Tuesday, October 30, 2012

Licensed to Speculate!!

This post talks about an untouchable sector, the institutional imperative and the art of speculation in long term investing (ironical isn't it!)

Notorious Cyclicality

Take a few moments to study and firm up your thoughts on the graph below.

Are there any noticeable patterns?? What do the extent of the swings tell you etc??

Done thinking?? Then read on…

The above graph [Data source: Directorate of Economics & Statistics, Department of Agriculture and Cooperation,link 4.23(a)] depicts the annual % change in area sown under sugarcane nationally for the period 1950-51 onwards. In a nutshell, it shows how fickle cropping behavior over the last many decades has led to the perception of the sugar sector being “notoriously” cyclical.

We culled out the following data from our thinking time on the graph

SY = Sugar Year ending 30th September

Thus in the period SY51 to SY12 (62 years), there have been 22 instances/times (35% of 62) in which land under cane cropping has swung within a band of + or - 5% from the previous year and so on. Likewise data is provided for the last couple of decades to see if there is any perceptible change in trends in the near term v/s the longer term.

The first noticeable point is that, not much seems to have changed in last couple of decades as compared to longer period data. Cropping swings remain similarly fickle!!

The second point is that this is no bell curve!! Cropping swings of more than 10% are visible in around 3 out of 10 instances during both periods. Much too often and large for a staple food commodity.

If you count the number of up and down years, you would notice that the ratio of years showing positive change v/s negative change remains roughly the same in both the long period as well as the last 2 decades at ~ 3:2. Clearly, the cycle of boom and busts continues with pervasive repetitiveness.

Of course, change in land under cultivation is just the first variable for sugar production. Other factors which effect production cyclicality are

1)   Yield per hectare: Can change based on climatic conditions, monsoons, cropping practices, quality seed usage etc. Yields have however largely been stable in the last couple of decades as can be seen from the same data link above, mostly fluctuating between +- 5% on a year to year.
2)    Cane diversion to other sectors like gud & khandsari as well as fodder usage and
3)    Recovery rates ie sugar content in cane, again largely climatic dependant

Other than production however, sugar prices also depend on government policies (probably the most regulated sector in the country), change in consumption (estimated at 22-23 MTPA in India, growing faster than global rate at ~ 3%), Global prices (domestic impact limited to prevelant export/import restrictions), Size of residual inventory etc. To understand the reasons behind sugar cyclicality and the extant regulations in detail you can access this.

Profitability of sugar millers in turn depends on govt policy including levy obligation, cane and sugar prices, byproduct regulation and prices and of course interest costs etc. Of course we are yet to discuss arcane issues like the impact of depreciation of the brazilian Real on sugar v/s ethanol profitability. All in all a sector with so many moving parts that it is easier to say “Why bother”!! No wonder then that “investors” have historically rarely bothered and left this sector for the “speculators”.

The wolf and the shepherd Boy

In the wolf and the shepherd boy, assume that you, a villager, regularly place a wager on the shepherd boy lying, in spite of the evidence to the contrary. It is likely that you would be a rich man by now. While it is true that you would finally lose your last wager, when the shepherd boy actually tells the truth and the wolf arrives, the net gains would still be high assuming that you bet the same amount each time without getting swayed due to your past winning streak.

Who is the shepherd boy in our story? On repeated cycle upturns (sugar tightness and thus healthy prices) industry captains have gone overboard heralding an end to the cyclicality, due to a “structural” inflection point (see page 11 of this). During downturns (high production and weak prices) like being seen currently, we see ministers talking about visible policy success at breaking the cyclicality (here). Since it is a matter of judgment/view, one cannot say the “shepherd boys” are lying, but simple plain wrong. The “notorious” cyclicality continues to prevail with uncanny regularity. Like in the above story, one can thus make a wager on the wolf not turning up, read continued cyclicality, and simply wait patiently to get lucky.

While in the absence of long dated derivatives, it might not be possible to “short” the sector during cycle upturns, it is surely possible to buy at times of relative pain and wait patiently for the “mean reversion” to happen. The strategy is thus to buy sugar stocks when the industry is bleeding due to oversupply expecting the cycle to reverse and provide reasonable return.

Isn’t this true for all commodities in general?? Of course it is, but the catch is the length and the relative predictability of the cycle.  Cycles in metals, oil etc. can be sometimes spread over extremely long periods, even decades, largely linked to global/local economic cycles and hence difficult to wager on. Due to the shorter cropping cycle (generally every 2 years, the farmer can decide whether to plant cane or move to a more remunerative crop) and stable consumption being a food commodity, the “black swans” are more likely to be spotted in the sugar sector.

So if you bought at periods of cyclical pain, without trying to judge if the worst is behind (not so difficult to judge) and sold at times of greed, as against successfully catching the frenzy (again not impossible to judge), it could be a rewarding strategy based on past trends of cycle completion over a 3-5 year holding period. Rather than getting swayed by the daily noise of the markets and confused by the various moving parts of the sector, the one single view that needs to go right, is that of mean reversion. Since Mr. Market generally ends up placing a wager on the shepherd boy, returns could be handsome even with a favorable risk reward.

Sweet Pudding

While the above is instinctively appealing, lets find out if the pudding has been sweet in the available stock price history of the past decade or so.

Sugar production at ~ 20 MT peaked in SY03 in the first of the cycles under consideration. Thereafter, production bottomed out at ~ 12.7 MT in SY05 (Note the extent of the production swing!!). If you had done a daily SIP in Balrampur Chini in the period 1st Oct 01 to 30th Sep 03 (period of high production) and spread your sale daily in equal proportion in the period 1st Oct 03 to 30th Sep 05 (period of production drop), you would have returned roughly 4.5 times your initial investment. Surely in these two phases, it did not take a rocket scientist to judge if the sector was going through pain or gain. For the record, a similar strategy in the sensex would also have returned 1.8 times your investment in the same period. If you had been a bit more opportunistic, the results could obviously have been even more spectacular.

The next cycle peak was in SY07 while SY08 while lower, was also healthy. Production however fell nearly 50% to ~ 14 MT in SY09. Buying Balrampur at most times in SY07 (period of maximum pessimism towards the sector) would have allowed you to sell at most times in SY09 returning between 2-3 times your investment inspite of the financial crisis in the intervening period.

Since there is significant hindsight bias here, we urge you not to use this data as any meaningful indication of return expectation. What you can do however, is simply ask yourself the question “Based on last 6 decades data, what in my view is the probability that India will see a sugar scare anytime within the next 5 years”. If the answer that your mind throws up is north of 60-70%, then maybe you should have a look at the sector. Because remember that even if money doubles at the end of 5 years, it translates into a CAGR of 15%, a return that most genuine ‘investors’ should be happy with. What with current production (25-26 MTPA) only about 10% higher than consumption (22-23 MTPA) and with 3 out of every 10 years throwing up cropping swings higher than 10%, you probably would not have to wait that long. The attractive risk reward inherent in the trade means that we may have the opportunity to manufacture our luck relatively safely here!! No wonder it is sometimes said that the best place to hide evidence is in plain sight.

Whoa!! But aren't we missing something ?? Look at Mutual Fund portfolios. You hardly see any exposure to sugar stocks. Aren't the institutional chaps amongst the smartest in the street. If it was truly so, why don't we see a fairer representation in their portfolios?? In our view, its thanks to the institutional imperative...

If your are a fund manager and even if you are aware that once in 3-5 years there is more than an even chance of making multi-bagger returns over a complete sugar cycle, would you be able to allocate a part of your portfolio to such ideas?? Immediately the spectre of looking like a buffoon while the stock doesn't move for months/years together and leads to huge diversion as against the benchmark starts haunting you.. So when will you look at allocating to the sugar sector ? Taking the liberty of putting on paper some experiences of the institutional investing world, in our view they will participate only when:

  • There is certainty of improvement in sector fundamentals in next 1-2 quarters accompanied by rising commodity prices
  • If in their view, there is minimal chance of making losses, even if they are temporary in nature
  • There is some news / buzz about the sector or reforms etc.
  • Peers in other fund houses start buying the stock
  • There are rumours about an acquisition in the sector and you expect a rub-off valuation effect

A three legged stool

Where do we stand in the cycle today?? As mentioned earlier, we do not need the services of a rocket scientist to answer that question with some confidence. While we do not know for certain if the worst is behind us, we do not see any reason to disbelieve that we are in a downcycle (high production, low prices). Sugar mills are raking up losses and shepherd boys are optimistic about breaking the notorious cycle on the back of 4 successive years (including SY13 forecast) of healthy production and potential sector deregulation. We are willing to bet that the wolves won’t turn up.

Are there any interesting opportunities??

A UP based miller, Triveni Engineering is the 4th largest sugar manufacturer in the country. Other than sugar the company derives revenues from the sale of power and alcohol which are sugar by products. The company also has a healthy engineering business in the areas of gear manufacturing and water. Last year, the company demerged its turbine business, Triveni Turbine from itself and continues to hold ~22% in the listed entity. More details can be found on their website .

Market participants usually value sugar stocks on the basis of a combination of P/B and P/E or EV/EBIDTA ratios. The larger companies like Balrampur have normally traded in the band of 1-1.5 times book, 8-10 times PE and roughly 6-8 times EV/EBIDTA. In the case of diversified entities like Triveni, SOTP valuations are also frequently used.

At the current mcap of ~ 550 cr and long term debt of ~ 500 cr Triveni is available at a standalone SY12E P/B of ~ 0.6 and EV/EBIDTA of ~ 6.(P/E not measurable since company is loss making). Operational cash flows are to the tune of ~ 100 cr inspite of the losses. Based on the current Mcap of Triveni Turbine, the company’s 22% stake (without holding company discount) translates to ~ 300 cr.

In comparison, Balrampur Chini (the sector bluechip) with a Market Cap of 1750 and long term debt of 750 cr trades at an FY13 P/B of ~ 1.2 and EV/EBIDTA of ~ 6. While crushing capacity for Balrampur is only ~15% higher than that of Triveni, it must be said that the company enjoys better cane availability and recoveries and thus produces roughly 40% more sugar. It is also better integrated towards alcohol and power production. However, its stool does not have other legs like Triveni of gears, water and investment in turbine business.

People also like to give a management quality premium to Balrampur. When looking at Triveni, we have not noticed any significant red flags when we considered management ethics. As regards competence, we think that well regulated commodity businesses like sugar leave little room for a fresh creative approach and thus like to discount the same.

Other companies like Shree Renuka & Bajaj Hindustan are less preferred on account of the very high leverage.

Triveni thus looks relatively interestingly cheap on the basis of P/B (more important than earnings based valuations in a down cycle) and market cap in relation to its production capacity. The market also seems to be ignoring its diversity in business as well as investments in Triveni Turbine.

However, in addition we would prefer to look at the company less conventionally. Since we are betting on a sugar scare, is it possible to judge how markets could react towards the stock in a favorable year?

The Engineering business EBIT (roughly 60-70 cr on a normalized basis) and the EBIT of the by products viz power and distillery (again roughly 60-70 cr) are together largely sufficient (with a margin) to cater to the total interest costs of ~ 125 cr. Thus the EBIT profit/loss of the pure sugar business (currently producing ~ 0.5 MT) flows through to the PBT level. In a year of sugar scare, it is not unfair to expect that millers will be able to eke out a profit atleast of Rs. 3-4 Rs per kg at an EBIT level. This could easily result in a PBT of 150-200 cr for the company (0.5MT * 3/4 Rs). With Mr. Markets penchant to repeat its mistakes, it would not surprise us if the company be valued at PE multiples of 8-10 times in these environments or a market cap of 1000-1500 cr. The stake in Triveni Turbine is ofcourse icing on the cake. We think holding the stock can prove to be lucky in the future !!

Investors may consider the sacrilege of speculation!!!

Best of manufactured luck !!


  1. Landed here from Neeraj's blog. I found the article quite interesting and it tickled my thought process.
    Plan to learn a lot from here. Wish both of you all the very best.


  2. Superb thought process... Very well written article.

  3. Well researched and in-depth coverage. Will definitely keep coming back for more investment tips. Will also help if you alert the group when in your view the recommended sector/ stock has reached the valuation you had predicted earlier and if it is time to sell/ buy more of the stock

  4. Wonderful thoughts, written very well.

  5. Superb analysis. I think most important thing which investor fail to understand that if a stock can double in next 5 years, then we will be able to earn 15% CAGR.

    Whitman Martin of Third Avenue fund had given very interesting argument for investing in stocks hit by housing crisis and I think we can also apply that logic for any cyclical sector like sugar. I posted a comment on brokerages using Martin Whitman logic here http://www.valuepickr.com/forum/not-so-hidden-gems/84567346 (see comments under name T Anil Kumar)

  6. This is great analysis. If one is disciplined to invest during bad times and sell when everyone is bullish, sugar is the sector. And like u have explained in great detail Triveni has huge advantages as holding co and other businesses. Its also now got a JV with GE

  7. Niren Bhai,.... also trying connecting the sugar cycle and Samajwadi Party in power In UP.. interesting insights... Cheers.

  8. Good one Sir..very nicely written and good analysis as always.. Just wanted to mention one thing..I had a detailed discussion with the management of Bajaj Hindustan few months back generally with a perspective to understand industry dynamics and how to determine the trigger points... One of the interesting things they pointed out was to track the cultivation/ production / scarcity / rates of wheat.. as over production / scarcity in wheat highly impacts area under cultivation for sugar and its overall industry dynamics. To be honest , I havent checked about the wheat-sugar cultivation pattern after the meeting. Do consider evaluating the sector from that angle if possible..maybe we may get some more interesting insights . :)

    1. Thank you viraj,

      We can add that to our list of moving parts of the sector!! Farmers generally will switch from one crop to the other based on superior crop profitability. As discussed in the post, our vote is on ignoring the numerous short term confusing data points which are largely noise and focusing on the repitition of the cyclicality.

  9. abhinav/ niren
    you have cor-related pricing/ production for supply tight year with the stock pricing. One concern i have is that the pricing during supply tight years is also regulated by the goverment.During such shortage period, the goverment tends to increase the regulated sale of sugar to PDS which is forced subsidy on the sugar companies.
    On the other side, the purchase price is also regulated by the state goverment. this may be additional moving parts, but they have a big impact on the profit and hence the stock price behavior. I have not check the co-relation, but have you check how this has played out during the supply tight/ surplus years ?


    1. Thanks Rohit,

      Tightness is supply leads to higher sugar prices. When it comes to commodity stocks, most market players follow the simple rule of thumb of buy the price ie when the underlying commodity price is bullish, buy the stock and sell otherwise. The suggested strategy is an attempt to profit from this kind of thinking. As regards past data, the section "sweet pudding" attempts to draw conclusions from history.

  10. I agree with your point. One can play the same trade on oil in the US markets or some such commodity. the difference i have seen is that if the market is not distorted by the government, then these trades work very well.
    the same trade has been a disaster (for oil) in india. during a downturn all the benefit on the drop is passed to the consumer as cheaper fuel and on the upside, the company's cannot pass the cost and hurt again. so it is heads i lose and tails i lose again (thanks to the stupidity of GOI)
    my concern is whether we have similar dynamics in the sugar industry which is controlled by a very irrational entity (our government)
    anyway just an alternative view


  11. Hi,
    Can u point to some document that covers ABC of Sugar sector locally and globally?


    1. http://www.in.kpmg.com/pdf/Indian_Sugar_Industry.pdf

  12. The Engineering business EBIT (roughly 60-70 cr on a normalized basis) and the EBIT of the by products viz power and distillery (again roughly 60-70 cr) are together largely sufficient (with a margin) to cater to the total interest costs of ~ 125 cr

    Where are these numbers from, how are you normalizing them and how have you calculated 60-70 crores from by products

    The Call is good, I agree, but the reasoning is weak, is an opportunistic trade which will work out, but the numbers are screwy

    Kindly focus on hard numbers as much as the concept, concept is great as long as numbers back it

    We all suffer from an illusion of control, I think by letting go of it, we will make good money in Sugar :)

    1. Hi Anonymous,

      Thanks for your feedback and your views.

      Given our weak track record on most forecasts we increasingly prefer working with back of the envelope “screwy” nos. rather than spreadsheet driven tight fits : ) We think a good mental map built on the back of sensible financial assumptions provides the required margin of safety to our errors of omission and commission as well as temper our own behavioral instincts of reacting to quarterly numbers etc.

      As stated in the quoted para, rather than be scientific about forecasting what the division profits would be, we are more keen in judging if the engineering and the by products (viz. power & distillery) EBIT put together is sufficient to cover the total interest costs. To put it differently, our thesis is that the equation [Engineering EBIT+ By Products (excl sugar) EBIT – Interest Expense (Total standalone business) – Unallocable expense is > = 0]

      The engineering business is on a stable healthy trajectory and seems to have the potential to build into the future.

      Given that conversion costs are low, by product viz. power and distillery profitability is primarily driven by cane availability in a given year. In a year when availability is low, the risk is that volumes could be lower thus reducing the EBIT. With sale primarily to SEBs at regulated rates, the power segment profits could reduce in that year, but the distillery in spite of lower volumes could be helped through higher end product prices. Also in that year interest costs could reduce significantly on account of lower sugar inventory in a tight year. Triveni is currently not sufficiently integrated and thus sells a large amount of bagasse and molasses to others for want of power and distillery capacity. Impending capex would help the company capture the benefits of the value addition better going into the future, thereby improving segment profitability.

      We think that it is not aggressive to be expect the above equation to work in such an environment.

      And yes, the trade is opportunistic and not suitable for those only seeking good quality buy and hold opportunities.

  13. Sirs,
    It would be great if you could put up a post on the art of shorting..i think lots of luck can be manufactured there too, if one has the right frame of mind..(i absolutely suck at it)

    1. Hi Neeraj,

      After your fantastic encouragement of our efforts, we should normally be saying "Anything for you". However, this is largely unchartered territory also for us. Will surely post in the future if we have any concrete insights to be shared..( Niren seems to be more keen on doing all this - fortunately has been able to retain his shorts trying to try out shorting till date but u never know !! :) )

    2. :-)
      Niren has retained much more than just his shorts!
      Looking fwd to your next post

  14. The way I looked at Triveni was to sit back and reflect on how we are positioned on the company. Essentially all that could could have gone bad has gone bad whether it is sugar cycle, irrational government policies, having to pay cane arrears, slowdown on the industrial business etc. So it was a question of using the concept that I regularly use as a starting point " Are we positioned for good luck or bad luck?". At the right price Triveni is a lottery ticket where some of these variables or all of it will turn around ( if you are really lucky). It is of course anybody's guess as to when the cycle can/will turn but the risk return pay-off looks favourable.

    1. Hi Ninad,

      Good to hear your views. Interesting to note your take on the role of luck. Thanks

  15. Hi,

    Very well written article.

    I had read a report by KPMG few years back on Sugar Industry in India. In that they had also pointed to a similar 2-3 year cycle, from over production one year resulting in lower price yield for the farmer moving to under production next year and price increase. The only issue is that this sector is highly regulated and government/political influences can hugely impact the profitability of the companies in this sector.

    Triveni Engg. seems to be a good bet as it is a diversified company. Any suggest on what price point to enter, how long to hold and when to exit ?


    1. Thanks Ashutosh for sharing your thoughts. We think for the idea to work, one has to be a patient investor and wait for the sugar cycle to turn. As elaborated, if you were to go by past history, it is not unfair to expect the scenario within 3-5 years.

  16. Nice article indeed.... u might nt remember but at some point in time i had an interaction years back. On article, for Triveni Engineering, bit disagree on mgmt quality. though cant pin-point from annual reports, but check the old history of delisting which happened some time in 2002-2003 and subsequent IPO in 2005-2006. again on their turbine business, Numbers are so attractive that devil in me says that thats incredible.
    ur comments would help me change/strengthen my view. thanks aagin

    1. Hi Ritesh,

      Good to have you visiting our blog and thanks for your appreciation.
      With some of these difficult to interpret issues like mgmt quality where also a lot of subjectivity is involved, it is mostly challenging to argue either for a 'yes' or 'no' forcefully. When faced with a dillema what we do is the following 1)Judge if we can sleep peacefully with the investment, if no then no point investing however attractive 2) If unsure (not negative) of the mgmt but positive on the theme, then allocate but take care not to overallocate so that again we can sleep peacefully :) For us that threshold is at 2-3% portfolio weight. Net,Net sleeping peacefully is imp.. :)

  17. Hi guys,
    I just came across your blog and I am mighty impressed by your analysis. I personally had been following Polaris and the sugar industry. Along that line, I want to ask you guys about your thoughts on EID Parry if you have researched the company. On the top, it looks like the company has good corporate governance, good production efficiency and is in the cyclical sugar industry. Thank you.

    1. Hi Ken,
      Thanks for your interest. EID in our view is a good sugar play but given that it derives a large part of its value from its holding in Coromandel Fertilizers, its valuations tend to be always distorted. As a rule we are generally averse to holding company structures.

    2. Thanks for your reply. Much appreciated!! :)

    3. Hi ML,
      As per current scenario, the company looks even more cheap and if it still holds 22% of triveni turbine, then its selling less than cash. Just to confirm the current shareholding pattern. Though, I checked & it seem to be similar compared to march 2013. Doesnt the company looks mouthwatering at these levels? Would glad to hear your opinion in current scenario.

      Vikas kukreja

    4. Hi Vikas,

      Our views havent changed much and Triveni continues to look interesting.However, given that the sugar cycle is yet to show any signs of turning, this idea is appropriate only for the truly patient investor.

  18. Hello sir , Thanks for the wonderful analysis...Is it right time to enter the Cyclical Sugar stocks ?