Deep value or value trap

Deep ValueOr

Value Trap?

Herb Simon

Satisficing

Extreme Financial Characteristics

“It always seemed, and still seems, ridiculously simple

to say that if one can acquire a diversified group

of common stocks at a price less than the

applicable net current assets alone — after

deducting all prior claims, and counting as zero the fixed and other assets — the results should be quite

satisfactory.” - Graham

http://en.wikipedia.org/wiki/John_Neff

Nifty (Large Cap)

-50

0

50

100

150

200

< 14 14 - 16 16 - 18 18 - 20 20 - 22 22 - 24 24 - 26 26 -28 28 - 30

-40-36-33-15

2151

84

121152

3 Year Forward Total Returns (%) Vs Current PE

Data Source: nseindia.com

Nifty (Mid Cap)

-100

-50

0

50

100

150

200

< 8 8 - 10 10 - 12 12 - 14 14 - 16 16 - 18 18 - 20 20 - 22 22 - 24 24 - 26 > 26

-65-48-44-40-37-2

39

125

190161166

3 Year Forward Returns (%) Vs Starting PE

Data Source: nseindia.com

Dogs of Dow

Spinoffs

Spinoffs

Value Investors Look at all Spinoffs

Case on Gesco

Part of the fixed assets are income producing

Earning stream is of very high qualityGrowing stream

Highly PredictableHow to value this income stream?

Part of fixed assets are not producing any income.

Not NPAsThey are valuable, but idle assets.

Capital WIP is an ongoing project which will complete within an year or so.

At the moment it is not producing any income.

Fixed assets are traded in a market of their own and their value can be

independently verified.

Nehru Place Property

Total built-up area: 51,810.07 square feet.The building is let out to various

multinational companies like Microsoft, Cisco, Heinz, and Royal & SunAlliance.The property managed by Gesco Corp.The tenants pay Gesco Corp. a composite sum which includes rent and maintenance

charges.

Nehru Place Property

Building has been constructed to international quality standards, and has been rated as one of the best commercial

buildings in New Delhi by an international property consulting firm and has been

rated as class "A".

Bhikaji Cama Place Property

Total built-up area: 54,973.35 square feet.Most of the floors are let out to Erricson at

Rs 150 per square feet per month.The lease deed also provided for an escalation of 25% on the rent on every extension of three

years.

Bhikaji Cama Place Property

The property is managed by Knight Frank, a company in which Gesco Corp. had a 16% stakeThis building too has been ranked as one of the best commercial complexes in Delhi by Richard

Ellis.

Valuation of two propertiesWe now knew the rents being paid by tenants

of both the Delhi properties to Gesco.In case of the Bhikaji Cama Place property, this was Rs 125 per square feet per month, and in case of Nehru Place property, this was Rs 95

per square feet per month.The annual rental revenue from the Bhikaji

Cama Place property came to Rs 8.24 cr.The annual rental revenue from Nehru Place

property came to Rs 5.90 cr.The total rental income came to Rs 14.14 cr.

Valuation of two properties

This tallies with the income statement of the company according to which the total income from operation of commercial complexes was Rs 14.09 cr. and the business centre revenues were Rs 0.68 cr.)We were have also informed through market sources, that both the properties were fully

leased and the typical lease term is either 6+3 years or 3+3 years, with escalation clauses of 25% after every three years which translates

into an annual increase in rents of 7.8%.


If we ignore the escalation clauses built into the lease agreements for the above two

properties, and further assume that the quality of tenants will remain unchanged, then the

annual rental income of Rupees 14.14 cr from these properties would resemble coupon

payments on a high-grade, perpetual corporate bond.

At that time, such a bond would produce a yield-to-maturity of 12% per annum (implying

a multiple of 8.33).


Using this capitalisation factor of 8.33, which we felt was extremely conservative, given the

location and the quality of these properties, the value of these properties came to Rs 117.78 cr. Notice, however, that this valuation ignores:

The increase in value due to rent escalation clauses. If we assume a perpetual growth of only 3% p.a. in

rents, then the value of these two properties becomes Rs 157 cr.


The reduction in value due to a clause in agreement with DDA which requires that 50% of unearned

increase is to be surrendered to DDA.The presence of this clause will have an impact on the resale value of the property but will have no impact on the earning power value because

the earning power value is based on rents which are unaffected by the presence of this clause.


If both the above points are taken into account, it is, in our opinion, safe to assume a minimum earning-power value of Rupees 100 crore for

these properties. This valuation of Rupees 100 crore for both properties translates into Rupees

9,364 per square feet.Now we can compare this earning-power

valuation figure of Rupees 9,364 per square feet with that of the prices fetched by other

commercial properties in Delhi.


According to Knight Frank, the outright prices for non-prime commercial properties in various commercial business districts of

Delhi were as under:Connaught Place: Rs. 7,000-9,000 per sq. ft.

Bhikaji Cama Place: Rs. 3,500-4,000 per sq. ft.Nehru Place: Rs. 3,500-4,000 per sq. ft.

Rajendra Place: Rs. 3,000-3,200 per sq. ft.South Extension: Rs. 4,500-5,000 per sq. ft.

Gurgaon: Rs. 2,500-3,500 per sq. ft.


According to Knight Frank, "A" grade buildings in these areas having power back

up, air-conditioning, latest fire fighting equipment etc., were quoted at significantly

higher rates than the above rates.


In fact, on our enquiries from market sources, class "A" retail trade buildings in Delhi were commanding outright sale prices as high as

Rupees 15,000 per square feet (in Ansal Plaza, for instance).

The price range for class "A" properties in commercial centres of New Delhi (such as

Connaught Place, Nehru Place, and Bhikaji Cama Place), according to market sources

range from anywhere between Rupees 9,500 to Rupees 10,000 per square feet.


Therefore, our earning-power estimate of Rupees 9,364 per square feet appeared to be

reasonable, considering the prevailing market rates of such properties in New Delhi.

Indeed, in our discussions with various property brokers in Delhi, it has emerged that the sale value of both the Gesco properties is in the region of Rs 12,000 to Rs 15,000 per square feet. However, we

stuck to our conservative valuation of Rs 9,364 per square feet.


Summary of valuations of both the Gesco Corp. Properties:

Great Eastern Center, Nehru Place, New Delhi: Rupees 49 cr.

Great Eastern Center, Bhikaji Cama Place, New Delhi: Rupees 51 cr.

Valuation of Capital WIP

Gesco Corp. took over capital work-in-progress valued at Rupees 22.9

crore from Great Eastern Shipping.A very substantial part of this capital work-in-progress was attributable to Great Eastern Plaza, Pune, one of the

premium commercial complexes.


Located on the main airport road, this building boasts of the following: (1) Granite

and glass facade; (2) Full air-conditioning; (3) Full power back-up; (4) Infrastructure for

satellite connectivity; (5) Two tier car parking space; (6) Total area of 140,000 square feet in two phases- Phase one of 70,000 square feet is complete; (7) Constructed by Singapore

Infrastructure Technologies.


The scheme of arrangement between Gesco and Great Eastern Shipping mentions that the total

area of the property owned by Gesco is 8,499.32 square meters. Elsewhere, it has been mentioned that the total area of 140,000 square feet was to be built in two phases of 70,000 square feet each, out of which phase one of 70,000 square feet is now

complete.EIH Ltd has built a Trident Hotel in the same complex.


As on 31 March 2,000, Gesco Corp's total capital work-in-progress was valued at Rupees 30.47

crore.The components of this capital work-in-progress, apart from GE Plaza, Pune were not known. What

was known, however, is that phase one of GE plaza consisting of 70,000 square feet of prime commercial

property is now complete.


According to Knight Frank, the current outright sale value of prime commercial property in Pune was

approximately Rupees 4,000 per square feet.Although, given the quality and location of GE

Plaza, its outright sale value ought to be somewhat higher than Rupees 4,000 per square feet, we were conservative and taken the value quoted by Knight

Frank.


On that basis, the value of phase one of GE Plaza comes to Rupees 28 crore. Further, if we assume that the remaining components of

Gesco Corp's capital work-in-progress have a value of at least Rupees 2.47 crore, the whole of the capital work-in-progress on the balance sheet of Gesco Corp. as on 31 March 2000 would be valued

at cost of Rupees 30.47 crore.This Rupees 30.47 crore value appears to be conservative

because: (1) it assumes a zero return on funds invested by the company in capital work-in-progress; and (2) it assumes zero value for the remaining portion of the premises of GE Plaza where phase two comprising of 70,000 square feet of prime

commercial property is to be built.

Valuation of Bangalore Property

The property comprises of 9,223 square feet of leased commercial property called Great

Eastern Plaza in Bangalore.According to Knight Frank, the current outright sale value of prime commercial

property in Bangalore was approximately Rupees 4,000 per square feet.

On this basis, the value of GE Plaza, Bangalore came to Rupees 3.68 cr.

Valuation of Residential Properties

Since there was no rental income from residential properties none of these properties are

contributing to the operating earnings of the company.

This does not mean that the properties are vacant.In fact, the document on scheme of demerger mentions

that the five flats in Belvedere are occupied by employees (of, presumably, Great Eastern Shipping).ere Court is reputed to be one of most beautiful residential

buildings in Mumbai.


According to Knight Frank, one flat in Belvedere Court was recently sold for Rupees 2.15 cr. at a rate of Rupees

10,250 per square feet.To be on the conservative side, we assumed a value of only Rupees 1.75 cr. for each of the five flats owned by

Gesco Corp. in Belvedere Court. Total value of these five flats, therefore, came to Rs 8.75

cr.

Belvedere Court

• India’s tallest residential apartment complex

• A bow-shaped, 40-storey, international style skyscraper, comprising of 3 and 4 bedroom luxury duplex apartments.

• Situated at Mahalaxmi in Central Mumbai

• Gesco build this property and owned 5 flats.

Belvedere Court


Gesco Corp. also owns five more flats in Mumbai, each of which have been

conservatively valued at Rupees 50 lacs. Finally, the company owns one flat in

Bangalore, which we are valuing at Rupees 25 lacs.

The total value of the residential properties, which were taken over by Gesco from Great Eastern Shipping comes to Rupees 11.50 cr.


In addition, the company has spent Rupees 9.09 cr. to its residential property portfolio subsequent to the acquisition of properties

from Great Eastern Shipping under the scheme of demerger.

Assuming the value of newly added properties to be at least equal to 100% of the cost of creating them, the minimum value of

residential properties of Gesco Corp. comes to Rupees 20.59 cr.

Valuation of Administrative Offices

The corporate headquarters of Gesco Corp. is located in the World Trade Center, Cuffe Parade,

Mumbai.The company owns the premises.

We took an arbitrary value of Rupees 5 cr. for this office.

The company also owned three offices in Pune and one office in Banglore. Each was assigned an

arbitrary value of Rs 25 lacs.Therefore, the total value of the administrative offices of Gesco Corp. comes to Rupees 5.75 cr.

Property Valuation Summary

Great Eastern Center, Nehru Place, New Delhi: Rs. 49.00 cr.

Great Eastern Plaza, Bhikaji Cama Place, New Delhi: Rs. 51.00 cr.

Capital Work-in-Progress including Great Eastern Plaza, Pune: Rs 30.47 cr.

Great Eastern Plaza, Banglore: Rs. 3.68 cr.Residential Properties: Rs 20.59 cr.Administrative Offices: Rs. 5.75 cr.

TOTAL VALUE = Rs 160.49 cr. (Book value 118 cr.)

Valued at Rs 160 cr.

Valued at Rs 37 cr.

Valued at Rs -7 cr.

Rs 160 cr. + Rs 37 cr. – Rs 7 cr. = Rs 190 cr.The company has 2.87 cr. Shares. Value/ share = Rs 66 per share.

Conservative [MARGIN OF SAFETY]

Let us now introduce an additional element of MARGIN OF SAFETY.

At what price per share would you call this hypothetical company’s stock a “screaming

bargain”?

What is the cash per share?Rs 37 cr./2.87 cr. = Rs 12.89 per share?

What would you do if this stock became available at Rs 9 per share?

What if the “Efficient” Market valued this entire company for Rs 26 cr.?

What would you do?Don’t answer yet before you get the next

bit of information!

What if, in this company, the promoters were holding a stake of 11% and the rest

of the shares were out in the market?

Now, what would you do?

Case on Majestic Auto

Negative Return in 7 Years

15,77,686 shares x 1,800 = Rs 283 cr.

Market Cap: Rs 57 Cr.Total Debt: Rs 90 cr.

EV: Rs 147 cr.

Ben Graham’s Frozen Corporation?

An Observation on Value Traps

“Go to where the puck is going to be, not to where it is.” -

Wayne Gretzky

“A company should be viewed as an unfolding movie, not as a

still photograph.”

Why did THIS HAPPEN?

The Bleeding of MTNL

Deep Value Or Value Trap?

Thank You

Deep value or value trap

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