Market volatility and circle of competence

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.

ITC’s Use of Cash

ITC has this great cash engine called Tobacco. I dug a little bit into the published 2015 results to see how ITC was using its cash.

There is good news and bad news. Bad news — Cash from Cigarettes which generated ~180%+ ROC is being used to fund FMCG and Hotels business where if the ROC is ~1% in 2015. 90% of the additional capital in ITC went into FMCG or the Hotels business. While one might argue that FMCG will make money in the long run, the hotels choice is a bizarre one as it is cyclical and a low return business. Also, they paid 500 Crores for a property in Goa that is being challenged in the courts right now. Was 2015 an anomaly on how much capital went to hotels or will this be a trend? While one might hope a more prudent allocation in the future, it is something one definitely must be concerned about. Also, a clear road to profitability on FMCG will help as well. Good News — 700 Crores out of the 1,500 Crores that were invested came from other parts of the balance sheet like deferred taxes, better TWC etc. Essentially only 900 Crores or 10% of net profit went into capital for in all FMCG and Hotels. Glass half full or half empty?

All Numbers in Crores INR
ITC Last 12 Month Net Profit 9765
Depreciation 1027
Owners Earnings Before Capex 10792
Dividends 5621
Net of Dividends 5171
Additional Capital Employed % of Capital Employed 2014-2015 ROC of Segments
Capital Employed in Cigarettes 121 8% 183%
Capital Employed in FMCG 632 40% 0.8%
Capital Employed in Hotels 769 48% 1.1%
Capital Employed in Agri -79 -5% 44.1%
Capital Employed in Papers 110 7% 17.0%
Capital Employed in Others 41 3% 32.6%
Total Capital Into Business 1594 31%
Net Capital Left After Investing in Business 3577
Additional Cash in Balance Sheet Compared to 2014 4299 Additional cash coming in from better Deferred Taxes, TWC, Cash Management etc;