We had once recommended a stock called Merck Limited on our blog. It seemed to be a value investor stock by all counts.
The cash flow of the company is reproduced below:
Looking at the last 5 year results, the company has made a good (and stable) profit and the average cash flow from operations works out to around Rs 93cr. – the last years cash flow fell because of higher inventories and receivables – a sign that the company probably tried to push its products at the end of the year. Nevertheless, a company with high cashflows.
Its dividend has been rising over the years – from Rs 2 per share in 1988 to Rs 20 per share in the 2007. However, in 2008 they did drop the dividend to Rs 17.5 per share to conserve cash, keeping the tough economic conditions in mind. Even at this reduced dividend, the dividend yield works out to around 4.5% on the CMP of Rs 398. Certainly, a situation where we are being paid to wait for the stock price to appreciate.
The company’s current market cap is around Rs 670cr, of which are Rs 330cr (as at the Dec’08 closing) was held as cash/ bank/ investments (not adding another 36-40cr in cash that they made till June’09). Hence, the market is valuing the company with an average cash flow of say 80-90cr a year at Rs 340cr (market cap of Rs 670cr less cash held of Rs 330cr). Say around 4-5 X of cash. That should be considered cheap.
Surely in the near term the prospects look tough given that around 50% or more of the company’s products are covered under the Drugs Price Control Order (DPCO), which means that to that extent they do not have the freedom to price their products (mostly vitamins). With input costs having gone up, this has meant reduced margins – which is showing in their recent performances. But thinking the contrarian way, Merck, being an MNC would like to introduce more products to get out of the DPCO’s grasp. And the company has been on the ‘prowl’ (as reported in a newspaper article in 2003) for an acquisition in the Indian market and has been conserving cash (almost 50% of their market cap) for that purpose.
But 2 years into my personal investment, lets relook at these assumptions: Merck (the parent company) has a 100% subsidiary through which it is reportedly introducing new products (this way they don’t have to share their profits with the minority shareholders). And why has the company not been able to find any acquisition target in India despite being on the ‘prowl’ for the last 6 years?
The market usually tires of waiting for a catalyst and that is true for Merck as well. But despite this, the price chart below shows that even during the period 2008- early 2009 when the markets went for a long holiday, the stock has actually done well to hold its own and didn’t fall by much. It has therefore served its purpose as a defensive stock when it was recommended in June 2008 (its market price then was around Rs 330 and hence has provided a 20%+ return).
But whereto from here?
Either we give up – admitting that it is unlikely to reach its expected value – which to me is atleast around double of its current market cap. Or else we wait.
But besides this, is there another choice? Should we just act as a Buy and Hold investor or try to be THE catalyst? That is the subject matter of this article.
Ronald D. Orol has covered this in a book called Extreme Value Hedging, wherein he has written on value investing v/s shareholders activism to catalyse value and about the pros and cons of the 2 styles.
He writes that Mohnish Pabrai, managing partner at Pabrai Investment Funds of Irvine, California, is a true value investor. Unlike activist investors, at no point will Pabrai engage or even seek to talk to the executives at the companies he allocates funds.
Executives at one company called him one day to see if he had any advice or ideas. Pabrai, an 18 percent investor in the corporation, says the call was a big mistake. "I have never made a phone call to any management of any of the companies I am an investor in," Pabrai says. "The way I see it, if they need my help, there is a problem."
In fact Pabrai questions whether activists, in their drive to raise the value of corporate shares, are actually improving the long-term businesses interests of their target companies.
Opportunity Partners' Phillip Goldstein (now runs a hedge fund called Bulldog Investors) takes issue with the idea that activists aren't contributing to the long-term viability of corporations. On the other hand, sometimes value investors infuriate activists with their passive approach. Goldstein says he once approached a value investor who held a substantial position in a company to see if that manager would support a possible proxy fight he was considering. Goldstein was contemplating a proxy contest to oust directors and pressure executives there to sell the business. The support of this particular value investor would go a long way toward putting sufficient pressure on the company's management. But without them, Goldstein says, he didn't believe he had enough leverage to sway the executives.
"I said to them that I believed the company was on a course for declining value and that it needed something to change its direction," Goldstein says. The value investment fund managers responded in a way Goldstein didn't expect. No decision would be made one way or another on a proxy contest until it happened. The manager was unable to tell Goldstein whether he would support his possible endeavor. "Do they even know why they own the stock?" Goldstein asked. "They want to stay aloof, but what they are doing is harming their investors."
Which approach is better? Goldstein says it's unfair to compare the profitability of the two approaches. It depends on a case-by-case, fund-by-fund analysis. Either can be successful or a failure in different instances, and when one strategy is successful, it often may be because it took advantage of the other strategy.
There are some definitive differences and similarities. While value investors, for the most part, quietly sit and wait for their investment to appreciate, activists must be successful at wooing other investors to support their efforts.
But unlike traditional value investors, activists will use their knowledge of the company's legal structure, their ability to file lawsuits, engage and negotiate with management, and launch proxy fights to provoke change and improve value. Insurgents argue that value investors must be careful not to fall in the value trap, that is, invest in a company they expect to appreciate in value within five years and find out five years later that because of management or external factors that company still remains intractably undervalued. (I am close to 2 years in my investment in Merck India.)
Zeke Ashton, founder of $50 million Dallas-based value fund Centaur Capital Partners, says a key difference between activists and value investors is temperament. "To be a successful activist investor, in many cases, takes a confrontational personality;' Ashton says. "It requires someone that will fight with management to accomplish certain goals."
Goldstein agrees that temperament is important to the approach. A successful activist can't get aggravated or lose sleep when faced with lawsuits or screaming CEOs. He adds that an activist must enjoy being the catalyst. "How much abuse can you take before you say this is not right?" Goldstein asks. "You can't be a shrinking violet and run for cover anytime somebody sues you; otherwise, you're going to get bullied."
Many traditional value managers will become reluctant activists if they become sufficiently aggravated about a particular situation. Even value investor extraordinaire Warren Buffett, arguably the most successful stock picker, has on occasion taken an activist tack. In a 2001 confer¬ence call, Buffett expressed his displeasure with real estate company Aegis Realty Inc.'s decision to buy P.O'B. Montgomery & Company, a Dallas-based shopping center developer, for $203 million. He also was involved in several quarrels with management of Berkshire Hathaway before he bought enough shares to take over the company in 1962.
Value investor Christopher H. Browne, managing director of Tweedy, Browne Company LLC, another firm that we think are amongst the true value investors, also grudgingly engages in reluctant activist efforts in some situations, when provoked.
On the other hand, Walter Schloss, (called a ‘superinvestor' by Warren Buffett) and a value investor about whom we had written in May’08, is truly of the old order. He likes to buy and wait, his usual holding period being 4 years. “Something will happen”, he likes to say.
In comparing value investors to activists, it is unclear whether the approach favored by Schloss, Pabrai, or Goldstein makes the most sense.
To me, the best investors are those that can adeptly engage in both value and activist strategies based on changing circumstances. Goldstein was once asked whether as a hedge fund manager he was more interested in the activism or in making money. His response: “I am out there to make money. The activism is the means to the end. “
I have to agree with that.
At my own end, I am clear that companies like Merck do not deserve to be listed on the stock market unless they can efficiently allocate capital. They need to either acquire a company at the right price (which I am sure would have been available a few months back when EVERYTHING was cheap) or distribute the cash as dividend. Or acquire the public shareholding by doing a buy-back. But surely something needs to be done.
While it can’t be me (I have a day job), I am hoping that just as in the cartoon someone will come out of the woods and insist (with a growl, I might add) that the management stops thinking that the company is their own backyard. The investors need their living room space too.
Till that happens, I am willing to wait – its not as if there are a lot of other investing opportunities right now in the Indian market and hence the opportunity cost is not high. All said and done, Merck continues to be a defensive bet even in the present market. And being a rationalizing person, I would think that I am still only at half of Schloss’s normal holding period. Maybe something WILL happen.
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