Understanding the Cash Conversion Cycle

"The cash conversion cycle (CCC) is one of several measures of management effectiveness. It measures how fast a company can convert cash on hand into even more cash on hand. 

The CCC does this by following the cash as it is first converted into inventory and accounts payable (AP), through sales and accounts receivable (AR), and then back into cash. Generally, the lower this number is, the better for the company. 

Although it should be combined with other metrics (such as return on equity and return on assets), the cash conversion cycle can be especially useful for comparing close competitors because the company with the lowest CCC is often the one with better management."

Read more at:
https://www.investopedia.com/articles/06/cashconversioncycle.asp

Technical updates – Container Corp and Indraprastha Gas

Stocks of PSU companies have never been my favourite because too often, management decisions have been dictated by government prerogatives and their bulging cash balances have been used to fix problems arising from faulty fiscal policies.

But if some one pointed a gun at my head and forced me to pick two PSU stocks – these two would be at the very top of my list. Why? Their near-monopoly status, and consequent strong fundamentals.

Container Corp is debt free, with RoE of 14%, and net profit margin of 18.4%. Indraprastha Gas has a debt/equity ratio of 0.18, RoE of 20.4%, and net profit margin of 9.1%. Therefore, it is no great surprise that the former has a P/E of 26.6, while the latter has a P/E of 17.6.

The charts below show that both stocks are trading in strong bull markets. But the general public holds just 1.3% of Container Corp’s equity and 6.5% of Indraprastha Gas’ equity. Two excellent investment-worthy stocks – and the public doesn’t seem to care about them!

Container Corp

The stock price of Container Corp. consolidated sideways within a ‘rectangle’ pattern for a year before finally breaking out upwards on a volume surge. As often happens, a pullback towards the breakout point gave investors an opportunity to enter.

The stock closed at a new high of 1483 in Nov ‘14, but negative divergences in all four technical indicators - which failed to touch new highs with the stock (marked by blue arrows) - led to a correction. The stock dropped below its 20 day and 50 day EMAs, but has recovered since then.

Technical indicators are looking bullish. Some consolidation can be expected before the up move resumes. 

Indraprastha Gas

The stock price of Indraprastha Gas consolidated sideways within a bullish ‘falling wedge’ pattern before breaking out upwards with a volume surge. It has been a strong up move since then, with intermittent corrections that ensured that the stock didn’t become too overbought.

The stock touched a new closing high of 465.40 in Dec ‘14, but negative divergences in all four technical indicators, which failed to touch new highs with the stock (marked by blue arrows), have led to a correction that is continuing.

Any drop below its 50 day EMA will be an adding opportunity.

How to value Companies with Negative Earnings

Negative earnings means losses. Most small investors should stay far away from companies with negative earnings. However, there are instances of even well-managed companies running into problems and making losses. If the problems are temporary in nature, then a turnaround may be just a few quarters away, and the stocks of such companies can give phenomenal returns.

But how does one know whether negative earnings have been caused by temporary problems, or whether the problems are more deep-rooted? Traditional valuation metrics, like P/E (or E/P) or RoE won’t work because the ratios will be negative. In a recent article at investopedia.com, three methods of valuing companies with negative earnings have been discussed.

Here is an excerpt:

“Investing in unprofitable companies is generally a high-risk, high-reward proposition, but one that many investors seem willing to make. For them, the possibility of stumbling upon a small biotech with a potential blockbuster drug, or a junior miner that makes a major mineral discovery, makes the risk well worth taking.

While hundreds of publicly traded companies report losses quarter after quarter, a handful of them may go on to attain great success and become household names. The trick, of course, is identifying which of these firms will succeed in making the leap to profitability and blue-chip status.”

You can read the full article at the link below:

http://www.investopedia.com/articles/investing/121013/how-value-companies-negative-earnings.asp?

How to select a stock - an analysis of the exercise for readers

Before I get into a detailed analysis of last week's stock picking exercise, I would like to extend hearty congratulations to all of you who participated.

Regardless of your answer, the willingness to participate in an open forum indicates a desire to learn and share - which are great qualities for success in life (and in investments). As far as I am concerned, you are all winners.

The information given about the companies was brief. But it was adequate to decide which of the three should be added to a list for more detailed analysis. Thousands of stocks trade every day, and it is not possible for small investors to check the fundamentals of even a fraction of the traded stocks.

One uses short-cuts to create a short list. I start with the cash flows from operating activities. Why? Because a listed company is in existence for one reason only - to generate cash. Cash in a manufacturing business is like gasoline to an automobile. Without a regular supply of it from its operations, a business can run for a while but will eventually come to a halt.

All three companies have positive cash flows from operations and negligible debt. But sales are low and so are the NPMs - an indication that the sector is a profitable one but has low volume and low margin. That is why, it is a bit surprising that all three have outperformed the Sensex by moving above their Jan '08 prices.

The fact that all three have been around for at least 30 years means that the business models are sustainable. The low P/E is an indication that the market is not enthused by the low growth of the sector.

As small investors, we don't have huge capital at our disposal. To make sure our limited resources are not frittered away in chasing multibaggers, the prudent option is to look for companies where internal accruals are sufficient to pay for expansion and investments.

Debt is not bad per se - if it can generate more cash than the debt repayments. But when debt is incurred merely for rapid growth - disaster happens. The sorry state of the high fliers in retail and real estate is a clear example.

So we have three companies - all with good fundamentals in a sector with low risk and low growth. How do we choose one over the other?

Most of you chose Stock 'N' and there were several reasons for doing so. Highest sales, highest EPS, best RoE, strongest technicals. The clinching reason - not mentioned by any one - is that its sales are more than the combined sales of the other two! Even in a low growth sector, one company is growing faster than its two closest and older competitors.

Though it is trading at a much higher price, Stock 'N' is available at a Market Cap to Sales ratio of less than 1. Some of you have mentioned about this ratio (without explaining why it may be relevant). Others haven't. Next Tuesday's post will explain the importance of the Market Cap/Sales ratio.

The exercise was an effort to demonstrate what kinds of stocks can be added to a 'watch list' for more detailed analysis. A 'buy' decision can only be taken after a more thorough look at past performance and business outlook.

Now for the awards announcements.

VJ gets the nod (and applause) for the most logical explanation covering all the important points. Just follow your investment plan, and you will retire a rich man!

sreyO gets an "A" for effort. Though his explanation wasn't brief, he pointed out that a comparison is possible only if all three stocks have the same face value. Pretty impressive for some one who hasn't started investing yet.

A big 'THANK YOU' to the rest of you for taking part in the exercise.

About Growth Stocks and Value Stocks

Should the title of this post be changed to Growth stocks vs. Value stocks? So many dichotomies have become part of our everyday lives - like Good vs. Evil, Black vs. White, East vs. West, Fundamental analysis vs. Technical analysis - that we have come to believe them as truths.

The reality is different. By creating compartments and divisions through our imagination or dogma, we get into behavioural patterns that are detrimental to our emotional and financial well-being. Once we decide to cut the Gordian knot of needless differences, life and investments become so much simpler.

Enough philosophy for a short week of trading. Let us get down to the nitty-gritty.

What is a Growth stock?

These are stocks belonging to companies that have shown a consistent above-average growth in sales or earnings in the past, and are expected to maintain the rate of growth in future. One measure of growth is RoE (Return on Equity) above 15%.

To fuel such growth, cash is a major requirement. So companies often forego dividend payments to plow the earnings back into the business. When the earnings are inadequate to fund the growth, companies resort to share issues and debt.

Typically, these are high P/E stocks with volatile price movements that make them risky to own. Investors expect to make large capital gains and often get trapped by the 'greater fool theory'.

What is a Value stock?

These are stocks belonging to companies that are considered to be trading at a level lower than their intrinsic values, as determined by fundamental analysis of sales, earnings, dividend payments.

These stocks have low P/E or P/BV ratios and high dividend yields. Hence they have lower risk and a bigger 'Margin of Safety'. Value stocks tend to out-perform growth stocks during bear markets and under-perform in the later stages of bull markets.

Like in life, which has more shades of gray than black or white, there is no distinct dividing line between a Growth stock and a Value stock.

No company can have a high growth rate forever. Sooner or later, as its size increases, growth rate will begin to slow down. If it survives, it will become a stalwart and pay regular dividends and grow steadily.

The key phrase is: 'if it survives'. Taking on too much debt, or issuing too many shares in the singular pursuit of growth can weaken the balance sheet so badly that the company can collapse under the weight of its interest payments. Stocks from the retail and realty sectors come to mind.

Should investors choose Growth stocks or Value Stocks for their portfolios? It need not be an either/or situation. Why not choose Growth stocks and Value stocks?

How about using the 80-20 rule? Keep 80% of your portfolio in Value stocks, and 20% in Growth stocks. Remember that the best time to look for Value stocks is when the stock market is down, not when it is up 70% from its recent low. That doesn't mean that Value stocks are not available in bull markets. They are just very difficult to find.

(Do you have an opinion about any good growth or value stocks in the current market? Please share it here for the benefit of other readers.)