Ishmohit Arora (SOIC)

Probably the most impactful teacher I've had so far. He took my fundamental analysis to a whole new level. I'm aware these notes aren't "wisdom", but they're concepts and mental models I use till this day!

Operating Leverage + DOL

• Is the relationship between fixed and variable costs.

• Airline industry tends to have high OL

  • Fixed costs are higher than Variable costs

  • Therefore it has a high OL. This means profits increase higher as the ticket sales increase because the fixed costs are already paid

• DOL = Degree of Operating Leverage

  • Measures how well a company generates profit using its fixed costs

    • (Sales - VC) / Profit

  • If DOL is 1.6 and sales increase by 10%, the profits will increase by 16%.

• What leads to operating leverage

  • Margin expansion

  • Asset turns improving 

  • Signs in con calls and interviews

  • Triggers linked to Variant Perception and Return Ratios playing out

• Triggers

  • Capacity utilization/expansion

  • Revenue mix transition

  • Acquisition Synergy

• How to use

  • In asset heavy sectors (hospitals, hotels, chemicals), track capex and assets

  • Look out for peak PE, margins, operating leverage

  • Type in “Margins will expand” or “Operating Leverage” into Screener

• In some companies, operating leverage can never kick in because the company is required to constantly do capex due to consumer demand 

Price / Earnings

• what decides the perception

  • when there are industry tailwinds pe ratio is rerated

  • bear vs bull market

  • higher interest rates lower pe ratio

  • company gaining market share will have higher pe ratio

  • higher earnings growth means higher perception meaning higher pe ratio

  • volatile business model means lower PE

• What decides your return

  • entry price = entry pe * EPS

  • holding journey = pe * EPS growth

  • exit price = exit pe * EPS

  • buying a stock with pe of 60+ exposes to derating

• How PE ratio can fool you

  • Low ratio

    • earnings are at cyclical peak

    • sitting on top of operating leverage

    • company is in dying industry or has stopped growing

  • high ratio

    • one off earnings

  • low pe example, aster DM concluding GCC business

  • high pe example, yasho industries capex

  • Peter lynch said “in a cyclical business sell low pe and buy high pe”

    • when it is high then earnings is destroyed

    • better to look at price to book and look at the trends

• PE forecasting

  • forecast the earnings growth rate (can be from company guidance)

  • divide by market cap today to find forward PE

  • can derive base/bull/bear case by multiplying the projected earnings by certain PE to figure out the new market cap and see how much growth can be there

• When to use specific ratios

  • PE - To be used for companies with no one off in earnings and linear to stable margins. Eg:- Can be used in IT industry.

  • EV/EBITDA - Asset heavy industries like hospitals, hotels

  • price to sales - to be used along with margin trajectory

  • price to cash flow - To be used in companies or industries where depreciation is high, and accounting PAT looks depressed. Shows real cash earnings of business in most cases.

  • price to book - most important use is in banking industry

  • mcap to order book - To be used in B2G businesses, contractors, Defence companies. Order book shows future growth potential.

ROE, ROA, ROCE

• ROA 

  • Indicator of how well a company uses its assets in terms of profitability 

  • Gives investor idea of how efficient company management is at using assets to generate earnings

  • Net Profits / Total Assets

  • Dupont of ROA

    • Net profit margin * Asset turnover

    • Asset turnover = Sales / Total Assets

• ROE

  • Measures company’s profitability in relation to shareholder equity 

  • Good rule of thumb is to target ROE equal to or just above average of the peer group

  • Net Profits / Average equity 

  • Companies with huge debt can fool you to show high ROE because it artificially reduces equity 

  • Dupont of ROE

    • Net profit margin * Asset turnover * Financial Leverage

    • Financial Leverage = Assets / Equity (per $ of equity, how many assets are being held) 

    • ROE is good if it comes from first 2, but not good if comes from financial leverage

• ROCE 

  • Assess company profitability in relation to capital efficiency

  • Understand how well a company is generating profit from its capital as it is put to use 

  • Hygiene of ROCE is reflected much better in balance sheet than it is in income statement

  • EBIT (Operating Profit) / Capital Employed

  • Dupont of ROCE

    • EBIT margins * Capital employed turnover

    • Capital employed turnover = Sales / Capital employed

    • Capital employed formulas

      • Debt + equity - cash 

      • Gross fixed assets

    • If EBIT margins is good then it shows demand side advantage

    • If CE turnover is good then it is supply side advantage

Finding Fraudulent Managements

• Reliance capital broke into nippon which was bought by a japanese MNC. today, reliance capital has mcap of 300 cr but nippon has over 40,000

• Learn from past

  • Use GPT to ask if there were any SEBI/Accounting issues with the company in the past

• Resignation of key management personnel

  • Search up resignation in Screener Announcements

  • Specifically CFO is important as they’re responsible for financial statements

• Promoter shareholding “skin in the game”

  • Hindustan Oil Exploration company is 98% public + 1.8% FII

  • Had many resignations in KMP

• Large number of Related Party Transactions

• Complicated corporate structure

• Companies that misguide investors

  • Hear the past 3 years concalls

  • Ctrl + F “growth” and “guidance”

  • And see what has happened

• Overly promotional CEO

  • Frequent TV interviews, PR stunts glorifying the prompts

• Regular promoter selling

  • Stock is at all time high yet there is no history of execution

• Management profile and background

• Politically exposed promoters 

Shareholding Pattern

• 4 types of shareholders

  • FII (foreign)

  • DII (domestic)

  • Public (retail)

  • Promoters

• Study showed that when there were 10% increase in retail investors with less than 1L investment, only 10% of the stocks went up rest were negative

• Must look at shareholding pattern looking at FII going up and retail not going up as fast

Working Capital

• Activity Ratios: type of financial metric that shows how efficiently a company is leveraging the assets on its balance sheet to generate revenues and cash 

  • Receivables: how efficient business is in collecting this 

  • Inventory: Inventory buildup

  • Payables: If bought inventory on credit

  • Assets: how efficiently it is used to generate revenues and cash

• Can be used to compare two different business within the same industry or to monitor a companies fiscal health over time 

• Inventory turnover ratio

  • Rate which company sells and replaces stock of goods

  • COGS / Average inventory

  • Sales / Average inventory

• Receivable Turnover

  • Quantify a company’s effectiveness in collecting its accounts receivable or the money owned by customers or clients

  • Sales / Average Receivables 

• Payable Turnover

  • Rate at which a company pays off its suppliers

  • How efficient a company is at paying its suppliers and short-term debts

  • COGS / Average Payables

• Working capital turnover

  • How efficiently a company is using its working capital to support sales and growth

  • Relationship between the funds used to finance operations and the revenue generated to continue operations and turn a profit 

  • Sales / Average working capital

    • Working capital = Current assets - Current liabilities

    • Net working capital = Trade receivables + inventory - payables

      • AKA cash conversion cycle 

    • Gross working capital = Trade receivables + inventory

• Working capital

  • Definition

  • If wc falls, balance sheet lightens up 

    • Debt falls

    • Capital employed falls

    • ROCE increases

    • FCF increases

Random Bits + Mental Models

• Industry capital cycle

  • Business investment declines, industry consultation, firms exit: investors pessimistic

  • Improving supply side causes returns to rise above cost of capital, share price rises 

  • New entrants attracted by prospect of high returns, investors optimistic

  • Rising competition causes returns to fall below cost of capital, share price underperforms. 

• Mean reversion 

  • Asset price volatility and historical returns eventually revert to the long term average of the entire dataset

  • How it can be used

    • Always look at the long term margins of companies

    • If a company starts earnings super normal margins without any change in product mix

    • Always be careful as there is a chance that the company is over earning

    • Peak valuation + peak earnings + peak margins all 3 lead to zone of danger in investing

  • “Only when the tide goes out do you discover who’s been swimming naked” - Warren Buffet

• When to sell 

  • Volatility STOP

  • ATR 

  • 2x, 1.5x for overvalued stocks

• PE ratio stops working when company is sitting on top of operating leverage

• Price to book value

  • Book value is the net difference between total assets and total liabilities. 

    • Total value of company asset that shareholders would receive if the company were to be liquidated

  • Why banks use P / BV

    • Macroeconomic conditions such as inflation, interest rate etc are the same for most banks

    • What differentiates is how efficiently the funds or assets are used and how best the spreads are managed 

    • normally  cost of funds and yields are around the same levels for most banks so the P / BV is determined by how well they enhance the spreads and how well they contain their NPAs

      • NPA = Non performing asset

• Over earning - company earning more than average due to some shortage or one off order

  • Leads to creation of massive expectations and a large base size

• Buffet on projecting cash flow

  • We first have to decide whether we can sensibly estimate an earnings range for 5 years out. 

  • If answer is yes, we will buy the stock if it sells at a reasonable price in relation to the bottom boundary of our estimate

• ADX - Average direction Index

  • Trend following indicator

  • Above 25 = Positive uptrend

  • 40-60 = Super trend

• VSTOP - Volatility Stop

  • Meant for exists

  • Volatility increases when dumping occurs