Market volatility and circle of competence

Posted on by balajithinks

The markets have been roiled these last few days to put it mildly. Dow Jones has been down 8.5% in the last four days. Indian Sensex is down 7.8%. Lots of individual stocks are down a lot more. There are a lot of investors wondering what’s in store next. Will the market fall another 10%? 20%? We have a very profound answer. We don’t know. And we don’t try to act or predict on something we don’t know.

However, whenever there is a sale, we are usually in the background looking around trying to see if something catches our eyes. When market goes down, assets get cheaper. It is akin to a shopping sale for us. If the market goes really, really down, it is a garage sale.

We believe what we do have is what Buffett calls a circle of competence. Limited number of companies where we think we have a good understanding of the fundamentals and what the companies might be worth 10 years from now. The intrinsic value of some of these companies is getting very interesting. We do not know what Mr Market will value these companies one year from now and even two years from now. However, we will still be okay if these companies go down 10-20-30% down after we buy it as we think the probabilities are high that the companies that we are investing in will be bigger, better, stronger ten years from now and that knowledge is our competitive advantage that enables us to deploy capital now when there is uncertainty and volatility around in the market. Once the capital is deployed, the key is to be patient and wait for the market to move from a voting machine to a weighing machine.

We are deploying some capital and watching to see if further bargains open up. Our war chest is ready. If none do, we just go back to whatever we were doing before and wait for more shopping festival seasons. If some bargains do further open up, we will be there buying things we understand.

Ashiana Housing — review after the quarter

Posted on by balajithinks

What happens when one of your top holdings loses close to 20% in a week. Full one-fifth of the market cap wipes out. Lots of investors likes to blog real-time when a security goes up 20%. Very few tend to write when it goes down.

Observation no. 1: Ashiana housing can be had 20% cheaper now than 10 days ago. Had to get that out of my system. The intrinsic value has come down a bit after a horrendous first quarter earnings. Net-net I paid a higher price than I could have this week. Since I was not expecting such a down quarter and Mr. Market’s reaction to it there was no way I could have anticipated this response.

Observation no. 2: Instead of blindly cost averaging down, like most investors would do. We are re-evaluating the intrinsic value with the additional information we have in hand.

Background:

Ashiana housing is one of the larger holdings we have in our portfolio. It is a business model we understand in the construction business. We do not really very well understand the business models of many other real-estate companies that count of large land banks as part of the valuation. We like the asset light model that Ashiana follows where they treat land as a raw material. Secondly, the company is developing a reputation with existing home owners by delivering good quality homes on-time and with good quality. It has almost become a competitive advantage for the company as 90% of the new sales are coming from referrals as per the latest from the company. Thirdly, the company seems to boast a decent management that is minority shareholder friendly.

Long term view:

In the long-run there are only a few questions that matter: a. Will the long term demand from affordable housing increase in India? The answer is overwhelming yes. b. Can Ashiana housing provide the best possible affordable housing to the growing population in India? Ashiana’s culture, execution record and processes seems to indicate that the company will survive long term and be one of the best providers of affordable housing c. Can the company scale up the execution and do so profitably? The current IRR of the projects that the company executes is north of 30%. The hurdle rate is high in our opinion. Even if it lowered to 25%, we think it is a very viable business model.

While executing currently, the company is building a network effect with huge portion of the housing units being booked upfront. This gives the company the advances required to complete the project and hand it over making the capital requirements very low. The higher the percentage of happy customers, more are the referrals for the next project. Ashiana seems to be on the right treadmill at this point. In a booming economy, real estate is all about location, location and location. In a down economy, it is all about reputation, reputation and reputation. Without reputation, capital requirements and cost of capital goes up very, very fast. Ashiana seems to be doing okay in this regard with 70% bookings on all ongoing projects.

So what happened this quarter?

  • The company has been constructing or executing at the rate of 0.5 million sq. ft per quarter. It has scaled up the operations to be able to execute around 2.5 million sq. ft a year. However, flat bookings are down to 0.16 million sq. ft this quarter and the company has slashed its guidance from 2.2 million sq. ft to 1.5 million sq. ft for the year (which is optimistic as per the company)
  • The year will be challenging from a cash flow perspective as the bookings have come down. However, given the advances already collected from customers, the company does not see much of a challenge to execution.
  • The company is seeing a decline of 25% in enquiries and 5-7% decline in site visits.
  • The company had previously indicated that it would deliver 1,800-2,000 units this fiscal and is maintaining the number. This will result in 1.5-2 Billion INR (after share of associates) for this year and the pipeline for next year deliveries also look robust.

When you take a step back, it looks like the real estate is going through what will be a significant draw down. A bubble in the real estate was expected and there has been some correction in the sector in the last couple of months but it does look like it is more in the early part of the innings rather an end of the draw down. Given that Ashiana housing caters mainly to tier II and III cities where the prices are a lot more reasonable compared to the tier I cities and Ashiana’s focus on non-Tier I cities does bode well for the company. However, one can expect collateral damage to the company as can be evidenced from the lower sales booking in the quarter. Perhaps, the argument of the tier II and III cities may not hold good as there is a draw down in the real estate.

Just like we were not able to predict this week’s draw down, we are equally inept at being predict when the real estate draw down will end. However, we are convinced that through the draw down process, the strong will get separated from the weak. We also firmly believe that Ashiana housing has the right ingredients to survive through this if the company continues to execute on existing projects.  Nothing about the company has changed that attracted us to the company in the first place, its execution, management, business models are intact.

However, given that we are hearing in the market about real-estate and the tight credit situation that many developers are facing, we are well aware of the opportunity cost that we are paying to to hold this scrip. We think it will even out but it will take quite a few years before we get paid for it. At this point, we are content to let Ashiana execute on the INR 338 crores worth of customer advances sitting on the balance sheet from the projects that the company is executing now. It has 6 million Sq. Ft of on-going projects which is close to 70% booked. This ensures that the company can sustain some amount of pain but it will be interesting to see when the trend reverses for the company.

Disclosure: Own Ashiana

Disclaimer: I am not a registered research analyst as prescribed by SEBI guidelines and any discussion about a particular investment idea shall not be construed as investment recommendation. This is simply articulation of my personal views. Readers shall do their own due diligence and/or seek advise from profession investment advisor before making an investment decision.

What are we reading? — Berkshire

Posted on by balajithinks

Mondelez International — a possible target for Kraft Heinz (Brooklyn investor)

Berkshire Hathaway profit drops 37% (WSJ)

Berkshire Hathaway nears deal to buy Precision Castparts (WSJ)

Stock owners of Precision Castparts (Dataroma)

Warren Buffett might bet on Aerospace boom to lift precision castparts deal (WSJ)

Why a takeover of precision castparts would be typical Buffett (WSJ)

Disclosure: Own BRK

What are we reading?

Posted on by balajithinks

Markel Q2 Results Discussion (RationalWalk)

Notes from the AGM — Bajaj Auto Ltd (Ankur Jain)

Cost of capital — Opportunity cost (Hurricane Capital)

Old Post — Alice Schroeder on Reddit (Reddit)

Buffett on Banks (Fundoo Professor)

What Geico’s acquisition costs and other associated costs taught me about business economics, management quality and valuation (Fundoo Professor)

Greenlight Re and Third Point Re

Posted on by balajithinks

We had written about the structural advantages of re-insurers before here. We ran through some numbers and here is what we found.

Both Greenlight Re and Third Point Re are structured similarly with Greenlight Capital and Third Point LLC running the investment books. Both follow 2% management fee and 20% incentive agreements with high watermark. Currently unearned premium is around 50% of equity (actually close to 40% of equity) for both the insurers. We have assumed cost of float as 2% for both the insurers. We tried to model the returns to the shareholders under various circumstances of underlying returns from the hedge funds. The shareholder equity varying as a function of float net of the cost of float.

Underlying Equity  $100.00
Float Leverage  $ 50.00
Total Assets  $150.00 102%
Underlying Rates of Return $150 Invested After 2% Management Fee After 20% Performance Net Underlying Returns to Investor Cost of Float Net Underlying Returns of Shareholder Equity
-30% $105.00 $102.90 $102.90 -31.4% 1.0% -48.1%
-20% $120.00 $117.60 $117.60 -21.6% 1.0% -33.4%
-10% $135.00 $132.30 $132.30 -11.8% 1.0% -18.7%
0% $150.00 $147.00 $147.00 -2.0% 1.0% -4.0%
5% $157.50 $154.35 $153.48 2.3% 1.0% 2.5%
10% $165.00 $161.70 $159.36 6.2% 1.0% 8.4%
20% $180.00 $176.40 $171.12 14.1% 1.0% 20.1%
30% $195.00 $191.10 $182.88 21.9% 1.0% 31.9%

Over a period of time, if one assumes that the insurers grow their float to get a structure where they have $100 of float for $100 of equity (which is still conservative as reinsurers typically write 5X of capital) However, given the general risky nature of where the float is invested, 1X is a more proper allocation for this strategy.

Underlying Equity $100.00
Float Leverage $100.00
Total Assets $200.00 102%
Underlying Rates of Return $200 Invested After 2% Management Fee After 20% Performance Net Underlying Returns to Investor Cost of Float Net Underlying Returns of Shareholder Equity
-30% $140.00 $137.20 $137.20 -31.4% 2.0% -64.8%
-20% $160.00 $156.80 $156.80 -21.6% 2.0% -45.2%
-10% $180.00 $176.40 $176.40 -11.8% 2.0% -25.6%
0% $200.00 $196.00 $196.00 -2.0% 2.0% -6.0%
5% $210.00 $205.80 $204.64 2.3% 2.0% 2.6%
10% $220.00 $215.60 $212.48 6.2% 2.0% 10.5%
20% $240.00 $235.20 $228.16 14.1% 2.0% 26.2%
30% $260.00 $254.80 $243.84 21.9% 2.0% 41.8%

One thing is very evident here, if the re-insurers are not prudent and conservative, it will wipe out equity fast as float functions exactly how leverage does. Companies like Berkshire own whole companies where earnings are less volatile compared to stock market instruments and they also own a lot of fixed income instruments. Third point returned -32.6% in 2008 and Greenilght Capital returned -22.6% in 2008. The above table clearly shows what would happen if another such year were to occur for these two insurers whose investment books are managed by the insurers. As the investments are starkly different from other insurers, it might be worthwhile to consider the volatility of the instruments.

How would Berkshire or Markel look with a similar capital structure? Remember, they do not charge 2% and 20%. However, they have taxes to drag them down and both of them have great historical performance to their back on running a reinsurer and its investment books. Markel lost 16% of their book value in 2008 which is remarkable considering that they were leveraged 2.2:1 on their float largely thanks for their fixed income instruments which was up 0.2% and equities were down 34%. Berkshire was down (9.6)% in 2008 thanks again to the fortress balance sheet and the fixed income securities that Berkshire owns.

If Markel or Berkshire had a similar structure, this is how they would look.

Underlying Equity $100.00
Float Leverage $50.00
Total Assets $150.00 100% 35% Full Tax
Underlying Rates of Return $150 Invested After 2% Management Fee After 20% Performance Net Underlying Returns to Investor Cost of Float Net Underlying Returns of Shareholder Equity Before Tax Net Underlying Returns of Shareholder Equity After Tax
-30% $105.00 $105.00 $105.00 -30.0% 0.0% -45% -45%
-20% $120.00 $120.00 $120.00 -20.0% 0.0% -30% -30%
-10% $135.00 $135.00 $135.00 -10.0% 0.0% -15% -15%
0% $150.00 $150.00 $150.00 0.0% 0.0% 0% 0%
5% $157.50 $157.50 $157.50 5.0% 0.0% 8% 5%
10% $165.00 $165.00 $165.00 10.0% 0.0% 15% 10%
20% $180.00 $180.00 $180.00 20.0% 0.0% 30% 20%
30% $195.00 $195.00 $195.00 30.0% 0.0% 45% 29%

With $100 of Float to $100 of equity

Underlying Equity $100.00
Float Leverage $100.00
Total Assets $200.00 100% 35% Full Tax
Underlying Rates of Return $200 Invested After 2% Management Fee After 20% Performance Net Underlying Returns to Investor Cost of Float Net Underlying Returns of Shareholder Equity Net Underlying Returns of Shareholder Equity After Tax
-30% $140.00 $140.00 $140.00 -30.0% 0.0% -60% -60%
-20% $160.00 $160.00 $160.00 -20.0% 0.0% -40% -40%
-10% $180.00 $180.00 $180.00 -10.0% 0.0% -20% -20%
0% $200.00 $200.00 $200.00 0.0% 0.0% 0% 0%
5% $210.00 $210.00 $210.00 5.0% 0.0% 10% 7%
10% $220.00 $220.00 $220.00 10.0% 0.0% 20% 13%
20% $240.00 $240.00 $240.00 20.0% 0.0% 40% 26%
30% $260.00 $260.00 $260.00 30.0% 0.0% 60% 39%

Markel at the end of 2014 had $145 of float to $100 of equities. Remember the fixed income securities and why Markel will not be very volatile and probably the returns will not exceed 10% on assets invested.

Underlying Equity $100.00
Float Leverage $145.00
Total Assets $245.00 100% 35% Full Tax
Underlying Rates of Return $200 Invested After 2% Management Fee After 20% Performance Net Underlying Returns to Investor Cost of Float Net Underlying Returns of Shareholder Equity Net Underlying Returns of Shareholder Equity After Tax
-30% $171.50 $171.50 $171.50 -30.0% 0.0% -74% -74%
-20% $196.00 $196.00 $196.00 -20.0% 0.0% -49% -49%
-10% $220.50 $220.50 $220.50 -10.0% 0.0% -25% -25%
0% $245.00 $245.00 $245.00 0.0% 0.0% 0% 0%
5% $257.25 $257.25 $257.25 5.0% 0.0% 12% 8%
10% $269.50 $269.50 $269.50 10.0% 0.0% 25% 16%
20% $294.00 $294.00 $294.00 20.0% 0.0% 49% 32%
30% $318.50 $318.50 $318.50 30.0% 0.0% 74% 48%

When one takes a closer look at the economics of the business models, it looks like third point and Greenlight re have managed to replicate a capital structure that replicates similar economics to Berkshire or Markel while getting much much better deals for themselves in the process instead of the taxman.

However,  things get interesting further. Greenlight Re is trading at 0.87 book and Third Point Re at 1.07 times book. Berkshire is trading at 1.46 book and Markel at 1.64 times book.

Underlying Equity  $ 100.00
Float Leverage  $ 50.00
Total Assets  $ 150.00 GLRE 3Re
0.87 1.07
Underlying Rates of Return $150 Invested Net Underlying Returns of Shareholder Equity P/B =1 P/B =1
-30% $105.00 -48.1% -41.8% -51.5%
-20% $120.00 -33.4% -29.1% -35.7%
-10% $135.00 -18.7% -16.3% -20.0%
0% $150.00 -4.0% -3.5% -4.3%
5% $157.50 2.5% 2.9% 2.3%
10% $165.00 8.4% 9.6% 7.8%
20% $180.00 20.1% 23.1% 18.8%
30% $195.00 31.9% 36.6% 29.8%

If the re-insurers grow the book to have float to 1X of capital.

Underlying Equity $100.00
Float Leverage $100.00
Total Assets $200.00 GLRE 3Re
0.87 1.07
Underlying Rates of Return $200 Invested Net Underlying Returns of Shareholder Equity
P/B =1
P/B =1
-30% $140.00 -64.8% -56.4% -69.3%
-20% $160.00 -45.2% -39.3% -48.4%
-10% $180.00 -25.6% -22.3% -27.4%
0% $200.00 -6.0% -5.2% -6.4%
5% $210.00 2.6% 3.0% 2.5%
10% $220.00 10.5% 12.0% 9.8%
20% $240.00 26.2% 30.1% 24.4%
30% $260.00 41.8% 48.1% 39.1%

A good comparison would be Markel today. I have just included what Berkshire would do with a similar capital structure.

Underlying Equity $100.00
Float Leverage $145.00
Total Assets $245.00 35% Full Tax Berkshire MKL
1.46 1.64
Underlying Rates of Return $200 Invested Net Underlying Returns of Shareholder Equity Net Underlying Returns of Shareholder Equity After Tax
P/B =1
P/B =1
-30% $171.50 -74% -74% -81.8% -83.8%
-20% $196.00 -49% -49% -65.1% -68.9%
-10% $220.50 -25% -25% -48.3% -54.0%
0% $245.00 0% 0% 0.0% 0.0%
5% $257.25 12% 8% 5.5% 4.9%
10% $269.50 25% 16% 10.9% 9.7%
20% $294.00 49% 32% 21.8% 19.4%
30% $318.50 74% 48% 32.7% 29.1%

Clearly given the valuation difference between Third Point, Greenlight Re’s with the Markel’s of the world, the risk-reward points clearly towards the former.

However, one must be very mindful on how the volatility is handled within the books. Markel and Berkshire have their fixed securities helping them manage well through a downturn. Will Greenlight and Third Point be able to replicate with their long / short strategies and event driven value investing?

Will the shareholders want the comfort of the Berkshire balance sheet at expensive valuations and a size that kills performance or the risk / reward of the newer re-insurers with seasoned hedge fund managers like David Einhorn and Daniel Loeb who have been lackluster of late and are still new to the re-insurance business. Or is there a place for both categories in one’s portfolio?

Disclosure: Own BRK.B, MKL; Evaluating GLRE and TPRE

What are we reading?

Posted on by balajithinks

John Malone and his Cable Media empire (jInvestor)

Piramal Enterprises (BigInvestor)

Roller Coaster investing (Sanjay Bakshi)

Titan Q1 dips 15% (MoneyControl)

A year on, how Vishal Sikka put his stamp on Infosys (LiveMint)

Worst investment / retirement mistakes (Subramoney)

How much do I need to retire early in India (FreeFinCal)

Is this India’s worst real estate nightmare (LiveMint)