Mr Siddharth Bhaiyya explains how value investors select stocks intelligently ! The share market can be mysterious, but sticking to the basics can help you to compound your wealth !

1. • HEG finished the calendar year 2017 with staggering returns of 1500% for the year. Closing the
year 2016 at Rs 150, it finished 2017 strongly at a price of Rs. 2400.
• The reason behind the 15x returns:
Consolidation in graphite electrodes (GE) led by global capacity closures. Ex-china capacity
declined ~17% over CY10-17.
• The Chinese government cracked down on polluting industries in the country. This led to
shutdown of 300,000 mt of graphite electrode manufacturing capacity in China since the 2nd
half of 2016.
• Similar crackdowns on steel mills has resulted in a drop in Chinese steel exports from 110 mmt
to 60-70 mmt. This has led to increased production of steel in countries which were hitherto
suffering due to cheap steel imports from China and consequently an increased demand for
electrodes.
• Turnaround in the steel industry globally has led to an increase in demand for the commodity.
This has further led to electric arc furnaces being viable which has also contributed to increased
demand for electrodes.
• We first purchased HEG on 26th
April, 2012 at a price of R. 230.
HEG FY12 FY16 (Feb) FY17 (Dec)
Market price ~230 ~120 ~2400
Market cap (crs) 920 480 9600
Capacity Ex-China in 2010 – 8,60,000 MT; 2017 – 7,18,000 MT ( down 17%)
SGL Closed 3 plants in Germany, Italy and Canada
Graftech Closed 3 plants in South Africa, Brazil and USA
Showa Denko Acquired 3 plants from SGL in Spain, Austria and Malaysia
Tokai Acquired SGL’s plant in USA & reduced capacities in Japan and Germany

2. Gross block (crs) 1182 1645 ~1700
Net Block (crs) 745 932 ~860
Capacity (MT) 80000 80000 80000
Net Sales (crs) 1424 869 2400 (E)
PAT (crs) 62 (8) 860 (E)
Replacement Cost 2500 crs
• Our rationale in purchasing HEG:
Oligopoly HEG was one of only a handful of players in the GE industry.
Entry barriers Technology available with a few players globally; capital intensive.
Structural changes Shift towards electric arc furnace leading to higher demand for GE.
Operating leverage Company and industry was operating at low utilization.
Margins Were 1/2rd
of the cyclically high margin of FY09.
Valuations Were reasonable given cyclically low margins; 15x PE; 0.65x Mcap/Sales;
50% of replacement cost.
• In February 2016, we owned approximately 1,00,000 shares at an average cost of 230. At the₹
bottom we had an unrealised loss of ~50% for our clients on HEG after 3 years of holding the
stock.
What went wrong
Steel prices Corrected from $650/Mt to $190/MT.
Record losses Some of the most efficient steel players globally such as Posco, Nippon,
JSW Steel etc. report record losses.
GE Consumption and capacity utilisation declined sharply for the industry.
Margins Collapased to 6% in Q3 16 from a high of ~38% in FY09.
What we did:

3. From Feb 2016 to August 2017, we increased our HEG holding from 1,00,000 shares to
9,00,000 shares with our average cost coming down from ~ Rs.230 to ~ Rs.207.
Our Rationale for increasing our stake:
Cycle bottom
(steel)
With the most efficient companies reporting record losses it
indicated that the steel industry was close to bottom.
Cycle bottom (GE) All GE companies in the world were reporting record losses.
Street interest Street interest in HEG was minimal with no brokerage reports and
barely any attendance on the conference call.
GE prices There was a more than 60% price erosion in GE prices.
News There was negative news not only for steel and GE but also for all
other commodities.
Valuation While there were no earnings the stock had fallen to less than 25%
of replacement cost.
Balance Sheet Although the B/S had deteriorated given the industry downturn
they were in a strong position to survive the downturn.
What’s changed now:
Steel cycle Global ex-china steel production and demand have increased.
GE demand Capacity closures and increase in demand have led to sharp revival.
GE Prices Have increased 10 fold from $ 2000/MT to a high of $20000/MT.
Street interest Countless research reports; extremely well attended conference
call.
News Needless to say the news flow has been extremely positive.
Valuation Stock trades at 4x replacement cost and while PE’s might look
cheap, the current earnings are very close to their cyclical peak.
Did we foresee any of this?
NO WE DID’NT.

4. We did not expect the Price of HEG to correct from Rs. 230 to Rs. 120 (else we would not have
bought it in the first instance)
We did not expect GE prices to increase 15 fold. (incidentally we did a call with the management
last April and even they did not have a clue about the impending blow-out in GE prices.
Having seen the market move from a state of extreme pessimism to a state of euphoria, we are
confident in saying that the current level of prices for graphite electrodes are definitely not
sustainable in the long run. Supernormal profits typically attracts higher competition and lower
profits. In the long run companies can only make economic profits
As to where the prices are headed from here - we have no idea. However it would be safe to
assume that prices are more closer to the top than they are to the bottom.
We have over the last 4 months significantly pared our exposure to HEG. We did not anticipate
such a huge run up in the stock 12 months back and we have no way of guessing what the future
holds for the stock.
We will continue to do what we know best, which is to buy good stocks with a high margin of
safety and then wait for the economic cycles to correct themselves.
We got lucky with HEG in that the upturn in economic cycle was something which nobody could
have imagined but one thing about cycles is certain they always turn!!!