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 EQUITY WEDNESDAY Issue #1 Hello EveryFinions!
We have set out to do a small experiment. We are introducing a second newsletter called Equity Wednesday on a temporary basis for the next 6 weeks. This weekly issue will focus on finding insights into stock market investments based on global trends and equity research. It is a must read for those who are serious about managing money and investing in the stock markets on their own. If there is enough interest in this content format, we plan to continue after the initial 6-weeks too. If not, don't worry - we will continue re-inventing.
IN TODAY'S EDITION
RESULTS UPDATE
Every week for the next 8 weeks, we will look at the financial results announced by companies for Q2 FY21 and compare it with how they performed in the same quarter a year ago. Unfortunately, we do not have the bandwidth to provide coverage on all the 5000+ companies listed in India. Our coverage universe is small, but is adequately well represented to get a pulse of the economy.
How to read this graph?
It is still early days to pass any judgement about the state of listed companies in India. But this chart will get a lot more interesting as more companies announce results.  UPCOMING RESULTS CALENDAR Tata Elxi Oct. 14, 2020 HCL Technologies Oct. 14, 2020 HDFC Bank Ltd. Oct. 16, 2020 Britannia Industries Ltd. Oct. 17, 2020 HDFC Life Insurance Company Ltd Oct. 19, 2020 Hindustan Unilever Ltd Oct. 19, 2020 KEY CORPORATE ANNOUNCEMENTS
TREND WATCHING (1/2) THE HIGHEST Returning Stock Market This Year - Take a guess?  The Danish stock exchange is the best performing stock market this year. The OMX 20 Copenhagen index, consisting of the top 20 traded stocks in Denmark, witnessed a staggering 40% gain in the last 1 year. This is in spite of COVID. To put that into context, our little champ NIFTY has recorded 6% gains in the same period. This rally in Denmark is largely driven by some of the big names in renewal energy and sustainable development. Vestas (wind turbine maker) is up +108%, Pandora (sustainable/ethical jewellery maker) is up 101%, Genmab (biotech company) is up 77%, Orsted (world’s most sustainable energy company) is up 62% etc. All of this is attributed to the big way institutional investors have embraced ESG investing. To give you another example, the church of England last week dumped a whole load of Exxonmobil shares it had in its portfolio since the oil giant failed to set goals to reduce emissions produced by its customers. ESG investing is going to become a big deal.
What is ESG investing? Socially responsible investing in companies that pay attention to the environmental, social and governance factors. Denmark and Scandinavian countries in general have adopted some of the most progressive policy measures in reducing carbon emissions and encouraging businesses to adopt more sustainable practices. For the Danish, this is approach paying off.
As I write this, there are 2 ESG equity mutual funds in India trying to do something similar – SBI magnum equity ESG and the Quantum India ESG equity. But their portfolio consists primarily of big names like Infosys, TCS, HDFC bank etc. We are not convinced. If you know of any other listed businesses who are strong adopters of sustainable business practices, write to us please! TREND WATCHING (2/2) After 25 years, HSBC bank's share price is...Unchanged!  World over banking stocks have suffered a beating. Bank of America and JP Morgan are down over 25% from the beginning of the year. Why? An entire decade of low interest rates made worse by COVID-19. When liquidity is in flush and interest rates are low, banks struggle to make money as their net interest margin (loan interest rates - deposit interest rate) narrows. But there are two more reasons.
Every opportunity banks find to make excess profits, regulators fix it by adding regulations. To give you a context, the Banking companies act introduced in 1949 had 21,194 words detailing out how banks will be regulated. The same act, after going through several rounds of amendments today has 60,608 words. Think about this – HSBC, the global banking behemoth based in London and Hong Kong, is trading at a stock price it last traded at in 1995! That is 25 years of lost return for HSBC investors.
This has led to more banking consolidations. Spain’s Caixabank and Bankia merged last month to create the biggest domestic lender. Bank of Spain’s chief wants more mergers. UBS and Credit Suisse are in discussions to possibly merge and create a Swiss bank 3X the size of Switzerland’s GDP. This week two banks in Saudi Arabia called NCB and Samba merged to form a $220 billion mega bank. My prediction is, consolidation in the Indian banking space will continue over and above the mergers that were announced last year. Cracks are starting to appear now on private banks. 4 PSU banks are still under RBI’s prompt corrective action framework. More action is certainly ahead. CORPORATE UPDATE Vedanta's failed delisting  Vedanta’s stocks tanked over 20% early this week following its failed attempt to delist the company. The buyback tender offer did not receive the required number of shares to delist the company. The twist in the tale came from LIC. Here is how delisting works – The company comes out to the open market and suggests a floor price. This is the minimum price the company will accept to pay to buy its shares back. Shareholders then submit their bids above the floor price at which price they will accept the buy back. Once the offers have been made, the company will take the bottom 90% of the offers made and announce the buy-back price. This buy-back price is the highest price of that bottom 90% and everybody who tendered in gets that price.
While most mutufual funds submitted bids that were 10%-25% over the prevailing market price, LIC submitted its bid at about 2.8X Vedanta’s shares' market price. That’s not the kind of money its billionaire promoter Anil Agarwal is ready to pay. So, he pulled out. But here is the worst part of this whole incident. The MD of a private equity firm posted on Linkedin about this delisting and told poor retail investors that, and I quote, “There may be no downside”. He opened a telegram channel which was followed by 400 poor souls and gave them a lot of gyan about how everyone should make a quick buck out of this opportunity. The share price tanked, and people lost more than 20%. Lessons learnt? Don’t bother. This will happen again. STOCK STORY Escorts Limited
Only 20 years ago in 1991, over 60% of those employed in India worked in farms. That figure today is just 40%. The same figures for China are 50% in 1991 and 25% today. The industrial revolution moved people out from agriculture to manufacturing and mining. The technology revolution is moving people out to jobs in the services industry. But the trend is unmistakeable – fewer and fewer people are working our farms. But food production has been on the uptrend. From about 150 million metric tons of food produced in the early nineties our country now produced a record 300 million metric tons of food grains last year. Thanks to better water management, warehousing facilities and government intervention in the form of minimum support prices, our country is able to feed most hungry mouths. But our yield per hectare, the actual amount of food produced per acreage, is by far one of the lowest in the world.  And if the historic trend is anything to go by, this will also change.
Fewer hands working the farms has meant that farmers have had to increasingly rely on tractors & agricultural machines to do the job. The abundance of credit availability has meant farmers have managed to buy them quite easily.
Last year alone (2019-20) over 7 lakh agricultural tractors were manufactured and sold in India (about 30%-35% of worldwide production and sales). The overall growth in tractor sales in India has witnessed an obvious trend.  While we saw a small blip last year in terms of number of tractors sold, this year’s demand has made a roaring come back.  How many more tractors can India really buy per year? Maximum? Average replacement cycle for a tractor is about 10 years. Given that figure and annual sales of 7 Lakhs tractors last year, the total number of tractors in use at any one point in time is about 70 lakhs. India has a total of 16 crore hectares of arable agricultural land. This indicates we have 4.3 tractors per square km of arable agricultural land. The same figure for China is 6. Data for other countries is hard to come by. But a study by World bank places that figure for other developed countries as below.  This data suggests that our stock of tractors in comparison to our total arable land has some way to go. Should tractor density go up to China levels, tractor sales per year could equal 9 Lakh units per year. That would be a growth of 30% from current levels. Should tractor density go up to levels seen in the EU, the industry size could double.
But food production is also slated to increase. In 2015, an average Indian consumed 2,455 Kcal per day. The same figure for an American was 3,639 Kcal and a British citizen was 3,440 Kcal. As the country’s economy develops, more people move out of poverty and consume more food. This suggests that Indian farmers will need to produce at least 30%-40% more food to keep the population well fed.
Putting these two together, the maximum industry size could be between 1.8X - 2.5X today’s figures. If sales grows at 7% per year, this industry might hit saturation in the next 10-15 years. So, we have a LONG way to go.
Right, now you want to know which companies stand to benefit?
Looking into the landscape of tractor manufacturers, there are primarily 5 manufacturers who control over 90% of the market share.  Only 2 of these are currently listed in the Indian stock market - Mahindra & Mahindra and its smaller rival Escorts. Our assessment is that Escorts is a better managed business compared to M&M. What’s so special about Escorts? Read further…
Escorts - The business
Established in 1944, Escorts is primarily a tractor and farm equipment manufacturer. They have 3 divisions.
This is how their revenue has grown over the years.  Here is the trend of their operating profit margin and net profit over the years. All metrics have grown significantly over the years.  And we dug in to find out how. The Escorts business as we see it today looked nothing like this 10 years ago. A book titled ‘Back from the brink’ records the company’s slide into ‘coma’ and how it resurrected itself from it. The man behind it all – The Wharton B-school educated founding family member and new kid in the block, Nikhil Nanda. Over the years since its inception, the group had expanded into telecom, IT and healthcare businesses which dragged the company into a whole lot of debt. Nikhil sold off these low margin/losses making entities to focus on the company’s core capability – Making engineering products for the heavy utility/mobility industry.
At the end of FY 2008, the business had Rs.840 crores in debt and made Rs.(-37) crores in losses. More than a decade on at the end of FY20, the business had Rs.6 crores in debt and made Rs.477 crores in profits. Return on capital employed improved from 6% to 19% during the same time. (The same ratio for Mahindra and Mahindra today is 8.23%). All of because of one thing – good capital allocation decisions.
The business generated Rs.2,100 crores in cash over the last 10 years of which Rs.650 crores was used to pay off loans, Rs.200 crores was used to pay dividends and the balance of Rs.1,250 crores was invested back in the business. The market cap of the business during this same time went up by Rs.14,235 crores indicating a 11X return on capital invested into the business.
The company has partnership agreements with 2 Japanese firms called Kubota and Tadano who offer technology support and collaborate with Escorts in exporting their product lines to other countries. Escorts makes significant investments each year into developing their R&D capabilities and their products are starting to stand out.
The company is predominantly present in north and central India with very low market shares in the west and south. But this is changing. The company today has about 1035 dealers and they think they need a total of 1,200 dealers in total for optimal distribution. So, they are going after new dealers. They are changing the distribution model too. Competitors like M&M have large dealers managing large areas/regions. In contrast, Escorts is adopting a low-investment dealer model where several small dealers are recruited with very low upfront investment required to manage smaller regions. Escorts is also trialling out a pay per hire model for their tractors to widen adoption.
But I really wanted to get a feel of what the farmers thought about it all. So, I went to find out. On Youtube! I looked up for Mahindra vs Escort on Youtube and a whole load of competitive tractor stunt videos came up. And here are just a few of the most liked comments I found.
And this love for their products shows in their market share gain over the years.  Summary Escorts is in an excellent footing today with over Rs.2,000 crores in cash & liquid investment investments and two industry partnerships with leading Japanese manufacturers in the tractor and construction equipment division. The promoters’ recent history of good capital allocation decisions gives us confidence about the future for this business. At a time when food production is slated to grow and mechanisation of farms is catching up due to wider credit availability, Escorts looks poised to capture this opportunity profitably. The construction equipment and the rail businesses while small are also positioned in industries that have a lot of growth momentum left in them.
But what is the asking price? Valuation? The business is valued at 34X trailing PE against a median historic PE of 25. Mahindra & Mahindra is selling for 1X total revenue, while Escorts is selling for 3X.
So, it is expensive.
But we need to pay a big premium to acquire good businesses, no? Perhaps so. But a good business does not really mean a good investment for us. Think about it this way. Escorts’ market cap today is roughly Rs.17,000 crores. Let’s get a bank loan and buy the whole business at market price. Then use the cash & liquid investments they have of Rs.2,000 crores to part close that loan. So, for a net purchase price of Rs.15,000 crores, we own a business which generated about Rs.500 crores in profit (FY20) - 3.33% return on investment. It really is expensive.
The market has recognised the business and it wants a premium for a piece of Escorts. As a buyer, we want maximum value for our money. But markets aren’t always rationale.
So for now, we will just keep a tab on the company and its stock price. When we get a sweet deal, we will not say no.
Disclaimer - I hold a tracking position in Escorts stocks. My views may be biased. This is not a buy or sell recommendation for the stock. It is merely intended to be an educational column. Please consult with your financial advisor before investing.
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