Operating profit margins and its importance in investing in shares

Operating profit margins and its importance in investing in shares

Introduction 

Operating profit margin (OPM) is derived when direct expenses are reduced from total sales. OPM in excess of 10-12% is considered to be good. Higher the OPM the better. In business environment lot of factors keep on changing in real-time which affects the margin of the business. If a company has higher OPM it will be able to withstand and sustain adversity due to change in business environment. Regulatory changes, demand-supply changes , currency fluctuations, commodity cycles, change in rate of interest etc. are some of the changes that can affect a business.

Business with very low operating margins shall be altogether avoided. Because even a slight change in business environment can hamper the growth of business negatively impacting shareholders value. To improve operating profit margin companies can focus on cost reduction steps or increase sales of products which have high margins by changing the sales-mix of products.

Operating Margin (%) = Operating Profit / Net Sales

Operating Margin Important points : 

• Businesses which are having high competition or which are approaching end of life cycle are likely to have lower operating profits and should be avoided. Eg. Wires Business or Computer hardware business

• Businesses which have monopoly or very high market share in a sector or some form of competitive advantage which cannot be easily replicated will normally have higher operating margins and shall be good for investment objective Eg. Alcohol industry due to barriers on entry of new players or Any Government enterprise having monopoly in a sector

• Operating margins of a sector can be altered substantially due to change in business environment which can make a new investment advisable or an old investment obsolete. Eg. Demand for Automobiles is slowing down due to rise of cab industry and is likely to go down further in future. So investment in auto sector may not likely be advisable.

• While evaluating an investment in shares, one has to ensure whether there is consistency in operating profit margins for a certain period of time to say like 3 or 5 years. Companies which have very volatile operating margins can have wild share price fluctuations regularly is unlikely to delivery good returns to shareholders

• To improve operating profit margins, company can eliminate or outsource products with low profit margins. Increasing proportion of products with higher margins or introducing newer products with higher margins can also help

• Cost-reduction program can be undertaken to improve operating profit margins. Reduction of cost can be done in various domains like packaging, transportation, raw material procurement, automation to replace costly labor etc.

• Operating profit margin of companies with similar size and similar business model can be compared to identify which one is efficient

Debt/Borrowing and it's Impact on Share Price in Investing

Debt/Borrowing and it's Impact on Share Price in Investing

Introduction

Debt or borrowed fund is used by companies for various purposes. It can be used either for expansion of business or repayment of higher rate debt or for working capital needs. Debt comes at a certain terms and condition and has implications on the business. It makes sense to borrow funds when company is capable to generate higher rate of return then the rate at which fund is borrowed. Eg. If Company generates return of 18% in it's business then it makes sense to borrow funds at rate lower than 18% and deploy it in business. Debt creates leverage which fuels growth of the business. Debt if used properly in business can help it grow multi-fold. However, if a company has excess debt then it can affect the cash flow as well as profitability of the company. Many instances have been observed where companies have gone into liquidation/insolvency due to excessive debt.

Major Uses of Debt :

1. Expansion of Business ( Capital Investment )
2. Working Capital Needs (Funding Debtors +Inventory )
3. Repayment of Existing Debt which has a High rate of Interest

Important Points related to Debt from Investment Perspective :

• Investors must check credit rating performed by various rating agencies in respect of the debt of the company. For listed companies it is available online. It can give investor an idea in respect of credit profile of the company. If credit rating of the company is good it can borrow fund at lower rate of interest. Companies with bad credit rating should be avoided for investment because its cost of borrowing will be higher and also possibility of default is higher so shareholder risk is increased in such case

• Debt to equity ratio upto 2 is considered to be safe for investing in a company. Many infrastructure companies in India borrow excess funds and when project gets halted due to any reason and there is cash-flow crunch it results in default and many other problems which ultimately and unfortunately erode share holder value

• Purpose for which a company borrows fund is very important to understand from investor stand point. When fund is borrowed for expansion of business then for initial period when the new unit is being setup only costs are recorded and so profit goes down initially. Once the plant is ready and starts generating sales then higher profits become visible and share prices are likely to go up

• When a company borrows fund for working capital one has to ensure that it does not have unusual high value of inventory(stock) or high debtor days than industry average. If it is so, it may indicate that inventory(stock) is not real and is being used to cover up some loss which is not being reported. Similarly high debtor days may indicate that some of debtors have turned bad debt but not being reported

• If a company borrows fund regularly to repay the old debt it is not a sign of healthy company. It may indicate that company is not able to generate enough cash-flow from the business in the longer run to make the repayment of principal value of debt

• Default in debt repayment is not a sign of healthy company. Due to extra-ordinary  circumstances or one time event if such thing happens then it can be ignored. But if proper justification is not available then investor must exercise caution while investing in such companies and should be avoided to the extent possible

• Investors must avoid companies with excessive debt. Companies which have debt to equity ratio in excess of 2 shall be totally avoided

• In case debt is raised from outside the country, then investor must check the annual report to ensure that proper hedging has been done for the same so that currency fluctuation does not have impact on the profitability of the company

Sector selection and Stock Selection for superior returns in Investing

Sector selection and Stock Selection for superior returns in Investing

Introduction 

Outcomes from the past if analysed thoroughly can help one arrive at various observations which can be used for better decision making in future. Sector selection is an important aspect in stock selection process for investing. Have you ever found any power company in the past that has provided extra-ordinary or superior returns to shareholder ? The answer from your end would be a NO in 99% cases for power companies. Similarly a lot of FMCG companies have provided multi-bagger returns in the past has been observed. So what is the fundamental difference ? Businesses which have natural demand, monopoly or some form of competitive advantage normally provide superior returns to shareholders in the longer run. Businesses like food products, alcohol, condoms, paint, pharma etc. fall in the above categories. Capital intensive businesses like energy, telecom, defense, steel, mining etc. generate relatively lower returns in their business and so shareholders value increases at a slower rate in such business. If one can understand these fundamental points than success rate in investing can be enhanced substantially.

"EFFICIENCY" is the driving Factor :

Stock selection process in investing is more or less revolving around Efficiency. Whether we are looking at returns or valuation or debt or any other factor. All we are looking for is to invest in an efficient business which can generate superior return with lesser capital and lesser risk.

Top-Down Approach : In this approach one identifies first the sector in which one wishes to invest and then looks for the best available companies in the sector.

Bottom-up Approach: In this approach one identifies first the stock in which one wishes to invest and then performs sector study to arrive at conclusion whether it is fit to invest.

Both the approaches are equally valid and effective. However, one point is to be kept in mind that investor must go across and understand primary information for all the sectors so that they can chose the best sectors and best stocks.

Sector Selection Important points : 

• Investing in sectors which have asset-light business model normally provides superior returns to Investor in the long-run. Eg. FMCG, service industry etc.

• Sectors which have natural demand for the products or services are attractive for investor. Eg. Pharma, consumer products etc.

• Sectors which are capital-intensive shall be avoided because larger capital is required for growth in such businesses and so the return on capital is lower for such stocks. Also as the technology keeps changing up gradations have to be made continuously on large scale basis so growth happens at a slower pace.

• Sectors which are highly regulated shall be analysed carefully before investing because change in government regulation can impact the returns in the stock. Eg. Insurance, real estate etc.

• Sectors which are unique or have some competitive advantage in the listed space can have potential for superior returns. Eg. Listed Art company or listed company manufacturing gas valves etc.

• Sectors which have a huge present and potential market size are good from investment perspective. Because as the market size is huge, the margins of such business is less likely to decline in future.

Fundamental Analysis or Technical Analysis ? Which is more effective to profit from Stock Market ?

Fundamental Analysis : 

Fundamental Analysis attempts to measure a stock's intrinsic value by examining related economic and financial factors, which can be both qualitative and quantitative in nature. End goal of fundamental analysis is to derive a value for a stock which can be used to determine whether presently stock is undervalued or overvalued for investment decision.

• Fundamental analysis uses revenues, earnings, return on equity, promoter share holding, profit margins and other data to determine a company's underlying value and potential for future growth

• Fundamental analysis may also use discounted cash flow models and various other models to arrive at intrinsic value. Comparison with peer companies in the same sector and macro analysis of broad economy is also sometimes included

• Fundamental analysis is subjective in the nature in the sense that every person may perceive VALUE differently for the same stock

• One of the limitation of fundamental analysis is that it takes into account only information in public domain and within the perception of person performing the same. Eg. If government of china enacts stricter environmental rules for chemical companies then the same can have favorable impact on chemical companies in India. Person performing fundamental analysis must have a wider perception to include most of the information that is likely to impact intrinsic Value

• Fundamental analysis assumes that markets are not efficient and there is possibility to derive profit due to mismatch between present value and intrinsic value. In spite of all the clarity that fundamental analysis brings in, it alone is not enough to arrive at the timing and extent of investment/trading decision

Technical Analysis : 

Technical analysis assumes that all information studied by fundamental analysis is already reflected in the PRICE of given stock. It is a method employed to evaluate stocks by analyzing statistical trends gathered from trading activity, such as price and volume. 

• In technical analysis historical data of stock is used to understand pattern of price movement and to evaluate stocks strength or weakness on the basis of the same.

• Technical Analysis has 3 major assumptions :

1. Price moves in Trend
2. Patterns tend to repeat 
3. Everything is factored in the PRICE

• Technical analysis is of great assistance for timing the entry and exit in investment or trading decision.

Intersection of Fundamental and Technical Analysis : 

For investment decisions it will make a lot of sense to COMBINE fundamental analysis and technical analysis. Fundamental Analysis will take care of the aspects which will help one arrive at intrinsic value and technical analysis will help one arrive at the timing at which entry and exit decisions can be made.

One must have observed or experienced that many a times you would have identified a very good fundamental company and taken a long position but the stock does not move at all for long periods of time. You may eventually exit and stock moves or stocks does not move for a few years and then suddenly moves. If support of technical analysis is taken then it is possible for one to know whether longer term trend of a stock is positive or not. Likeliness of a stock to move up is higher if stock is in uptrend and fundamentals are also good ! 

BDH Industries : Small Cap Gem

                                        BDH Industries : Small Cap Gem

CMP : 76-78

BSE CODE : 524828

Market Cap : 44 Crore

LISTED ON : BSE

TARGET : 150/175

Time Frame : 24 Months 

History of the Company :

BDH Industries started off as fledging unit in 1935. It has grown into a major facility and earned global acclaim. BDH industries is engaged in the manufacturing of therapeutic formulations covering a range of pharmaceuticals. Company offers a range of oral solid dosage (OSD) technologies. The company offers its products in various therapeutic classes, such as antifungal, antibiotics, anticancer, anti-diabetic, antidepressant, anti-ulcerant, antimalarial, anti-inflammatory, analgesic, antispasmodic, anti-tuberculosis, cardiovascular, dermatological, non-steroidal anti-inflammatory drugs, psychotropic, trichology, and vitamins and minerals.

Company has state of art manufacturing plant comprising of 42,500 square feet which meets WHO GMP standards. Fully automated manufacturing system gives company unique capability to go into wide range of dosage forms such as tablets, capsules, external ointment, small volume parenterals etc.

Company exports to over 60 countries across the globe and has won many awards for its performance in the business

Main Business Activities : 

• Formulations
• Speciality Formulations

Financials of the Company : 

• Profit After Tax (PAT) for the year ended on 31st March,2018 has been reported  at Rs 3.76 Crore and turnover at Rs 41.01 Crore.
• As per the numbers as on 31st March,2018 the company has generated Return on Equity of approx. 13%,Return on Capital Employed of 15% and Return on Assets of 10%
• The company is a regular dividend paying company and has paid dividend for past 8 consecutive years.
• Debt to Equity ratio is below 1 and is reasonable in nature
• The company has carried out a major expansion in 2017 and the impact of same is gradually visible on top and bottom line in this year

Investment Rationale : Why to Invest in this Stock ??

• Shareholding of the promoters in the company is 55% indicating strong interest of promoters in the business  as on 30th December,2018
• Market Cap to Sales Ratio : 0.78  is very attractive for a Pharma Company
• OPM (Operating Profit Margin) of the company is gradually improving since past 3 years
• At current price of 76 Rs per share and EPS of 9 Rs on trailing basis, the stock is presently trading at an attractive P/E ratio of 8
• At a forward reasonable P/E of 15 and EPS of 10, we expect the stock price to soar higher atleast to 150 and higher levels in coming time.

Disclaimer Note: The above is not a research report but information as available on public domain and it should not be treated as a research report. Registration status with SEBI: I am not registered with SEBI under the (Research Analyst) regulations 2014 and as per clarifications provided by SEBI: “Any person who makes recommendation or offers an opinion concerning securities or public offers only through public media is not required to obtain registration as research analyst under RA Regulations.

Disclosure: It is safe to assume that I might have BDH Industries in my portfolio and hence my point of view can be biased. Readers should perform own due diligence before investing. We do not assume any responsibility or liability resulting from the use of information , judgments and opinions for Trading or Investment purposes on the Blog.