wealth creation study 2005-2010

UU Investing Creating wealth from the unknown and unknowable

By Raamdeo AgrawalDecember 15, 2010

www.motilaloswal.com15th Annual Wealth Creation

Study2

Discussion Points

• 15th Wealth Creation Study Findings

• Theme 2011: UU InvestingCreating wealth from the unknown and unknowable

• NTD to TTSUU framework to identify banking stocks for 2020

• ConclusionsNOTE: The core idea in this presentation is drawn from the paper, "Investing in the unknown and unknowable“, by Richard Zeckhauser, Professor of Political Economy, Harvard University. All quotes in this note are from this paper, unless otherwise stated.


Study3

Wealth Creation Study Findings


Study4

Concept of Wealth Creation:The process by which a company enhances

market value of the capital entrusted to it

by its shareholders

Net Wealth Created:Change in Market Cap over the study

period adjusted for corporate actions

Wealth Creation Study Methodology


Study5

Biggest Wealth Creators:Minimum wealth created should be Rs 100

crores over the previous five-year period.

(This year, the 100th wealth creator created

Rs 4,000 cr wealth)

Fastest Wealth Creators:The top 100 wealth creators are sorted by

fastest rise in their adjusted stock price

Most Consistent Wealth Creators:Based on no. of times a company appeared in

the last 10 studies

Wealth Creation Study Methodology (contd)


Study6

10 Biggest Wealth Creators

Rank,Company

NWC (Rs cr)

Price CAG

R

1. Reliance Inds.

255,598

37%

2. ONGC109,23

713%

3. NMDC101,42

350%

4. NTPC100,02

319%

5. BHEL 97,990 44%

Rank,Company

NWC (Rs cr)

Price CAGR

6. Infosys 86,975 18%

7. TCS 83,758 17%

8. SBI 80,160 27%

9. L&T 79,928 46%

10. Bharti Airtel

79,185 25%

Reliance is largest wealth creator for 4th year in a row

Last 7 years, top wealth creator has been from Oil & Gas: ONGC for first 3 years, Reliance in the next 4 years


Study7

10 Fastest Wealth Creators

Rank,Company

Price Appn.

(x)

Price CAGR

1. Unitech 28 95%

2. Areva T&D 22 85%

3. Jindal Steel 20 82%

4. Adani Enter. 16 73%

5. Sesa Goa 13 67%

Rank,Company

Price Appn.

(x)

Price CAGR

6. Shriram Trans. 10 57%7. Exide Inds 9 56%8. Titan Inds 8 52%9. Bhushan St. 8 52%10. Hind. Copper 8 51%

Unitech: Fastest Wealth Creator for 3rd time in a row

4 metal companies in top 10 fastest wealth creators

5 of the top 10 had mcap < Rs 1,000 crores in FY05


Study8

Most Consistent Wealth Creators

Intuitively, non-cyclicality of business is key for consistent wealth creation

But interestingly, 3 commodity companies are in top 10 consistent wealth creators, latest being Hind Zinc

Rank,Company

Appeared in WC

Study (x)

10-Year Price CAGR

1. Hero Honda 10 34%

2. Sun Pharma 10 33%

3. Asian Paints 10 32%

4. HDFC 10 29%

5. HDFC Bank 10 27%

Rank,Company

Appeared in WC

Study (x)

10-Year Price CAGR

6. Reliance Inds 10 24%

7. Infosys 10 20%

8. Kotak Mah. Bk. 9 59%

9. Hindustan Zinc 9 57%

10. ONGC 9 32%


Study9

Wealthex v/s Sensex (2005-2010)

Wealth Creators outperform markets without trading at significant valuation premiums

Mar-05Mar-06Mar-07 Mar-08Mar-09Mar-10 5-yr

CAGR

BSE Sensex 6,49311,28013,072 15,644 9,70917,528 22%

YoY (%) 74 16 20 (38) 81 Wealthex – rebased 6,49311,03512,568 17,15411,47022,054 28%

YoY (%) 70 14 36 (33) 92 Sensex EPS (Rs) 450 523 718 833 820 829 13%

YoY (%) 16 37 16 (2) 1

Sensex P/E (x) 14 22 18 19 12 21 Wealthex EPS (Rs) 497 566 774 963 954 1,141 18%

YoY (%) 14 37 24 (1) 20 Wealthex P/E (x) 13 20 16 18 12 19


Study10

Wealth Creation by Industry

Industry(No of cos.)

WC(Rs cr)

2010 (%)

2005 (%)

Metals (13)494,93

0 19 13

Oil & Gas (7)441,17

1 17 37

Banking (15)387,90

7 15 16

Engineering (11)

272,198 10 7

IT (7)267,85

4 10 0

FMCG/Retail (14)

187,824 7 3

Ultility (4)147,00

6 6 3

Industry(No of cos.)

WC(Rs cr)

2010 (%)

2005 (%)

Auto (8) 130,287 5 7

Pharma (8) 100,948 4 5

Telecom (1) 79,185 3 0

Cement (5) 52,077 2 3

Const/RE (2) 33,426 1 0

Others (5) 57,387 2 6

Total2,652,1

99 100 100For the first time since 2004, Oil & Gas has lost out to Metals as the biggest wealth creating sector.

Going forward, users of commodities will have challenging times unless their franchise is very strong.


Study11

Two cases of wealth migration

From MNCs to Indian companies

From PSU to Private sector

28 3026

2218

25

16

30

49 51

36

25

35

27

1999-2004 2000-2005 2001-2006 2002-2007 2003-2008 2004-2009 2005-2010

No of PSUs % Wealth Created

19 168 12 10 10

1623

1110

21

43

50

9147710723

2330

15

94-99 95-00 96-01 97-02 98-03 99-04 00-05 01-06 02-07 03-08 04-09 05-10

Top Wealth Creating MNCs Share of Wealth Created (%)


Study12

Wealth Creation by PAT growth

High growth companies have delivered superior stock performance despite sharp valuation de-rating

Markets cannot price hyper growth (UU) correctly, resulting in huge wealth creation at a rapid pace

2010 2005

0-10 15 18 16 9

10-20 16 27 18 12

20-30 28 25 23 22

30-40 18 43 22 16

40-50 7 46 17 17

50-70 10 37 20 34

>70 6 51 17 54

Total 100 28 19 13

P/E (x)PAT Growth Range (%)

No. of Companies

Price CAGR (%)


Study13

Wealth Creation by base ROE

Contrary to popular perception, rather than absolute RoE markets give more importance to change in RoE as it is an indicator of things to come.

46

29 322626

3228

23

<5 5-10 10-15 15-20 20-25 25-30 30-40 >40

Avg Price CAGR: 28%

2005 ROE Range (%)


Study14

Wealth Creation by valuation

For the first time ever, price performance is homogenous across P/E and P/B bands

Most likely an aberration


Study15

Wealth Creation & Payback ratio

Payback ratio of less than 1x is the most reliable indicator of rapid wealth creation

Payback = Market cap divided by Next 5 years’ expected profit

Payback in 2004 (x)

No. of companies

PriceCAGR %

Lastyear

<0.5 7 61 57

0.5-1.0 28 36 25

1-1.5 23 23 19

1.5-2 26 28 21

>2 16 21 11

Total 100 28 21


Study16

“There is absolutely no substitute for paying right

price.

In the Bible, it says that love covers a multitude of

sins.

Well, in the investing field, price covers a multitude

of mistakes.

For human beings, there is no substitute for love.

For investing there is no substitute for paying right

price – absolutely none.”

— Van Den Berg, OID, April 2004

Wealth Creation & Purchase Price


Study17

Theme 2011

UU InvestingCreating wealth from the unknown & unknowable


Study18

• UU Investing is investing in the unknown & unknowable (UU i.e. the “world of ignorance”)

• What is UU? = Situation where future states of the world are unknown

• UU investing = the art of “selecting assets that will fare well when future states of the world become known.”

What is UU Investing?

”

“The real world of investing often

ratchets the level of non-knowledge into still another dimension, where even the identity

and nature of possible future states are not

known. This is the world of

ignorance.


Study19

• 3 states of the world – Known (K), Unknown (U), Unknown & Unknowable (UU)

Understanding K, U and UU

Understanding UU

”

“The real world of investing often

ratchets the level of non-knowledge into still another dimension, where even the identity

and nature of possible future states are not

known. This is the world of

ignorance.

Knowledge of outcomes

Investmentenvironment

Stock market relevance

Known(Risk)(K)

Outcomes known; Probabilities known

Distribution of returns known

Not very relevant; very few outcomes have known probabilities

Unknown(Uncertainty)(U)

Outcomes known; Probabilities unknown

Distribution of returns conjectured

Faced by all stock market investors

Unknown & Unknowable(Ignorance)(UU)

Outcomes unknown;Probabilities unknown

Distribution of returns conjectured

Complementary (i.e. special) skills rewarded

Profitably exploited ONLY by intelligent investors


Study20

Evolution of stocks – from UU to UK to KK

Evolution of investor – from KK to UK to UU

UU Investing in stock markets

• When the future is broadly a continuity of the past, it becomes knowable through research and analysis.

• When the future is discontinuous from the past, it enters the realm of the unknowable, and calls for unusual judgement, courage and patience.


Study21

Past examples of UU investing

UU

UK

KK


Study22



Study23



Study24



Study25



Study26



Study27

• In the traditional investing model, portfolio return in excess of benchmark is called "Alpha".

• We call the very high excess return possible from UU situations “Omega”.

UU investing for Omega returns

”

“There are

systematic ways to think about unknowable situations. If

these ways are followed, they can

provide apath to

extraordinaryexpected

investmentreturns.


Study28

Step 1: Know UU Success Principles (SPs)

Step 2: Look out for UU situations

Step 3: Be aware of the pitfalls

How to go about UU investing

”

“Clear thinking about UU

situations, which includes prior

diagnosis of their elements, and

relevant practice with simulated situations, may vastly improve

investment decisions where UU events are

involved.


Study29

SP #1: High asymmetric payoff

Step 1: Know Success Principles

”

“The opportunity

to get a 10 or 100 multiple on your investment as

often as you lose virtually all of it is

tremendously attractive.

• Higher the challenge, higher the payoff

• Higher the skill, higher the upside payoff, lower the downside payoff

• Unlimited upside, downside capped at 100%


Study30

SP #2: High level of complementary skills

• Domain knowledge of specific businesses

• Past experience elsewhere (in other companies, in other industries, or in other geographies)

• Management assessment

• Imagination and unusual judgement

• Conviction and courage to commit the investment


”

Alas, few of us possess the skills to be a real estate

developer, venture capitalist

or high tech pioneer. But how about becoming a star of ordinary

stock investment? For such efforts

an ideal complementary skill is unusual

judgment.

“


Study31

SP #2: High level of complementary skills (continued)

With complementary skills, the investor moves from Quadrant C to Quadrant D, earning healthy returns


”

Alas, few of us possess the skills to be a real estate

developer, venture capitalist

or high tech pioneer. But how about becoming a star of ordinary

stock investment? For such efforts

an ideal complementary skill is unusual

judgment.

“Easy for Others to Estimate

Hard for Others to Estimate

Easy for you to estimate

A. Tough markets; no excess returns

D. Benefit from the UU situation using special skills

Hard for you to estimate

B. Avoid action; possibility of significant loss

C. Potential UU situation


Study32


SP #3: Portfolio approach to diversify risks Initial Portfolio

Healthy final portfoliodespite low stock success ratio

1 1 1 1 1

5

Stock A Stock B Stock C Stock D Stock E PortfolioYear 0

0.25 0.50 0.75

12.5

510

1

PortfolioYear 0

Stock A Stock B Stock C Stock D Stock E PortfolioYear n

Portfolio up 2.5x


Study33


If none of your investments looks foolish after the

fact, you are staying too far away from the unknowable.

“SP #4: Non-aversion to hindsight criticism• Non-aversion to hindsight criticism is the core behavioral principle.

• UU portfolio may offer healthy returns, but several individual ideas would perform very poorly.

• This creates room for hindsight criticism of these investment decisions.

SP #5: Long-term outlook and patience• To allow for the UU situation to play out into KK

and for the positive upside to pay off

With time and patience, the mulberry becomes silk.— Chinese proverb ”


Study34

Step 2: Look for UU situations

Unknowable situations are

widespread and inevitable

“• Where the future is discontinuous from the past

• In 3 areas: (1) Business (2) Management (3) Valuation

1. Business UU situations Low history of industry and/or company

Huge size of opportunity with scalability

Technology intensity of business

Change (or scope for change) in regulation

Value migration

Demand J-curve inflexion point

Change in competitive landscape

Turnaround

Discontinuous corporate action

Discontinuous change in operating metrics

”


Study35

Step 2: Look for UU situations

2. Management UU situations Management with no track record

Change in management

Integrity issues with management

3. Valuation UU situations

Extreme pessimism and optimism in the marketscreates UU situations e.g.

Infosys valuation at the height of dotcom boom

Indian stock valuations at the height of global crisis in early 2009.

If the events areunpleasant, it is

not clear when to celebrate their

end.

“

”


Study36

Step 3: Be aware of pitfalls1. Overconfidence

“If you lack Buffett capabilities, you will get chewed up as a bold stock picker.”

2. Hindsight criticism

“One might be blamed for a poor outcome if one invests in ignorance when, in fact, it was a good decision that got a bad outcome.”


Study37

NTD to TTSIndian Banking Sector: Stocks for 2020

• UU situation: Which bank(s) will deliver superior stock returns through 2020

• Complementary skills: Clear NTD framework

UU Investing case study


Study38

• Size of opportunity: TTS by 2020 - Ten Trillion Saving (in dollars, decadal cumulative), 5x last decade

Huge opportunity for financial intermediation

NTD to TTS


Study39

• Asymmetric payoff possibility: - Banking sector profit in 2020 will be 6x 2010

Growth will be even higher for banks with UU potential

NTD to TTS

2010 to 2020 – Business up 5x … and profit up 6x


Study40

• Which stocks to bet on?

Judgement based on several factors including – Value migration from PSU to private banks

Impact of technology on various banks Assessment of bank managements Past profitability analysis

So, the final unusual judgement? …

NTD to TTS

Sh

are

of

Ass

ets

80 75 74

6 13 15

0%

20%

40%

60%

80%

100%

FY01 FY05 FY10

New pvt banks

Old pvt banks

Foreign banks

PSU banks


Study41

The Final Judgement

1. Buy a small/medium high growth bank – YES BANK Management with established credentials Growing at 2x industry growth rate Branch scale-up plans to increase CASA; expand NIMs Not among the cheapest banks, but absolute market cap

low compared to size of opportunity and that of peers

2. Buy a large, unpopular bank – CENTRAL BANK Among top 10 banks by asset size Recently completed 100% CBS; benefits to accrue Management focus on margin improvement through

focus on high-yielding retail segment Not among the cheapest in terms of P/B, but very

attractive in terms of MCap/Assets.

So, the final Alpha, Beta, Omega picture?

NTD to TTS


Study42

The Final Picture

NTD to TTS

UU investing (omega)Central Bank, Yes Bank

Returns

Traditional investing (alpha)SBI, HDFC Bank

Market-linked (beta)Bankex

Time

Omega

Alpha


Study43

• Metals/Mining sector has dominated this year’s Study.

• Low payback ratio (Market cap/Next 5 years’ profits) remains the most reliable indicator of fastest wealth creation.

• UU situations offer asymmetric payoffs; these can be exploited only by investors with complementary skills, unusual judgement, and no fear of hindsight criticism.

• India’s high linear economic growth will create exponential business situations – the perfect backdrop for UU investing.

• TTS – Ten Trillion Dollar Savings through 2020 – will throw up many UU investing opportunities in Indian financial services.

In Conclusion


Study44

Wishing you exponential returns in exponential times with UU investing!

Thank You & Happy Wealth Creating !!

wealth creation study 2005-2010

Business

annual wealth creation

consistent wealth creation

concept of wealth creation

consistent wealth creators

wealth creatorcreated

fastest wealth creators

biggest wealth creators

wealth fromthe unknown