There are huge opportunities in some stocks that have taken a massive hit because of panic selling
If there is an intellectual high in buying neglected, undervalued stocks, the joy of making money on widely followed stocks the crowd has turned against is even greater. Most often, these opportunities are the result of a short-lived earnings disappointment or unexpected calamity that leads to panic selling. Senior management is keenly aware of the disastrous consequences of even a slight negative earnings surprise.
Not surprisingly, this is what leads to a reluctance to report bad news and creates the temptation to cross the line by fudging the numbers. John Templeton, the legendary value investor, chose to deprecate the importance of quarterly earnings only for this reason. The incredible swings in the emotional pendulum of investment analysts can irreparably damage the perception of a company among professional investors.
While there is no rational explanation for the chain reaction this sets off, the first to head for the gates are the day traders who survive on leverage and cannot tolerate even the most wafer thin losses. Next to press the panic button are the investment advisors and smaller, nimble-footed funds that need to showcase their consistency and boost quarterly performance. Finally, the big boys who fear being caught in a no-growth situation ask their brokers to get them out at any cost. The selling barrage that results ensures the stock is now devoid of a single supporter! The most minute blemish about the company, whether real or imagined, is now out in the open and yesterday’s darling is comprehensively trashed. Finally, a quiet sense of satisfaction prevails – the investment manager is vindicated by the stock settling at a price even lower than his point of exit. Brokers seize the day by making a round of thinly disguised “self-congratulatory” calls to clients as the company finally hits a 52 week low.
The current economic environment characterised by stubbornly high interest rates, a grievous fiscal imbalance and political ennui is the perfect setting for the “Holi” bonfire! Entire industries are now categorised as being leprosy-ridden and fatal for prudent investors. A wonderful example at the moment is PSU banks with capital-equipment manufacturers not far behind. No matter how bizarre such attitudes may appear, the purpose for sensible contrarians is to exploit the fickleness of markets and figure out when to buy a specific company and at what price. It is vital to point out that the deluge of selling may take days, and sometimes weeks, to exhaust itself and regardless of how undervalued the company may be, the price could well plateau or even decline marginally before it finally turns up.
The best place to rummage for such opportunities is the daily list of 52 week lows. Quite often, the list of yesterday’s largest percentage losers is a great place to identify stocks in the throes of a major decline. Now here is “Bhattacharyya’s Paradox” built on the insight of many hard knocks in implementing this strategy. Having identified a stock that fallen drastically, don’t rush to buy it! The single most important consideration at this stage is to comprehend whether the reasons for the decline in price stem from long-term considerations or are temporary. There is no point in seeking a bargain to either be arrogant, stubborn, or eager to be proven right. A detailed analysis of downside risk is essential to dealing with the “cockroaches in the kitchen sink”. Have the assets or brand been seriously impaired? Is a dividend cut in the offing if margins continue to remain depressed? Is the impact of negative events — such as a labour strike, currency volatility or high interest rates — likely to persist for more than a year? Is the enemy within — the loss of a key manager, a failed new product, weak cost control — a harbinger of an even more lethal hit in the months to follow? The nub of the scrutiny is to make sure that the fundamental earning power of the business remains intact. If such be the case and the prospects of a recovery over the next 3-4 quarters seems reasonable, aim to buy the stock either at the low end of its PE trading range over the last five years or a meaningful discount to book value. Be sure to review the ten year history of the company’s fundamental to avoid getting carried by recent price behaviour.
Now that you have picked a beaten down, large-cap stock that resembles a “fallen angel” two further questions remain. First, what is the impact on the company’s cash flow and financial leverage or debt burden? Second, has senior management objectively come to terms with the problem and are they capable of coming up with a plan that re-builds investor confidence. It is worth noting that institutional investors are slow to forget a snake-bite and their prejudice against a particular company or industry can often persist for a prolonged period despite evidence of a recovery. Hence, one needs to be primed for a long wait recognising that you are doing so at very good prices. Investing in “fallen angels” is a low risk approach and the gains can be significant over a three year time-frame even if the stock does not regain its previous status as a high-flier and soar to lofty heights. What it certainly needs in abundance is internal fortitude, a healthy dose of patience (self-belief, maybe) and the willingness to focus on the long-term performance record of the business.
Here is a candidate that clearly qualifies as a fallen angel in my book: A highly predictable business with stable margins and very limited capital requirements for future growth with a current market capitalisation of Rs 25.5 billion. Compounded annual growth over the last nine years in net revenues and net worth is just over 10 percent, while the corresponding number for post-tax profits is 16 percent. The good news is that dividends have compounded at 32 percent during the same period! The company has scrupulously avoided taking on even a single rupee of debt and has delivered an average return on equity of 32 percent since 2003, with the worst year clocking 21 percent! At the current price, the company is almost 20 percent off its recent high and trades at 19 times trailing earnings with an attractive dividend yield of 4 percent. During the last 5 and 10 year periods, the company has delivered considerably superior total shareholders returns compared to the market leader with marginally lower price volatility. The company described above is VST Industries (Rs 1,655 ).
Disclosure: This column is neither an offer to sell nor solicitation to buy any of the securities mentioned herein. The author frequently invests in the shares discussed by him.