Buy damaged stocks not companies

A successful self trader – Rule # 36

The difference between a damaged company and a damaged stock can be tricky and subtle. But it is also true that the markets are the best advance warning system for damaged companies. That is where the biggest opportunity arises. You must go in and buy damaged stocks where the company’s core strength is intact. Also, sell damaged companies where stock damage has just begun.

The difference is subtle but very significant

An interesting but real story of 2 investors will serve to underscore the subtle difference between damaged stocks and damaged companies. The first case was of an investor who had substantial holdings in Infosys in early 2003. After the 30% correction on results day, he just sold off his entire stock of Infosys. Between 2003 and 2014, Infosys became a multi-bagger.

Another case of the exact reverse situation was with another company, Educomp in 2007. The investor continued to hold on to the stock, despite indications of squeezed margins and unmanageable debt in the books. By 2012, the stock price was a fraction of its peak price and does not look like bouncing back even in the distant future. These 2 cases highlight the difference between damaged stocks and damaged companies and also underscores what you strategy should be in either of them.

Infosys’ financials and fundamentals were never in doubt. It was always a zero debt company and had top quality management and execution skills. Educomp, on the other hand, was overstretched and had a fragile business model. The question now is how do you differentiate between damaged stocks and damaged companies?

3 questions to be asked about bad companies

Is the company overleveraged?

Too much debt has been the bane of most businesses. Any company with a high debt equity ratio and low interest coverage is a primary suspect. In times of economic downturn, such companies are the first victims. Always be extra cautious about overleveraged companies.

Is the industry going through a churn?

We have seen this so often. It happened to textiles in the 90s, when they lost out to China. It happened to retail outlets the world over when the internet became a seamless market. And of course, it has happened to real estate too. Avoid these!

Is the company going from high growth to slow growth?

 This is a deceptive investment trap. Some companies continued to be high quality but their sectors have moved from high growth to low growth. Telecom, Power, Capital goods are classic examples. Not the right time!

“Buying or selling a stock is more than just about price, which is why it is an art” – Warren Buffett

Real jackpot will be good companies in lousy sectors

  1. The word Jackpot can be quite misleading. My first example is the cement industry. This sector has been a mediocre performer with high overheads, limited pricing power and weak demand. But in the midst of all these Shree Cements continues to outperform on the back of its North focus and its ability to keep margins and ROI at attractive levels.
  1. When you talk of auto companies and two wheelers, the names that immediately come to mind are Tata Motors, Maruti, Bajaj and Hero Honda. But in their midst, one company has outperformed all classes of auto companies. With a focus on distribution, a bet on the Enfield motorcycle and mid-sized trucks, Eicher has been a 40-bagger between 2008 and 2014!
  1. In the technology space, it is size that actually matters. But the real stock market returns arise from mid-sized companies that are evolving into large caps. Infy, Wipro and TCS have given 60-80% returns in 3 years, but it is HCL Tech with 400% that stands out. Catch them young and watch them!
  1. Niche players always have an advantage. NBFCs have never been an outperforming sector. But look at 2 stocks, M&M Finance and Shriram Transport. M&M Finance with a focus on rural micro finance and Shriram with a focus on truck finance have outperformed peers by a huge margin. A niche focus with a unique market strength and brand matters a lot. The makings of a Winner!
  1. When you look for good companies, remember they do not always come from fancied sectors. Two super-performers stand out. Page Industries in innerwear and TTK Prestige in appliances are in ostensibly competitive markets. But their ability to hold margins, differentiate their products and leverage their distribution channels is exemplary. No doubt they rocked!

When does this difference manifest?

The companies that stand out in a mediocre sector or group are best seen in 2 situations. The first is in a period of irrational exuberance. Idea stands out among the telecom companies for this feature. At a time when companies like RCOM and Bharti were heavily investing in expansion, acquisitions and infrastructure, Idea was more prudent in stretching itself. Prudence in exuberance is the first sign of a good company.

The companies that stand out also manifest resilience in times of economic hardship. ICICI Bank post 2008 and ITC post 1997 are classic cases. ICICI fought out doubtful assets, global exposure and a liquidity crisis to emerge with a stronger and leaner balance sheet. ITC got over excise evasion issues, compliance questions and negative industry vibes to position itself as a veritable force in the FMCG space. Resilience surely differentiates the men from the boys.

Takeaways from the ‘Damaged Stock” Debate

In a nutshell, good companies with damaged prices are classic buying opportunities. Of course, holding period can be an X-factor, depending on the nature and colour of the problem. But identifying a damaged company can be a lot more difficult. Lifting the veil and looking behind results, guidance and publicity calls for skill and rigor.

As Peter Lynch put it, “There is no shame in buying damaged companies. We all do it all the time. What is shameful is holding on to such damaged companies; or worse still, averaging and adding more damaged companies in your portfolio”. Erring once is a mistake, but erring twice is force of habit. You surely don’t want a portfolio of bad companies, do you?

 

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