification from revenue to loan is common.
  5. Extremely lower rate of taxes without tax incentives.

Actually I want to go on and on. I think to do justice lets talk about forensic and creative practices separately in a thread. There can be simulation to millions of situations.

I do have a piece of analytics done for Maithan, don’t have courage to use in public forum and you know why. :slight_smile:

If you feel to have a discussion on further on this subjects, please ask specific questions. There are many people to answer it.


  • I will move to financial metrics to see the competitive advantage confirmation and simultaneously we can do an analysis of growth, health and profitability. They are linked to each other, this is the core part of financial analytics including key ratios etc.

Developing a Investment System

My new mentor Mr P seems to be more impressive than my initial assessment and I am not surprised. I am pretty sure now India has thousands of maverick investors not used as trump cards when it comes to education!

Part of my recent interactions and learning (which still continues by the way) we spoke about developing an investing system. It’s pretty much a flat concept which includes a combination of research, money management and behavioural finance. But the gold rush is in finer details, here they are:

He told me how do you know:

  1. To protect capital when market goes against you?
  2. When to take profits?
  3. How much to buy or sell when you decide to do so?
  4. Is there a single method that works for all stocks?

He rightly prompted people make money in market by unleashing their potential and getting aligned with market. Investment is about 83% behavioural finance, money management and 17% research (though this number can vary for a casual investor).

Today I just want to cover the questions one must ask (whether new or old investor) before even thinking about creating a investing method or system.

  1. How much capital do you have (one time and recurring)?
  2. How much money you need to survive every year?
  3. How much money or profits you are expecting from market?
  4. How much time you can devote to investing or trading?
  5. Are there too many distractions?
  6. What are your skills in business strategy, behavioural finance, mathematics, finance etc?
  7. What is your edge in investing?
  8. How much money you can afford to loose?
  9. Can you work yourself day after day?
  10. How will you know your system will or is working?

We spoke about conceptualising a system, infuse theory of probability for risk management to money management and much more. I will come back and update them.

Also will try to get back to study of financials soon.


Building a investing/trading system

As the name suggests it targets speculation (you can call it technical analysis) with an attempt to break market data to theory of risk management and probability. The end game is to address uncertainty with more reliability. Some of the noting here you may apply to investing (long term) as well.

Before getting into specifics, this is a customised approach I have been working with my mentor and well wishers for a month or so. My mentor in turn is heavily influenced by Dr Van Tharp. But nothing sounded to rocket science after a hard work of one month or so. Yet I never implemented a bunch of them may be due to my predominant lenience towards traditional value investing.

Broadly we looked at following areas:

  1. We started with behavioural finance which include the holy grail, biases, and set customised objectives.
  2. Setting the seedbed for system namely key concepts that is required and criteria for selecting including theory of expectancy.
  3. Dissect key components of trading system including set ups, market timing, stop loss, profit taking, position size, opportunity cost.

I went through more than a dozen books in this period but one book which I would like to give 9 star 10 star even out of five is this:

This is my customised end result:

  1. Creating a trading system
  2. Drill down a stock universe
  3. Apply entry techniques and timing
  4. Trade management
  5. Continous improvement

Still I am building a complete plan, you can see a current abstract of it here:

But this is not important rather to understand key terminologies and concepts behind a system (I may not be anywhere close to a robust system with limited testing so far).

You would get detail in Dr Tharp’s book and lectures, let me write down the abstracts which were eye opener for me:

  1. People make money in the markets by finding themselves achieving their potential, and getting in tune with markets.
  2. For a successful trader psychology plays 60% role, position size 30% and system development 10%.
  3. Analyse winners and losers, intellectually estimate what made these movements, a first set of criteria what I have defined are:
  • waves and pull backs
  • nature of trend (sharp, gradual)
  • Long or short consolidation
  • Sputtering or non sputtering
  • Volume/price relationship
  • Level of speculation
  • Level of participation and trade size
  • Impact of management announcement (expansion etc)
  • Fundamentals (accelerated earnings and low debt etc)
  1. Worst case scenario for every trade
  2. Expectancy- how is your position size, trading investing style, stop loss determines a higher return. I think this is the biggest take away which I was never so clear.
  3. Understanding of different phases of market phases and use them as set up.
  4. Developing your own entry signal.
  5. Different types of stop loss and profit taking strategies with respect to risk multiples.
  6. Decide the amount of investment based risk appetite.

Dr Tharp’s lecture and book pretty detailed and self explanatory. I am not going repeat them all, but it require 3-4 readings to create a plan and put into action.

I strongly recommend/request you go through, it may change the way you think at some of area like position size and expectancy forever.

Do let me know questions if any, I have clubbed the performers analysis to jewels of India. The moment I finish will post the results.

1 Like

Decide the LESSON you want to learn: applying behavioural finance

Few days of extreme volatility, experts are back with a long list of advices. They are all over television to telephone, news paper to New Delhi! Though I stopped reading news paper and watching television for sometime now, something caught me. While these financial wizards (at least they claim so) trying to sooth our nerves I was gathering few common factors pointed out by these gentlemen at the time when balm is required to relieve pain. Here they are:

Risk appetite management: invest according to capacity, diversify your asset class. It goes with rhetoric and irritating comment such as” don’t put ALL your eggs in basket” and this is called as age old wisdom. Does this work for everyone?

In first place what is relationship between risk appetite and diversification? Appetite means desire to eat food, sometimes due to hunger. Risk appetite is tolerance the level of risk an object (organisation or individual) is prepared to accept. I have 300 rupees to invest a. I pay 100 bucks to underworld b. Another 100 to black marketeer c. 100 bucks in gambling (race course/game) . What wonderful diversified assets are, well I am diversified boy.
If you are 20 plus something it’s assumed your risk appetite is higher and if you are 60 plus then you should read holy books and go for pilgrimage after keeping money in fixed deposits. Throw the 40 years of experience in stock market to trash bin!
how do I determine my risk appetite, I need to ask few psychological questions and decide the asset allocation. Now take a question do you have life insurance policy? No man I don’t have one; oh my god are you crazy? How can you survive without an insurance policy? So what I am Warren Buffett or Mukesh Ambani? Still life is risky, I need to insure. Similar concerns for mediclaim insurance without even knowing how many claims are getting rejected? Majority of insurance policies are not valid after 60-65 where you need the most.
you must buy a flat on EMI even if my economic profit is negative. So what, I buy a house at 23, buy the time I retire it requires 50% of cost as maintenance! So what even if the real estate doesn’t go anywhere in last ten years.

Biggest fallacies you can find within risk appetite simply because it’s a complex subject needs customised approach.

  • If you know ONE asset class stick to your expertise which will reap benefits. Knowledge is built over the years, so if you are good at equities don’t waste it by diversifying, same goes for real estate. Losses from asset class can be managed through MONEY MANAGEMENT not diversification. Diversification adversely impact return on investment, what bigger joke it can be, to avoid uncertainty you jump into an area where you have no clues!
  • Insurance may not be solution for all, if you are 40 year old and have 40 years of net worth days…all you should be concerned developing a plan which ensures your money move faster than inflation. Shut down the damn insurance policy!
  • Don’t make house on EMI as emotional decision. Real estate is nothing but an asset class, if it doesn’t offer you adequate returns don’t mind to look for alternatives. For example upmarket properties in Bangalore has fallen into abysmal rental return of 1.5% or even less per annum! Can you imagine your payback period is 70 years?
  1. Tax benefits: You know you get tax benefits on dividend, or even long term capital gain on shares (actually they are tax free now). Similarly you buy a house , you get tax breaks! Why so much insistence in saving taxes, well I don’t know what the govt is doing with my taxes? Valid question, by paying 70 bucks for a petrol (which includes hefty excise and sales tax) you even don’t know what the govt is doing with your money. If one earn simply pay off taxes, or get ready to fight govt in courts. There is no third solution, use tax benefits like usage of credit cards. If a tax benefit and sale of asset coincides then use it or else ignore!

  2. Invest over long term: famous dictum, in equity they add word systematically also! So what Bangalore is becoming a concrete jungle with 40% inventory lying empty? So what on 5th of Nov stock market is expected to crash over election results because my systematic plan says 5th? Because in long run asset class performs better, well the man who sold me a stupid insurance policy 15 years back is not working with company any more not even to clarify the word long term. Cyclical trends, secular fluctuations are eternal truth for any market which is based on supply and demand. Learning those curves will help better!

  3. Average your investment price: one of the biggest fact for loosing money in equity markets. The reason behind a fall may be due to my error in calculation, market risks etc. I must respect demand and supply, evaluate carefully than blindly averaging out. Every 90% fall in price requires 900% to break even!

  4. Don’t sell in panic: you shouldn’t sell in panic when your goal is long term. BSE in 1979 was 230 and now 27000, really? How many have invested at 230 and 27000? 230 level appeared for 1 second and you know I was a Batman who reacted almost like robot and clicked the button on 230. I am a Dinosaur expected to survive another 350 years , hence I am long term! So what I loose 90% of investment? So what I invested in a rogue company? Set strong rules and kill the position beyond your so called risk appetite. Market is not going anywhere, you will get plenty of opportunity to do well and buy.

  • Avoid negative CAGR which is more damaging for wealth creation. Three years 16% positive return followed by 4% return is far better than 3 years with 30% positive return and 1 year negative return of 40%!
  • Asset classes are full of uncertainty and remain going stay like than unless government regulate them. It’s only rules and plans will help you to cut out the emotions.
  • Your lifestyle decides your net worth not income, manage discretionary expenses out of discretionary income. If your annual spend is 6 lacs, all you need is 40 lacs to make 15% on ROI.
  • Don’t block your economic profit perpetually. For those not clear about economic profit here it is. Economic profit is the one you generate after paying for cost of funds. So if I am making 10% return on investment (say capital appreciation on flat per year) against interest rates of 10% then your economic profit is a big ZERO!

Currently I am working with my young cousin who happens to be extra ordinarily brilliant……this 25 year old have 1 twenty years EMI, 2 five years EMI, half a dozen insurance policies apart from tax saving instruments. Don’t forget those sweet little credit cards, I can see a 45 year old now still scratching head with EMI. Habit developed can be changed but not so easily as people think!

Stay safe and have fun!

Turbulence is ahead.


MEN at WORK: Quality of Management

I am using the word MEN at WORK specifically, in my continuous dabbling with markets we get carried away by integrity, ethics, governance, sustained discipline and big words written all over.

Before we move into minds of woking men, ponder over the below lines (purely my past:):

  • for a decade or so I lied 19 out of 20 times when I reached office late. After I realised; may not depend significantly on salary income, revealed 20 truths on all next 20 occasions. End result was burning hearts, gossip and question mark every where. Fortunately I didn’t burn my finger much as end game was to get out of system completely. Now load this into those management people who talks goodies and goodies, for sure all is well with them- what about company?
  • my systems is so fragile and intermediary; every perception floated on work floor become a stack rank of disruptions. Owo, what I am trying to say, sidha bolna bhai! these are errors found in system and needs to be rectified within this and that date. This is new age problem with management with high vocabulary. Note a heavy hand of vocabulary you will always find when the person is ignorant.
  • studied engineering and MBA , then moved to investment bank as campus hiring. Suddenly the great man realises needs to do something swadeshi:). Back in a high margin like software business and got a name for progress. After few years realised no excitement in life, let’s turn around a company and landed himself in power generation and distribution company. Fascinating career.

Let me stop here for now, what is the message?

  • Man at management is reflection of human mindset, put yourself into same situation you will get plenty of answers. If the CEO is son of Promoter who worth few billion dollars don’t expect him to always wear dhoti so that he looks frugal!
  • Too much diversity backed by a solid education and vocabulary does not lead to any conclusion, but you will seldom notice these become important factors when we analyse about management. Have you wondered, how come the blogger investors or wealth wizards who manage twitter handle has rarely passed out from a top B or grad school. Sometime I feel to become an investor all you need is a blog, read books and publish them all over what ever you read; who cares about education? No one is saying education is a must or else likes of Durant, Jobs or Livermore couldn’t have existed. But it doesn’t mean by not having education make one immensely successful alone. The truth is far from it!

Big question first- what is management

MD/CEO, CFO, Chairman or similar kind of designations often get through lens to evaluate the aspect of quality. As they say what is there in a name? Let’s understand how management layer works in India.

  • Promoter starts a company , invites capital from others including retail. Capital include debts or loan taken from financial institutions.
  • A board which is been assigned to task by shareholders constituting both independent and company people.
  • The task masters are at tactical and operational levels through several layers of office and floors be it managers or vice presidents.

We are simply concerned with people who are at WORK meaning ability to take and execute decisions, nothing else. This is the single most important aspect under investment proposal. These MEN can be influenced by lenders, promoters or regulators. All we need to do is evaluate the decisions taken by MEN at WORK.

Decision making

Barring strategy the operations, financials and compliance is mostly managed by these men. Strategy involves a combination of people including men at work. Leave aside strategy for now;

  1. Men at work is responsible for all decisions that lead to operational efficiency. The number should be all over whether cash conversion cycle, receivables management, cost drivers.
  2. These men executes all capital expenditure decisions, expansions, corporate restructuring. This is despite of strategic support required by board. The board may pass resolution, add few points and discuss but the action lies with these men at work.
  3. Responsible for laying down corporate instructions, policies and procedures. This include very importantly internal controls, accounting policies which are visible to us.

Overall decision making I split into five varieties:

  1. Operational efficiency- available metric, if not financial ratios.
  2. Above the line decisions- every corporate restructuring, management action as bonus/split, expansions, huge capex.
  3. Accounts, finance and controls- including management accounting, balance sheet management and stat audit.
  4. Capital allocation- managing surplus and deficit both. This may also include above the line decisions.
  5. Rewards against risk- how the guys are compensated and rewarded. Risk include trade off decisions taken including on shareholder’s return.

Why not ethics and integrity, why not a man of philanthropy. If numbers and commentary stack up in available document that should be suffice than searching for a photograph in English news paper. A long queue of companies exist which have published the photos doesn’t exist now, or even donated with open hand with share holder wealth destruction at the peak!

Let’s discuss about few specific steps next which I follow every time I analyse the management aspects.

Good wishes



Bernard Baruch- A legend who dreamt freedom for human

Walkover investment legends Warren Buffett, George Soros or even giant speculators like Arthur Cutten, Jesse Livermore; Bernard Mannes Baruch was undoubtedly the most influential investor of all time. There is seldom any debate on this question as no one influenced five American presidents, two world wars. All major political leader of the era has once travelled in the back seat of Baruch’s Rolls Royce. Such was influence of Bernard Baruch he was awarded Army Distinguished service medal by the President then. Baruch was investor, speculator who turn to political advisory before world war which perhaps saved him from wrath of 1929 crash. Otherwise known for grand philanthropy donated 63 kilometres of land among many other things. Please do read about Bernard Baruch in case you haven’t; these kind of personality comes once in a hundreds of years.

He has wrote several books, you can find them all in Amazon. Here is link to his biography

Few very important quotes of I came across during classroom session ongoing! It may be relevant for the threads like this:

“I keep an important fact in mind that I am very unusual. You call it my biological upbringing , I like to repel my cognitive biases and that’s the basic DNA behind my career of investment.”

“I knew investment was right decision for me as I was always an individualist, never afraid to disagree with authority.”

“I want to define myself at deathbed whether I made a difference , whether I lived fully and well.”

“People don’t follow their dreams due to single fact they are afraid of falling in their endeavours. They like to follow predetermined path as they know they can achieve rather than one of their own making where they will be tested.”

“If we don’t take a certain step we don’t believe we will succeed, we have placed a barrier in front of that success that is far stronger than reality. If we try we may fail but we may succeed. If we never try at all, we make it impossible to succeed.”

“I learned more from mistakes than accomplishments, this could never have been possible without risking failure.”

“Don’t worry about how much time you have spent on a career you don’t like or how much you have invested in relationship that you know will not work. “

“It is easier to make a lot of money if you don’t really want it badly. Being wealthy doesn’t make you happy. I know. I have tried it several times. I went bust many times, it didn’t affect my life as I was sleeping in same house on same bed before and after wealth”.

These are quotes from Curtis Faith, Bernard Baruch and so on. No CAGR, no cash reserve or yield anywhere. Food for thought?

Fair, lets grind back to topic of management. Last time we said management must take decisions on five things:

  1. Operational efficiency
  2. Above the line decisions as business restructuring
  3. Accounts, finance and control
  4. Capital allocation
  5. Trading off rewards and risks

Great, how do we know all this? No matter what ever we do, we may not get all information. The idea is to draw a reasonable conclusion.

This is what I am trying to do:

  1. You get what you see- available crisp and clear information
  2. Reading between the lines- moving from literal interpretation to objective interpretation
  3. The triangulation technique- using different methods for checking same subject

You can only perform any of 3 activities above if something somewhere to start with, isn’t it?

  1. Management communication- financials, management discussions/presentation and all other communications to stock exchange.
  2. Analyst review and analytics- all sort of wise analyst publishing different reports on buy, sell call or even commentaries on management. Idea is to screen them not believe them.

Here is a little known secret, the second best information prepared and analysed is not available to us. These are income tax authorities, second is financiers if they are involved. Nevertheless we can do only what ever is available to us:

How to establish a relationship tools against available infrastructure, bellow is a table I use:

Rather than going a complete analysis which will take time let me pull out some specific workings and its basis here:

A. Operational efficiency

Management operational efficiency begin with published numbers, what are the ratios help you is :

Around profitability- consistent tax rate, net margin, asset turnover, ROA, financial leverage, ROE/ROIC, interest coverage
Growth- sales, operating profit, net income and EPS
Cash flow- operating cash flow growth, free cash flow growth, capex/sales, FCF/Sales, FCF/Net income
Financial health- current ratio, quick ratio, financial leverage, debt/equity
Efficiency- Cash conversion cycle with break up, fixed asset turnover, asset turnover

All these ratios are well known with detailed commentaries. The trick is level basing and interpretation.

For example take a case of level basing:

When I calculate Return on Assets I use Net Operating Profits After tax. Two major reasons it removes all below the line effects and neutralise tax rates. Second my cost of capital for valuation calculation is basis NOPAT, every margin above cost of capital is a economic profit for me.

Now interpretation:

This can be complex and easy depending on methods you are using. Say over years my assets have gone up by 45% of which 80% of increase is supported by tangible asset. This is good and bad both. Liquidation and balance sheet valuation goes up where idle asset may hit your ROA/ROE. Hence use PL and Balance sheet ratio combined for an interpretation.

B. Above the line decisions

This is a specialised area for assessment. If you are beginner my suggestion is avoid. We may need separate thread for this. You can read this book meanwhile:

C. Accounts, finance and controls

This is the most assured area as large amount of transactions are audited. The task is here to tie management discussion, financial statements and disclosures etc. For example:

In Management discussion and analysis:

Management says we feel receivables are good and recoverable. And we have not provided any provisions accordingly.

In notes to account auditor says:

An amount of XXX receivables is more than 2 year old, in management’s opinion these are recoverable and accordingly no provisions have been made.

Come next year management has written off all old debts at one go. Here it become a battle of intent- was it purely business decision or manipulation of balance sheet?

Investment stated at cost than M2M….can be double edge sword.

D**. Capital allocation**

Use five year cash flow statement and spot following:

  • growth and maintenance capex
  • dividends paid
  • buybacks
  • acquisitions
  • borrowing repayment
  • investments made

Idea is to compute A. Gross Capital distribution-all adjustments stated above B. Gross surplus/deficit- cash flow from operations minus gross capital distribution C. Non operations funds managed i.e. borrowings or capital taken to manage deficit or pay off surplus via dividend/interest. D. Net surplus/deficit- Gross deficit/surplus minus non operations fund ; if management is managing capital efficiently net surplus should be minimal which is nothing cash balance held for working capital max.

E. Trading risks and rewards

Spot changes in management compensation to two variables, one is performance i.e. ROE, second trade off decisions.

For example by taking a decision of leasing an asset on lease instead of buying management has been able to reduce capital expenditure funding. The return on invested capital is superior to cost of capital which resulted higher ROE/earnings. It deserves a case for compensation rise.

Few other questions from the book “The Investment Checklist”

  1. Whether management is owner operator or hired hand? This is a good point but most of good small cap are owned significantly by promoters in India due to unfavourable valuation and reluctant financiers.
  2. History of manager to rise - if he has spent lot of time from floor to board room considered as an asset. Bit dicey to me, likes of Bansals or Zuckerbergs will vanish then.
  3. Compensation to ownership- preferably one should own more shares than taking big salary. This is again debatable, it depends on governance structure. Vishal Sikka leads Infosys well, but don’t expect him to own 15% of Infosys…he just can not afford to. Mukesh Bhai reducing his salary every year, does it really matter?
  4. Management buying and selling- valid point, if management is selling what is the point of buying. Except the intent, if Mukesh Bhai sell 200 shares it may be some technical requirement, how does it become relevant to his burgeoning billion dollar wealth.
  5. Involved in day to day operations- agree, that’s why I call them Men at work.
  6. Earnings guidance- if company is issuing guidance management may be under pressure to achieve target and in process takes decision which are not good for long term health. In India few issues earning guidance , small cap almost zero.
  7. Decentralised business- agreed, but struggling for long time…how? And what is the impact on competitive advantage?
  8. Valuing employees- no comments!
  9. Capital allocation- agreed
  10. Buy back- agreed, part of capital allocation decision
  11. Passion- love business not money; great but how do I know?
  12. Moment of integrity- lots of good guys never publish goodies what they do. If you know fine.
  13. Management communication consistent- agreed, we spoke in detail

Lastly few years back one of my seasoned investor friend was gung ho about a owner promoter who was chatting with normal shareholders at break during AGM. I immediately drawn his attention to iconic William Durant who was known for all these chit chats, ultimately he went bankrupt along with feel good investors! Not trying to say every story echoes in same way.

The point I am trying to make is 98% efforts should be applied for reading between the lines, triangulation than AGM chit chats, news paper philanthropy. For that I guess we need to be least bothered if my CEO use chartered flight as long as he is delivering stellar returns and profits for us. Not all of us like same lifestyle, frugality is a feel good factor, but can it be forced decision???

Good wishes

Few good books focussing on specific aspects of management in my eye would
be :


Apart from this most of vanilla investment books would have a section on
management aspect.

Financial Analytics- peeping behind the numbers

Now assume the company is enjoying a competitive advantage or comes with new landscape such as Blue Ocean with a more than decent management who is driving the company. Question I always encountered how do I know numbers are stacking up, can I see them in financials? Financial analytics is also used for screening of stocks but that’s not something we are focussing today.

Financial analytics means we are trying to use the accounting numbers that is recorded and information that is available. The most popular financial analysis of course is common size balance sheet/PL, ratio analysis.

Answer is you can but before that few important category I use and before I get into financials:

Category 1 :A company with existing competition who has a customised or tailored value chain (please see various discussions above to know what is tailored value chain, a fit etc) the above normal earnings and equity value should have been start kicking.

Category 2: If a company is in process of tailoring the value chain, numbers may not reflect but there exist better ways of gauging the advantages to come. Many people call it as “emerging advantage”.

Category 3: Now a Blue Ocean type of company (more like a growth and new value proposition) where numbers may not tell you everything.

Category 4: Last category is a company who was enjoying competitive advantage and messed it up in middle (for whatever reasons like bad management) and now on a come back trail.

Second aspect is the objective of financial analytics:

  1. To see and feel numbers including balance sheet, earnings and cash justifying your hard work on business understanding and analysis of competitive advantage or a Blue Ocean.
  2. This one is dicey, to compare my company with similar companies where information is available (either listed or not). In realty no two companies are similar head to toe, very important to know the differences then.
  3. Next one compare my numbers with a industry metrics and benchmark.

Now the challenges and opportunities:

  1. Any standardised portal like Morning Star, Economic Times, Screener, Money control have ratios, and KPI calculated ready made.
  2. These tools compute based on standard programming, so if you want variables to be customised may not be possible. Except in Screener where you can create your own ratios using variables.
  3. Ratios themselves have no standard framework like GAAP (Generally Accepted Accounting Procedures). It is up to the user of these KPI to interpret for their own need. So ROA for IT company and ROA for infrastructure company are not comparable.
  4. The ratios are calculated using audited financial numbers, so accuracy and validity of numbers can be trusted to a large extent unlike when you pull consultant published industry metrics who doesn’t take any accountability.
  5. KPI’s are evolving with industry progress e.g. EBIDTA was not used few decades, even EVA etc. Expect the ground line to move again.

Let’s come to action, the financial analytics centres around :

  1. The profitability
  2. The growth
  3. Cash flow
  4. Financial health
  5. Efficiency

The Profitability

How much company is profitable? Is higher profit also means higher margins? Has the tax rate levelled? Has the profit resulted return to shareholders?

Although we would like to have 3 margins (namely Gross, Operating and Net margins) our financial doesn’t provide all of them ready made.

Our ground lines in financials looks like this:

  1. Profit before taxes
  2. Profit after taxes

Yes that’s it (not confusing with extra ordinary items). So only Net Margin can be calculated straight forward from published numbers (profit after tax divided by Revenue)

How do we know Gross margin and operating margin? And in first place why it is important to know?

When we take out cost of goods sold or services from revenue from operations we get gross profit. Gross profit divided by revenue gives us the gross margin. Cost of goods sold indicates the direct cost required to produce the goods or services. And this is not easy for any retail shareholder to calculate, this is why:

Not all costs can be easily identified as direct cost. Discretions are used including apportionment of costs between direct and indirect. Example a plant financial controller is considered as direct cost, well he does a lot of thing for head office as well.In service industry it’s more complex, everyone and anyone can theoretically prove they are directly attributable to producing cost of services.Google it, you will get plenty of examples further. In real life situation company maintains MIS which breaks down the goods and services into multiple variables like product costing, SBU accounting etc. Company is not obliged to disclose these informations.

Theoretically higher the gross margin company has better reserves to manage other costs and obligations. If a gross margin is falling you can increase either price or cut down cost.

Next operating margin, this is to gauge operational performance. Operational performance depends on nature of operational expenses which is required for operations. Now you can say are the direct costs above in gross margin not operational cost? No, these are costs which are not directly attributable to production e.g. Research, Sales & Marketing , Administration over heads etc. Operating margin how much we are making before financial and regulatory charges hits us i.e. from operations. If your gross margin is higher and operating margin is lower you need to manage operating expenses properly. This is a pure cost management, price increase is part of gross margin maintenance.

Do we get numbers ready made? No, Research is reported separately in directors report. Sales and marketing may include multiple cluster accounting heads. Further let us understand one more thing:

The capital expenditure is not charged to financials same year because the benefits from assets are expected more than financial period. So only we consider operating expenditures for both gross margin and net margin calculation. Operating expenses include depreciation which is an amount kept aside every year against wear and tear of asset. You can say maintenance capital expenditure. What about purchasing assets for business growth? We call the as Growth Capital expenditure, this is not part of margin calculation, of course depreciation chargeable would have been included in expenses.

Lastly net margin , this is what left out after paying everyone. This is owner’s money which can be utilised for paying dividends, retain for further growth etc. The net profit after tax is a resultant number, so we do not have classification issue like operating and gross margin. However Net profit margin tells confusing story always, when interest comes down net margin goes up. It’s not necessarily good for company, a leveraged company (who has taken loan) utilise the advantageous cost of capital for shareholder return. If loan is reducing and interest costs coming down possibly growth avenues are stagnant. Take another example, a favourable tax rate due to Govt’s incentivisation may be temporary which can inflate net margin.

How do we use these margins for analysis?

  1. Year to year comparison to say are we improving?
  2. Second comparing with similar company to see whether are we delivering superior margins?
  3. Third if industry has a benchmark like say 20% operating margin where are we?

Suppose we get a positive answer for all three above. What happens? Multiple answers can be there, keep 2 key things which can be used in valuation:

  1. Assets are superior which are delivering stellar results.
  2. Management has been excellent to manage cost and price

If by using asset at a cost of capital 10% I am able to generate 40% operating margin and 20% net margin consistently this is nothing but called as competitive advantage of company.

Note: Tax rate- if tax rates are lower for some reason then normalise profit to that extent.

Lets think how we can use the margins for category of companies:

Category 1: Numbers should be healthy while comparing to peers or benchmark. Even internally improving YOY.

Category 2: this type of companies spend big bucks for creating resources. They may not deliver good net margin due to high leverage, sales may not have kicked off. Comparison with peers is of little use as every emerging company would be at different stages.

Category 3: Blue ocean type of companies, they don’t care about what competition does as they are on their own territory. No point in comparing with others. Even if you are going to compare internally you need to be careful vis-a-vis their value innovation, the activities are always on move

Category 4: come back companies will throw up divergence. Meaning operating margin goes up due to freshness of assets where as net takes a hit as loans are still getting repaid.

Every margin improvement should result superior return for shareholder otherwise its meaning less, how do we measure?

Return on equity- this is the return for equity shareholders, in other words earnings divided by equity. Return can be attributed to superior margins, efficient utilisation of assets and cost of capital required to fund assets and resources.

Margin combined with asset utilisation is nothing but return on assets. This tells us how much we are squeezing asset to get earnings out of them. Now few of the between the lines here:

  • A superior ROA with a lower depreciation can be dangerous as capital assets are not replaced in time.
  • Similarly high ROA with lower tax rates which can be temporary.
  • ROA for service industry can be subdued as intangible assets are floor to accounting book keeping. They are more supervisory and discretionary.

The second fire power comes from funding the asset or financial leverage. Cost of capital varies a lot depending nature of funding. For example shareholder’s fund doesn’t have a fixed cost, so if my balance sheet is 90% equity and 10% debt this can add superior returns. Also I am making 15% net margin on my product and cost of funding (loan) is only 10%. Every 5% minus taxes goes to owner.

Return on equity can be managed by delivering excellent operational management (ROA) or financial management (Financial Leverage).

Now few between the lines:

  1. Considering lower cost of capital for equity capital is some time questionable. Everyone invests with an aim for capital appreciation and dividend. Ignoring capital appreciation completely can be error prone and not close to ground realty.
  2. Loans incentivise (subsidised) will enjoy leverage temporarily.

Now put your category companies for own understanding.

Finally Return on Invested Capital (ROIC)- this was a magic ratio when Prof Porter highlighted ROIC is the best ratio to measure competitive advantage of company.

Its basically a measurement of return to those who provided capital, doesn’t matter equity, debt, bonds etc. As only operating profits neutralised with taxes is used it reflects the return that has come from operations than below the line items. Companies within a superior industry enjoy high ROIC. For companies with high capital base this is an effective indicator, in other way if ROIC is more than Cost of capital every pie goes to shareholder.

Will ROIC work for Blue Ocean company, yes it will but to the extent for internal comparison only!

Next lets focus on growth and cash flow.

Few suggested readings:

Five Successful Rules of Investing by Pat Dorsey

Financial Statement Analysis by Fernando Alvarez


Lovely! Rarely have I come across something as lucid as this. Thanks a lot Suvi and others who made it happen!

Suvi, How did you arrive at 73%,Why you are discounting 22.99 why not with 59.63.Sorry if i sound stupid.

Suvi, i could not understand any special situation and understated situation could you please make me understanding.

Sorry friend
Not been here for a while. Apologies for the delay; let me reply your questions if I can:

Special situations are those cases which are not reported through published number. Say company has bought a land in 1978 in Bandra for 5 cr. The land is stated at cost in balance sheet, unless the management revalues the asset the price you will see in balance sheet is only 5 cr. And revaluation is a management discretionary activity. In real terms the stated land in 2017 may be well over 200 cr’; one has to dig underlying information to know the exact business realty.

In this case when a company hold shares of associate company which are stated at cost say 10 rs per share. But the business would have grown multi fold and 10 rs may not be the right price, perhaps way beyond that.

Example: see GMDC holding in Gujarat State Petronet at cost value or the land in Ahmedabad at cost.

Please let me know if you need further clarification.


As this is a old post, I don’t have numbers at finger tip now. I will explain the rationale with same example and let me check old laptop; it may have the calculation file. I will come back to you either tonight or next week end.

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