Ashiana Housing — review after the quarter

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

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?

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

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?

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)

Buffett’s Capital Structure and Alpha; Greenlight Re

Lots of work has been done trying to reverse engineer how Buffett managed to build his $350B behemoth. Tons of books discuss about value investing as practiced by Buffett, while some of the smarter ones delve deeper into the insurance operations that Berkshire operated. When we look closely at the insurance operations, some of the key advantages of this structure are:

  • Float generated by insurance offers good amount of leverage for the portfolio that Buffett manages
  • Cost of float has been less than zero; Buffett gets paid to manage the float; (see below table) Buffett can borrow cheaper than the U.S. government.
  • Float is not directly connected to the markets but to events; the debt will not disappear overnight or cannot be called overnight and hence almost non-recourse
  • As long as the insurance companies continues operations, a significant piece of this float will be available for long time (almost permanent capital)
  • Insurance operations are exempt from the investment act of 1940 which place restrictions on operations; Berkshire could not have intervened in Geico, Salmon, special situations or own whole public companies; Berkshire would have been regulated as a mutual fund
  • Insurance operations can buy whole public companies

.Table from: Paper on Buffett’s Alpha (here)

Cost of Float

So, float provided a cheap source of leverage and (almost) permanent capital. What would Berkshire look like if Buffett had invested in S&P 500 instead of handpicking companies? Joseph Taussig of Taussig capital did do the work and reverse engineered the investments.

S&P grew 9.7% CAGR for 40 years between 1969 and 2009. Warren Buffett’s investments grew at 12.4% CAGR.  If one had taken the taken all the money (close to $70M when Warren Buffett assumed Berkshire in 1969) and put it in S&P 500, one would have $2.5B and with Warren Buffett’s stock picks, one would have $4.3B. Around 2009, Berkshire’s market cap was about $150B. Why the difference? The study from Taussig capital does a great job of explaining this difference in simple terms,  for every $ of equity capital, Buffett used 2$ of reserves, with 12% return on investments, Buffett earned 12% of equity plus 2 times 12% on reserves = 36% net of 4% cost of float (2% for every 1$ of leverage / reserves) and ended with a ROE of 32%. Since Berkshire is domiciled in the US, it has to pay taxes, and the post tax returns are 20% CAGR which takes us close to $150B. The difference between $4.3B and $150B (in 2010) came from the insurance structure.

So, a huge piece of the returns came for Berkshire because of the capital structure than from the investing alpha that Buffett created. Warren Buffett did pick the right insurance companies to buy which mattered a lot. Buffett’s big alpha were from picking the right insurance vehicles that have created the massive conglomerate. As long as the insurance operations do fine and returns on incremental investments is decent, Berkshire will do fine in the future as well.

How does an investor starting today structure an operations with a capital structure better than Berkshire? Remember that Buffett also defers taxes by not selling securities and compounding the float from the taxman. Also note that the ROE’s came down from 32% to 20% because of taxes.

Enter David Einhorn and Greenlight Re. David Einhorn started a re-insurer based in Bermuda (which is tax free) and re-directs all the cash to Greenlight capital to invest which creates better economics than Berkshire does. Although, as Warren often points, insurance as an industry runs at a net loss through the cycle. Greenlight Re has been struggling to keep the combined ratio low and there are additional headwinds for a shareholder. Einhorn charges 2% management fee and 20% of profits of every year (with watermark). It is a very lucrative deal for David Einhorn. With earned premiums close to 50% of capital, the portfolio is levered at 0.5X. If S&P returns 10% and David Einhorn invests to meet the market returns of 10%. With the leverage, it will be 15% minus the  2% management fee and 20% incentive fee, it will be worth 10%.  The effects of leverage are being eaten up by Einhorn and not flowing to the shareholders. However, if the unearned premium does go up, it might present interesting possibilities as he has returned 18.9% CAGR on investments in Greenlight Capital since inception in 1996. Einhorn’s ability to create alpha plus the fact that the stock is trading at a discount to book value offers additional possibilities if the unearned premiums go up.

For now, we are content just monitoring Greenlight Re and Third Point Re (Daniel Loeb’s version of the same structure) and watch it for more time.

Current Portfolio of Allan Mecham (Dataroma)

The current portfolio of Allan Mecham as of 31st March, 2015 (From DataRoma)

Stock
% of portfolio Shares Recent activity
hist BAC – Bank of America Corp. 14.35 6,453,725 Add 9.00% $15.39
hist CMPR – Cimpress N.V. 14.02 1,150,329 Add 5.39% $84.38
hist DNOW – NOW Inc. 12.70 4,061,596 Add 123.99% $21.64
hist SNE – Sony Corp. 11.64 3,009,375 Add 2.68% $26.78
hist OUTR – Outerwall Inc. 9.88 1,034,260 Add 5.68% $66.12
hist LUK – Leucadia National Corp. 8.39 2,604,158 Add 8.44% $22.29
hist IBKR – Interactive Brokers Group Inc. 8.30 1,688,495 Add 32.42% $34.02
hist Y – Alleghany Corp. 6.40 91,001 Add 8.83% $486.99
hist MSM – MSC Industrial Direct 4.83 462,853 Buy $72.20
hist CHEF – The Chefs’ Warehouse 4.13 1,274,374 Reduce 6.17% $22.43
hist BRK.B – Berkshire Hathaway CL B 3.43 164,318 Add 13.50% $144.32
hist BRK.A – Berkshire Hathaway CL A 1.35 43 Reduce 2.27% $217511.63
hist CPRT – Copart Inc. 0.51 93,357 Add 9.52% $37.57
hist HEI – HEICO Corp. 0.05 6,611 Buy $49.61
hist DSWL – Deswell Industries 0.03 100,981 $1.84

Allan Mecham — Links of interest

Came across a few articles of Allan Mecham from Arlington Capital who has been beating the pants out of S&P 500 since 1999. He does not use spreadsheets or any models, he just sits, reads and thinks. While we have not seen the audited performance, it does seem like that certain audits were carried out and it was kosher. Sharing a few links to read more about this guy. It makes an interesting read.

MECHAM

Is this the next Warren Buffett? (Forbes & Forbes)

The 400% man (MarketWatch)

The 400% man – A lesson for aspiring investors (BaseHitInvesting)

Musings on the 400% man (Alephblog)

Interview with Allan Mecham (ManualOfIdeas)

Allan Mecham — The Early Years (ValueWalk)

Allan Mecham 2014 Letter (Valuewalk)

Allan Mecham on the Bull Case for Sony and Alleghany (Valuewalk)

Allan Mecham Unloads Berkshire and Loads Up Outerwall (Valuewalk)

Allan Mecham a Businesslike approach to Investing like Ben Graham (Valuewalk)