One of the hallmarks of a well managed company is that it should not have too much debt, because more of it would eat away the company’s operational gains. According to Warren Buffet, an increase in interest rates can drastically affect a company’s profits and make future cash flows unpredictable. Hence he refrains from investing in companies with too much long-term debt.
Moreover a well managed company should always strives to sustain its operational efficiency, which means that the company strives to reduce its operational expenses as compared to its operational income. This may seem like a very basics of running a good business, but in the real world, it’s very tough to implement.
In India, 2008 was the year of high interest rates. Hence a company that was able to increase or even maintain its interest coverage ratio (ICR), i.e. operating profits upon interest payments, would be an ideal candidate for sustaining profits in hostile situations.
Last year not only saw high interest rates, it also saw rise in prices of commodities like metal, minerals, crude oil, etc.. This created problems for companies requiring commodities as raw materials. The operating expenses of companies went up and their margins got squeezed down.
We looked up for companies which were able to reduce their expenses in the last three quarters. Based on our custom filters, we looked at the BSE 500 companies and ended up with nine companies.
The companies that do very well in a high interest rate environment are banking companies as their interest incomes go up. Hence, predictably, our list has three banks — HDFC Bank, Indian Bank and Yes Bank.
HDFC Bank, the second largest private bank in India, has improved its net profit margin by 67 basis points for the Q3 2009. This has boosted its effort to keep operating costs on the lower side. However, it still has some way to go before it achieves the operating efficiency of ICICI Bank.
On the other hand, Yes Bank may not be the largest player, but it has one of the lowest operating ratios across all industries and sectors. Its net profit margin is at par with the HDFC, ICICI and the SBI. The third bank in our list is a public sector bank, Indian Bank. Its net profit margin was at 16.76 per cent for the September 2008 quarter. Further-more, its operating ratio is 27.86 per cent, which is better than both HDFC and ICICI. But like Yes Bank, its disadvantage is that it is a small player in the industry.
Another dominant industry in our list is the pharma sector, with two companies — Cadila Healthcare and Aventis Pharma. Both of these companies have more or less the same operating ratio and net profit margin. However, Cadila is the larger of the two with almost double the profits of Aventis. Hence, Cadila is trading at four times premium to its book value. But Aventis has the leverage of being zero debt company.
Power Trading Corp. (PTC) is a unique company in our list. Although its operating ratio generally remains near to one, we have stuck with it because it is a trading company. PTC buys power from power generating firms and sells it at a premium to firms which are unable to keep up with the demand. Because of the nature of its business, PTC has a high operating cost and low net profit margin.
Another noteworthy company is Sterlite Industries. By buying into PSUs like Hindustan Zinc and Balco, Sterlite has leveraged to turn into a more diversified mining and smelting company. It is the second biggest company in our list with profits of over Rs 400 Cr. By consistently keeping a check on its expenses, the company has been able to increase its net profit margin Q-o-Q.
Then there is MIC Electronics and Ingersoll-Rand. While the former is involved in the manufacturing and sales of led-video display screens, the latter is an infrastructure solutions company. MIC Electronics is trading at 1.24 times its book value and Ingersoll-Rand is trading at 1.08 times its book value. But both are trading at a less than market PE, considering the niche segment they carter to.