Why do stocks go up?

Why do stocks go up? Benjamin Graham, the father of value investing was asked that question. And his answer was: I don’t know.

Many others are less frank. Some say it has to do with earnings, others say it has to do with the market fancy or hype. For most others, it is akin to asking a question like, is there life anywhere else in space – some will say an emphatic “yes”, others will say “no” and many others will shrug their shoulders and say, “who knows?”

On Jan 31st of this year, I looked at a stock called ‘Standard Industries’, which looked cheap. It was then priced at Rs 24 with a market cap of Rs 154cr. Its main line of business used to be chemicals and textiles at one point in time (it is a 104 year old company). However it lost its way on the main business. But here is the twist: fortunately it had 93 acres of land in navi mumbai. They asked a Singapore company to develop 30 acres and recieved around 230 cr. for the same last year.

Why it looked cheap was as follows: While the company was valued at Rs 154cr., it had Rs 139cr. of hard cash sitting on its balance sheet. And it had 63 acres of land left from the original 93 acres.

So if one was to extrapolate the value of the 63 acres of land on the basis of what they had received for the 30 acres, it meant that it had land worth at least Rs 460 cr. With the hard cash of Rs 139 cr., the company should have been valued at almost Rs 600 cr. Against this, the current market cap was of Rs 154cr. More or less at a quarter of its value.

Being on a day job and working out of Singapore, I requested a friend, a professional and a past master in this field, to find out why the market was treating the company so shabbily. He found out through a colleague that there was indeed no reason for the market to not recognize the value. But there was a problem. The volume was very low and so buying a meaningful quantity was difficult.

Meanwhile, within a month and a half of this dialogue, here is what happened to the stock price:



And ofcourse the volumes went up too.

Hence, to ask the earlier question in a more pointed way, what has changed between February of this year and now, when the price is pushing Rs 52 a share (117% increase)?

Well nothing as far as the company is concerned. There are no announcements from the company, no news announcement far as I can tell. Note that it has still not reached anywhere close to its true value, but once the market decided that it is undervalued, it was being bought like it had just been launched.

And the answer is??

Well I am in the category of the ‘shrug-your-shoulders-and-say-who-knows?’ But I can quote something else from Ben Graham, which has remained with me ever since I read it:

If you have formed a conclusion from the facts and if you know your judgement is sound, act on it – even though others may hesitate or differ. You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.

Day-to-day price changes can be inexplicable. And that's a really good reason for not watching one’s portfolio too closely. Concentrating on the company's intrinsic value and acting on it is far healthier than worrying about why stocks go up.

Shinier Teeth or brighter clothes?

Looking at my personal portfolio, one of the stocks that has returned me ~ 100% on the original investment (made around 2.5 years back) is Colgate Palmolive India.

Browsing through my research notes of the time (Q4 2007) when I had done the research on the company, I had written the following:

Result: Financially a strong company, debt free, cash rich and generative, knows how to keep shareholders happy either by giving higher dividends or as happening now, by returning capital (deemed dividend). Has deep franchise value in the market and consequent high ROE (50%+).

Now, just as a perspective, this was a time when the stock market was reaching dangerous levels and the markets were about to crash at the start of 2008. The chart below shows the price movement of the company as it charted through choppy waters of the economic meltdown and beyond.



As is evident, the stock has returned around 64% or so in the last one year, which is really around the same as that of Sensex so I wouldn’t call it an extra-ordinary performance in a relative sense. The real extra-ordinary performance was in the fact that it provided the rest of its increase in value (40%) during the time the markets were discarded like old fashioned trousers by the investors. So in that sense, it served its purpose for me as a great hedge against the uncertainties. Perhaps like Gold would have.

On the other hand, I looked at the performance of another wonderful company of our times: Hindustan Unilever Limited (HUL) (which I don’t own).

This company, like Colgate, also has super ROE of over 50% - last year the ROE was over 100%. And it is MUCH bigger in size than Colgate. It is also a company’s whose financial management is the matter of folklore amongst finance professionals (I did a project on its working capital management when I worked for Modi Xerox and then again looked at its insurance management – they had a unique system of self insurance – when I was at PepsiCo India. In both instances we implemented the learnings from my projects and saved a lot of money for the respective companies).

This is a company that generates to the order of around Rs 2000-2500 cr of free cashflow every year, has around Rs 2000 cr in liquid or near liquid assets, has a negative working capital and has some of the best brands and minds in business.

When Professor Greenwald (Columbia University) had come visiting India in January of 2008, he had singled out this company as the one to invest in, given the times that we were headed into (I remember it was only a few days after his warning at the conference that the world stocks went into a tailspin).

And HUL’s subsequent price performance (shown below) right through the crisis has proved Professor Greenwald’s words entirely true:



However, unlike Colgate, the price performance of HUL has languished in the past year. In the last one year, it has returned 2.5%. Comparatively, the Sensex returned over 65%.

So unlike Colgate, which has continued to perform in good times and bad, HUL has served the investor well only during the bad times.

The difference in the 2 companies lies inter-alia in the growth rates – and we know the market is obsessed with growth. Colgate has done supremely well on this front– growing its topline by around 15% and more (quarter over previous year quarter). And its PAT has grown by even a higher percentage.

HUL on the other hand, has had an anaemic growth in topline and its PAT has in fact shrunk. This is the result of its ongoing ‘Detergent wars’ with P&G (which I might add that it has been on the losing end of) and earlier due to a severe cost inflation.

This ofcourse may be a simplistic explanation and there could be many other factors – like management quality etc, which I do not have enough knowledge about.

The comparative story of these 2 stocks provides me with many important lessons, 3 of which are:

Firstly, this debunks the theory that a ‘good company’ (which HUL surely is, looking at its brand value and financial solidity) equates to a good investment. In fact compared to both HUL and Colgate, there are many stocks that have returned over 200% in the last one year alone. Even now, HUL is valued at over Rs 48,000 cr (USD 10bn) in the market, which to me, still looks rich. But then so is Colgate looking at its present price, though the latter has growth in its favour.

Secondly, what may be a good investment during a certain period may NOT be a good investment during another period. HUL was a ‘safe’ stock during the crisis due to its financial solidity. At that time, most investors were more worried about the return OF investment than return ON investment (incidentally something which we should always remember).

And surely in that respect, HUL had all the hallmarks of safety. An FMCG company in a huge market, great brand names, no debt and steady cash flows. Growth was not important. But when the economies became steadier, every investor headed for the greener pastures. Suddenly the same company LOST in market value despite having more cash on its books and having had a more profitable year than earlier.

Lastly it reminds me that the price of purchase is all important. I wouldn’t buy Colgate at today’s prices because the growth is factored in it. But there must have been a time when HUL was much more expensive than it is today. Its price in 2006 was higher than now by 33%. So in a sense, the stockholder who purchased the stock at that time has really paid the price (pun intended) of buying the stock expensive.

Neither did they have the benefit of the bull market of 2007, nor the recovery of 2009/ 2010. They only had the pleasure of knowing that they did not lose as much as others did over 2008.

As a parting shot, I would say that what may seem uninteresting today may not remain so forever. Managements and companies change every now and then, and so should opinions. If HUL were to come back on a sustainable growth trail with a brilliant marketing strategy that blows P&G away, then who knows – it may yet again become the stock market’s darling.

That’s the beauty of the stock market. It has time for everyone – the shining teeth as well as the brighter clothes.