January 13, 2013

Falling off the cliff

You may have heard about the fiscal cliff drama in the US. We have some companies which have already gone through their own version of the cliff

Look at some of the price action below

As you can see in  these two cases, the price has dropped by 75% or more in the last 6-12 months. I normally ignore fluctuations in stock price, as most of it is noise. However a drop of 75% or higher is a signal that something fundamental is happening.
Why analyze failure
The question is why bother to analyze such cases? I subscribe to the philosophy that if one wants to be a good investor, then one should study and learn from exceptional success and failure. One should not only analyze companies which have done well in the past (such as Hawkins or titan), but also look at the companies which have destroyed a large amount of shareholder wealth.
The best reason for analyzing failure is illustrated by the phrase – invert, always invert, by Carl Jacobi who said that one of best ways to solve some problems is by inverting them.
As Charlie munger has said, if you want to succeed, learn to avoid failure. If one can identify why the above companies dropped off a cliff, one can use that learning to avoid such cases in the future.
Is it all fraud?
It is easy to ascribe the drop to some kind of fraud (as it happened in the case of satyam) and avoid any further analysis. I think that is intellectual laziness and will not help us learn anything.
I would like to put the above examples in two buckets

  1. Attractive core business, with management diversifying into poor businesses with heavy leverage
  2. Mediocre core business with poor cash flow resulting in high debt
Poor diversification and failure of corporate governance
You can read the story of Deccan chronicle here. In a nutshell, the company had a very profitable core business – newspapers and diversified into loss making ventures such as Deccan charges, retail ventures etc.

Over time these cash guzzling businesses consumed the entire cash flow of the core business and more , resulting in high levels of debt on the company. The management on its part, hid the problems and the extent of the debt from the shareholders. When the same was disclosed, the stock price collapsed.

It was not easy to see this problem coming (atleast to me) as the annual report as late as 2011 did not display any kind of serious problem. We had a failure of corporate governance and lack of appropriate disclosures (fraud or not, I am not sure).

Weak core business
The case of zylog systems is different. If you read the past annual reports, you will be able to see that the company has not been generating adequate free cash flows and has funded the high levels of growth via debt. The ‘cliff’ seems to have happened due to the following events

  1. poor operating performance resulting in cash flow problems (in addition to commoditization of the core business)
  2. Cash flow problems resulting in higher debt which was taken to fund the growth
  3. higher debt resulting in promoter pledges to get the funds
  4.  Point a. causing the stock to drop, resulting in margin calls and forced sale of the pledged stock.
  5. The forced sale, causing further steep drop in the stock price
Difference between the cases
Although the end result is the same (as of today), the underlying cause is different. In addition, it is easier to identify companies with a weak core business (and high debt and promoter pledge).
In comparison, companies like Deccan chronicle had a healthy amount of cash on the balance sheet until it suddenly became known that there were a lot of hidden issues (and debt). Such companies are more difficult to identify and one is likely to only get some faint signals that there is something out of place.
So what can one learn from the above cases ? Let me share mine

  1. Follow the cash flow, ahead of the profits. If the company is showing a high level of growth, which is increasingly funded by debt, one should get cautious. It is a time bomb, which can blow up if things don’t play out as planned.
  2. Poor Capital allocation – if the management is investing in all kinds of ventures with a history of poor profitability, then one should avoid such companies . These kinds of decisions eventually catch-up with the company.
Disclosure : Have invested a tiny amount  zylog from a tracking perspective.  Please make your own decisions and read the disclaimer


Investing Thoughts said...

Hi Rohit,

Good post! I think you can add one more company in this "cliff" list : Arshiya International.

Company price is down around 50% due to cash flow issues.

This could be in second or third (new) category depending on quality of business.


Anonymous said...

Hi Rohit,

One other company in the "IT" Sector is Glodyne Technoserve. I was going through this company and it looks like a fraud company to me. Can you have a look?

BTW, it has a similar graph to the one's above. A "cliff" pattern :)

Best, Vidyanshu.

zulfiqar said...

what made u invested tiny amount in zylog, u must have some logical reason?

zulfiqar said...

what made u invest in zylog?

Anil Kumar Tulsiram said...

Thanks for another good post. Just want to share my experience and learning by investment in Deccan Chronicle.

This is not a stock which I buy in general but made an exception as I saw there was probability of substantial profits and also probability of total loss of capital. Invested very tiny amount for experimental purpose. But it was a great lesson for me in learning that we should sell the stock when the reason to buy it no longer remains, instead of inventing new reason to continue to hold. Another lesson was in most cases ‘cockroach theory’ holds true and just like there is never a single cockroach in kitchen, there is never a single problem. I bought it in early August 2012 believing on newspaper reports that debt is around 1,500cr and on that enterprise valuation of around 1,800cr, I thought it still holds some value. But the mistake I made was I did not sell in Sept-12 when the total debt zoomed to 5,000 cr. I could have sold it at INR 10 even at the lowest price in September-12, but I hold on till Dec-12 and finally decided to sell at INR 6 after CDR was refused and ALL independent directors resigned

Rohit Chauhan said...

investing thoughts
yes true , ashriya is going through the same. however i dont see anything new ...its the same - high leverage, cash flow problems and the market now punishing the stock hard on it


Rohit Chauhan said...

hi vidyanshu
oh there are many more - glodyne, crane etc which have dropped off the cliff.

i checked glodyne earlier ..i could not see outright fraud - atleast not at any big scale. it seems to be same story - pricey accquisitions, commoditizing busniess and weakining cash flows all leading to unsustainable debts

on a broader basis i am getting very concerned of the IT space. it is commoditizing fast and we are seeing the impact the lower end ..will it catch up with the big guys too ? time will tell


Rohit Chauhan said...

i am testing a hypothesis that the management will fix cash flow problems and the business is worth more than the current mcap

however it is a speculative position with a large probability of loss. it is also a very tiny, insignificant position


Rohit Chauhan said...

hi anil
i would not call such postions a mistake. i do such things actively - on very tiny amounts

these position have a large learning value which is worth more than the money lost. one could get the same by just watching it, but when you put real money, the experience is very very different.

it helps one in avoiding such mistakes in the larger serious position.

I have actually allocated a very small % of the portfolio to such speculative plays


Nandish said...

I actually don't track Deccan Chronicles but I'm curious as to how such a huge pile of debt was hidden? Can you just briefly help me understand or any article which I could go through...Thanks

Mokhtar said...

In Zylogs case more than the cash flow problems, I think it is just the recent Satyam scam fresh in investors minds which made them sell and the stock kept collapsing. Perfect example of 'Herd mentality' at play.
Zylog officials say they have the financial strength to withstand the crisis. May be they are right may be not. But at current levels there seems to be tremendous value. U too find value at th current levels right?

Vishal Mittal said...

Rohit, very nice post.

I think a major part of investing is avoiding such bets! It can kill years of compounding.


Pradeep Raghunathan said...

Hi Rohit,

Your position in Zylog and the thought process behind the same is well explained in this post which I found very interesting:


Niloy Gogoi said...

Very nice post. As said - it is important to learn from history - the prepared mind learns from others mistakes.

Anonymous said...

Excellent article Rohit.

It is coincidence, I was just discussing the same with a friend few days back.

I have seen such examples over and over again i.e. ppl loosing money when they enter other businesses than their core expertise.

It is restlessness and sometimes the suggestions/advise from our friends that lead to such ventures.

Good one..keep such gems coming.


dilip said...

nice post, very good learning,
can u give some opinion on gmmpfaudler/gujarat machinery, listed on BSE. fallen from 140 to 72 in 8 months- after buyback at 88 which closed about 1/2 months back