The Deadly Sins, the stock market and the art of survival

The Deadly Sins, the Stock Market and the Art of Survival (originally posted in June 2008)

Despite their many ideological differences, one of the things that various religious scriptures
converge on, are the deadly sins of human nature – Anger, Greed, Envy, Gluttony, Lust, Pride
and Sloth.

As part of our work routine, we go through research reports of several large institutions. And in
reading them, we would venture to add that when it comes to these institutional forecasters, overoptimism could be a deserved addition to the list. In proof of this, it was recently reported in
Bloomberg that only 5% of all advice on stocks ever got a ‘sell’ tag since the US’s Great Depression.

And taking up from where we left off last month in our article on Greed and Fear in the market, when it comes to the general investor, we should add despondency to the list of the deadly sins too. In proof of THIS fact, well, look around in the stock markets today.

Let us see how. At the time of writing this article, the (P/E)* multiple of the BSE Sensex is between 18 and 19. If we peel the onion a bit and look at the list of the BSE 500 list (which contains the top 500 important stocks), then we’d notice that there are 20 companies with P/E of over 100. Amongst these are BF utilities (1900), Reliance Power (750) and GMR Infrastructure (360). (No typos here!).

* P/E, for the uninitiated is the current price of the stock divided by past year’s profit. In that sense, the higher the P/E multiple, longer it should take to recover the price paid. Admittedly, the P/E ratio, despite being one of the most overused tool by analysts, is not something which can be taken merely at its face value. A stock which looks cheap at a P/E of 5 may turn out to be an expensive mistake. Similarly, a stock having a P/E of 100 may actually be cheap. That’s because the P/E of a stock is determined by the stock market on the basis of various factors, amongst these being Growth, Dividends, Level of debt in the company, industry and other macro outlook, quality of management etc. Hence for example, as long as the market feels that a company has a great future, (say, a doubling of profits year on year) they are willing to
pay a premium for it. Yet, due to its simplicity it is a good benchmark for the purpose of this article.

Being rationalizing rather rational, analysts provide all kinds of reasons for a stock to be a ‘buy’
even at seemingly ridiculous prices. Here is an excerpt from a large institution’s research report on GMR infrastructure (the same one with 360X P/E):

“We have valued GMR Infrastructure on a sum-of-the-parts basis using the DCF methodology for each of the projects. The projects in the power and road segments are valued on a single stage DCF method through the lifecycle of the respective project. Our price target is arrived at from the embedded value of each of the projects undertaken by GMR Infrastructure and as the company develops more projects our target price would be revised to include the value of the new projects.”

Ergo, they were asking us to put money on the stock since there are a number of operational projects that will be completed sometime in a distant FUTURE. Well, as value investors we like to invest on the present and only reasonably foreseeable future. Anything too far out in the future, is in our view, not quite certain. (Interestingly, at the time of that particular report, the price of GMR was 235 vs 110 now. The P/E of the company was not even mentioned in the report but we can guess that it would be closer to 700 at that time!)

Here is another excerpt, this time from an ‘India strategy report’ of another institution. Funnily
enough, their report is titled: ‘Stay defensive until macro concerns abate’. And included as one of
their ‘safe’ recommendations? Educomp Solutions. Here is what the report had to say:

‘A large and un-penetrated market and increasing importance of technology driven education delivery provides Educomp Solutions with enormous growth opportunities. We rate this stock a strong buy at 4039 with a target of 5313.’

Educomp, which was not so long ago selling at Rs 5,500 per share is now selling for RS 3,400 a share (note that the large institution had issued this as a ‘defensive’ buy at Rs 4,039). The company has a current market cap of 6000cr (roughly $1.5 Billion) vs their last full year profit of 71cr (roughly $17-18MM). That’s only around 84 times last year profit. That’s cheap. Compared to the PE of 150 when the stock was selling at Rs 5,500. Maybe there is logic to all this but we cannot fathom that.

‘Okay’, you say, ‘so you guys think that all those smart fellows employed by top notch institutions aren’t giving great recommendations, so what about you folks?’ Well, we are breaking our own little rule by talking about stocks, the variety of which we are comfortable with even in this environment.

Merck

Merck, for us is a defensive pick. Here is a company with a total market cap of Rs 550cr and a steady cashflow of around Rs 80cr. On a standalone basis, that works out to around 7 times cash profit. But it has around Rs 345cr of cash on its balance sheet. Hence the market is valuing a Company with a net market cap of Rs 205cr, with a yearly cash profit of 80cr at around 2.5 multiple. Now that’s a change from the companies with the 100+ P/Es!! Further, excluding the cash on its balance sheet, it has capital employed of Rs 95cr and hence a Return on Capital Employed of 85%. To top it, it has a dividend yield of around 6%. Can it go lower than the current price? Sure, if it does, we might want to pick up some more.

Wyeth

Wyeth, we feel, is an example of a dividend capture strategy. This cash rich company, currently priced at Rs 435 a share, is very likely to pay Rs 30 per share (same as last year) as dividend by August or before (it has paid its dividend by August for the last 9 years). That works out to close to 7% dividend yield. Tax free. Hence if one looks at the net cost to us (Rs 435-30 dividend), and then compare that to the chart above, one will see that a price of Rs 400 has not been breached since 2005.

One would say, that’s a reasonable probability that one would not lose money on this transaction and maybe make 7% or more in 3 months. That’s 28% annualized. We will take it.

BASF

This is an example of a ‘special situation’. This company, which is debt free and by itself not too
expensive, announced a few days back that the parent would like to acquire close to 22% additional equity in the company. This would take the parent stake from 53% to 75%. And they would do so at a price of Rs 274 vs the then market price of Rs 245. We estimated that after considering the percentage of public which will tender their shares for such an offer, we will make anywhere between 5%-10% in this transaction in a period of 2.5 months. That’s annualized yield of 24%-48%, relatively risk-free.

Many will sniff at the above examples because for them the stock market is a place for multibaggers, mistaken usually for only the high growth companies. But they forget that in buying such high growth companies, they may already be paying a high premium. In a market downturn therefore, they are the first ones to become despondent and reject the stock market as a casino where the house is the ONLY winner. As Buffett said, “The market, like the Lord, helps those who help themselves. But, unlike the Lord, the market does not forgive those who know not what they do”. We have chosen the above examples to show that growth companies are not the only ones to profit from.

We do not venture to forecast which direction the market will take in the future but it is apparent that there are several headwinds to the world economy and hence it is important in our view to be focused on downside protection till clarity emerges (As John Maynard Keynes said, the markets can stay irrational longer than you can stay solvent). We have therefore allocated a part of our portfolio for tactical investments such as above.

However the ones listed above are not the only companies, and neither are these the only methodologies that we are adopting presently, but these are the simpler ones. Besides these, we are continuing to pick up cheap and fundamentally strong mid-caps, ones which have been discarded by the panic stricken market. Those that qualify are ones with a) consistently strong cashflows, b) little or no debt, c) products in demand, d) no foreseeable pressure on margins and e) a price that can yield us good returns in future. Alternatively, there could be beaten down stocks which are likely to benefit from the likely future events. More on these categories sometime later.

We end with what we have always been saying – the time to pick up stocks is when the prices are down because price is what determines the rate of return on the investment. In relevance to today’s times, we’d say that on a longer time scale this is the only way to beat inflation. If we just look around, there’s so much more choice in the stock market today than 6 months ago - it’s the off-season discount sale after all! And unlike hoarders of other commodities, there is nothing in the law preventing us from hoarding cheap stocks. Even though a sin in the scriptural sense, Greed can be good now! Mr. Market, in his manic worst refuses to acknowledge the value of even good companies and no amount of investor meetings by the managements of these good companies can convince the market participants otherwise. It’s a bit like that joke where the Doctor pronounces a patient dead. “But I am alive”, says the patient. “Shut up”, says the Doctor. “Do you know more than me?”