Hidden Value or Value Traps
I recently read a story about how Mr. Anil Agarwal, founder and Chairman of Vedanta Resources Plc, early in his career, bought a distress factory on sale with bank borrowing, and repaid the bank loan within a month by selling copper inventory in the company’s warehouse! Now this is classic value investing with a LBO spin – buying a company at a steep discount to conservatively calculated intrinsic value.
We as investors in the stock market try to do the same – buying companies at price lower than our estimate of fair price. Apart from the obvious difficulties in trying to foresee the future (estimating discounted cash flows), there are other challenges we face.
We don’t have any semblance of control over the assets or cash flows of the company. We are at the mercy of the management to take the right decisions or let a rising tide (bull market) bail us out.
The market is plenty of statistical cheap companies – from cash bargains to net current asset bargains to companies trading at low P/E or P/B. But we as investors make money when cheap companies stop being cheap companies or better become expensive companies!! As any bruised investor will tell, differentiating between companies which will remain cheap and which will become dear is a game – equally of skill and chance.
The problem with lot of these cheap companies is that due to poor moat/ growth/ RoE, any long term investing in these companies becomes a losing proposition. As Warren Buffett says “Time is the friend of the wonderful business, the enemy of the mediocre”. First, such businesses are very fragile to economic downturns. How profits suddenly turn to losses is very surprising reality to see. Second, low growth and low RoE means that longer than anticipated holding period could dramatically lower the annualized average return. Thirdly, management of many of these companies can always be counted to take stupid/ unethical/ sub-optimal businesses decisions, and any statistical value proves to be pure maya.
When investing in such companies, we have found following some rules to be quite valuable:
1. Giving primacy to normalized earning power and trough earnings, rather than asset value (especially hidden assets!)
2. Demanding a much higher margin of safety when investing in such companies (to compensate for longer holding period and lower growth)
3. Trying to investing in companies with sales/ profit growth and RoE of atleast 15% each.
3. Having a good starting dividend yield (of 4%+) – to reduce potential downside as well as getting paid for the waiting period
4. Capping allocation to certain percentage of portfolio (25%-30% in our case) so that dead stocks do not impact the overall portfolio returns
5. Increased diversification within this category of stocks (putting large allocation could be very profitable or very painful)
6. Limiting time frame to reasonable period (2-3 years in our case) so that money can be channeled in profitable manner
Of course, there is always lollapalooza effect which needs to be considered – how confluence of the above rules will impact investment decisions.
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