Investment versus speculation

Seth Klarman, in the first few pages of his Margin of Safety, makes a distinction between investment and speculation. Any purchase that generates cash flows for its owners while they own it is an investment while one that does not is a specualtion. This is an important distinction. By this definition, buying stocks and bonds are investments. But buying commodities, art and precious metals as investments, in the hope of being able to sell them off for a profit in the future are all speculations.

The difference is that in the latter case, one is buying something and hoping that there will be someone (or many) who will be willing to bid a much higher price for it in the not too distant future. Does this sound familiar? If it does, it might be because this closely resembles the definition of the Greater Fool Theory. Thus, buying a Raja Ravi Varma because you would like to admire it in the privacy of your home is not speculation, while buying one because you have read that the price of art is going up in the Economic Times definitely is. Similarly, buying gold jewellery for your daughter's wedding is not speculation, but buying gold because you believe that the relentless rise in its price in rupees over the last decade will continue on in the future definitely is.

In both the above examples, the important difference is in the intention of the buyer. In the first alternative in both cases, the intention is to buy because the buyer appreciates the underlying or intrinsic value of the purchased item, and derives some utility from it. In the second alternative in both cases, the purchase is made purely with the intention (or rather hope) of being able to find a buyer who can take the item off your hands at a much higher price than what you paid.
This difference in intention can be applied while buying stocks and bonds as well, to classify the purchase as an investment or a speculation. If one buys a stock because one read glowing media reports about it, was influenced by endless plugging on financial channels, or in response to a 'buy' signal from some sort of technical analysis, and this purchase is completely done without regard to, thinking about and understanding what the value of  the underlying business would be to a long term owner, then that stock purchase falls in the realm of speculation.

Removing the bad apples

In a previous post (here), we spoke about how Blue Star was an extremely good business going through a temporary setback due to, partly, high inflation, a slowdown in Indian commercial real estate development and also more directly due to management chasing growth at the expense of taking on prudent contracts. We mentioned our belief that management had woken up to their folly and were working on fixing the bad apples in their order book. We further anticipated that as the cleanup proceeded, numbers on the income statement would get worse before they could get better, as bad debts were written off and slow, non-progressing jobs were shortclosed.



The anticipated changes have been underway at Blue Star since Q2FY12. The company has been singularly focused on reducing the capital employed in the business, and this focus has been yielding results. The total capital employed in the business, which peaked at Rs 956 cr at the end of Q1FY12, has now dropped to Rs 628 cr at the end of Q4FY12. This 34% drop in total capital employed was possible due to a 44% drop (from Rs 626 cr in Q1FY12 to Rs 351 cr in Q4FY12) in the capital employed in the Electromechanical Projects division which has historically generated over two-thirds of Blue Star revenues.

The bad apples in the carry forward order book still number about one third of the total order book, and management estimates that it will be another 12 to 18 months before the business is able to put them all behind for good. The process of healing the ailing business has made great progress in the last 3 quarters, but much work still remains to be done and Blue Star is not completely out of the woods yet. However the worsening of the income statement over the last 3 quarters has caused the stock price to crash by another 32% from the time of our last post on this subject 10 months ago. The business meanwhile has been getting better all this time. The Blue Star franchise among commercial businesses remains extremely strong as is evident from the new orders that have been flowing in over the last 4 quarters. The carry forward order book remains robust, albeit subdued, compared to the greedy contract signing times of FY08 and FY09 for which the company paid the price in terms of balooning and uncollectible receivables in FY11 and FY12. Most new contracts in the electromechanical division are being taken on at more conservative terms than before, sacrificing growth for profitability and project predictability. In the Cooling Products division, the newly introduced residential air conditioning products continue to sell well and show strong growth. When inflation becomes more benign (we have no idea when this will happen, although there is little doubt if it will happen), the business will get a double whammy of tailwinds - first, from improved margins as costs are brought under control from FY12's high cost environment, and second, from a higher rate of growth of commercial real estate development that should inevitably follow from a more benign interest rate enviroment.

The Blue Star stock represents an excellent business with superlative management that is available at 8 times its lowest earnings out of the last 4 years (prior to the loss making FY12). Comparing Blue Star to Voltas, the biggest competitor to Blue Star in India and a member of the Tata Group, we see that over the last decade, Blue Star has been able to convert each rupee invested into the business into over 3 times as many rupees of cash flow for the owners as Voltas has. A small part of this superlative performance of Blue Star can be attributed to a marginally higher EBITDA and net margin compared to Voltas. But the main reason for this exceptional business outperformance is due to a significantly higher total asset turnover. Blue Star has been able to extract more juice from its fixed assets and its working capital than Voltas. Blue Star has also largely avoided the practise of parking capital in investments that have been generating a significantly lower return than the main business, a practise that Voltas has been undertaking consistently and that has penalizing its economic performance significantly over the years.

The difference between the two companies can be attributed to management philosophy - a management focused on the most efficient allocation of capital can make a significant difference to the economic output of the business over and above conditions inherent in the business itself. Such a management can be an investor's best friend and an ideal long term companion as a co-owner in an exceptional business.