Dear Purushottam,

Thanks for participating in our blog.

I agree with you that Maize-processing segment is the most profitable segment for GAEL. In the year 2010-11 it contributed 56% of total profits for the business. And in the first quarter 2012 it almost contributed 75% of total profits generated.

I also agree with you that management is working to raise its capacity for this segment. And by December 2011 the other facility will be ready to contribute to its business.

Now if you look at total revenues for 1st quarter they stand at 370 Crore and maize processing segment contributed 31% (112 Crore) of it. They reported net profits of about 15.22 Crore of which 75% (11.42 Crore) came from this segment.

Return on equity (ROE) is the best economical tool to compare any investments. It helps you even to compare with other assets (bank Fixed term, bonds etc) to make any decision. For the year 2010 –11 GAEL reported ROE of 22% that is great! That translates that for investment of Rs100 the company generated Rs22 from its activities.

Now to keep that ROE sustainable to 22% they will have to report net profits for the year 2011-12 for 111.37 Crore. After looking at 1st quarter results and considering all the elements (1st Q and 2nd Q are slow and companies move towards Maize sector) it looks challenging to maintain that return and currently gives picture of 12% ROE for the year 2011 –12. Now whole of this analysis is evidence-based analysis there are no assumptions.

Something to remember about quality and performance ratings…

Rated A1, A2, B1, B2 and C, every listed company is rated based on a series of over 30 separate metrics, measured at both a point in time and over time. Most importantly, the Quality and Performance Rating is applied without any subjectivity. All companies are judged according to the metrics they generate. A1s have the lowest probability of a liquidation event. “Lowest probability” however doesn’t mean a liquidity event won’t occur. It just means far fewer A1s will have a liquidity event imposed on them compared to C. A liquidity event includes a capital raising, debt default or renegotiation, administration, receivership etc. An A1 company could of course raise capital if it needs to fast track construction of a new factory. Sticking to A1s and avoiding C’s should, over time, produce better returns.

Now this company is still trading at discount of 45% to its intrinsic value but is regarded as B1 business. It has low ROE and its cash flow is in negative. There is a risk of catastrophic events or probability of them is high compare to A1 businesses that are trading in market. 

 

Do you buy in stock in which promoter is selling hugely?

Do you buy in stock if lot of equity dilution is happening?

 

When it comes to assessing management, who is rowing the boat is not always as important as the boat you get into. You should know that your returns are more a function of the type of boat you get into, rather than the oarsmen. If the boat seems leaky do not step aboard.

If I don’t evidence any change in business fundamental it doesn’t concern me if promoter is selling his shares.

Equity dilution is concern but promoters or biggest shareholders dilution or moving out of the business doesn’t concern me as long as business is intact with all fundamentals.

Your last question is interesting subject to talk about. I will try to explain it with example:

Dividend Payment Policy

Lets assume a company XYZ started with Rs100 and ROE is 20% and trades in market at multiples of 10 PE.

Year

Beginning Equity

ROE%

Earnings

Payout Ratio %

Dividends

Ending Equity

PE Ratio

Share price

1

100

20

20

50

10

110

10

200

2

110

20

22

50

11

121

10

220

Dividend payout ratio is 50%. Buffett said: “ growth benefits investors only when the business in point can invest at incremental returns that are enticing- in other words, only when each dollar used to finance the growth creates over a dollar of long-term market value.”

Now imagine same business but not giving any dividends (like Berkshire Hathaway of Buffett):

Year

Beginning Equity

ROE

Earnings

Payout Ratio %

Dividends

Ending Equity

PE Ratio

Share price

1

100

20

20

0

0

120

10

200

2

120

20

24

0

0

144

10

240

 

But imagine if business could not keep consistent ROE:

Year

Beginning Equity

ROE

Earnings

Payout Ratio %

Dividends

Ending Equity

PE Ratio

Share price

1

100

20

20

50

10

110

10

200

2

110

15

16.50

50

08.25

118.25

10

165

Paying dividend is a tactics often used by management to engender support for a company’s share. And well-supported share price is in interest of shareholders, so board can argue that indeed it is acting on behalf of shareholders by paying dividend. But Berkshire Hathaway price performance has done its shareholder a far better service by paying no dividends. To this Warren Buffett said:

“ Owners must guess as to what the rate (of return on equity) will average over intermediate future. However, once an informed guess is made, the rest of the analysis is simple: you should wish your earnings to be reinvested if they can be expected to earn high returns, and you should wish them paid to you if low returns are the likely outcome of reinvestment.”

It is important to understand over here am that I am not suggesting investors to buy only companies that retain all of their profits and refrain from paying dividends. Nor I am suggesting investor eschew the purchase of extraordinary businesses because they do pay dividends.

My conclusion is that a company with high rate of return on equity and an ability to retain profits, grow equity and continue to generate high rates of return is worth more to an investor then a business generating the same rate of return on equity but paying all of its earnings as dividends.

In the case of GAEL they are finding it difficult to generate high returns on retained earnings and they will possibly increase their dividend payout to its shareholder. And that will affect its price.

** The above tables are derived from the work of University of pennsylvania Prof James E Walter and Warren Buffett’s 1981 chairman’s letter to its shareholder of berkshire Hathaway in particular section entitled ‘ Equity value-added’ where, by way of example, Buffett writes : ‘if on the other hand, all earnings of our typical American Business are retained and return on equity again remains constant, te price of our typical stock will grow at 14% per year.’ Similarly derived tables can be found in Buffetology by Mary Buffett and David clark (Pages 212 and 224 of the 1997 edition).