April 29, 2013

Snatching defeat from the jaws of victory

I wrote about hinduja global solutions (Now HGS) in jan 2009 (see here). The company was selling for below cash and thus the operating business was available for free.

As we know, the stock markets recovered by May 2009 and HGS was up 200% in a short span of 4 months.



In case you are wondering, this post is not about how I smartly exited in July and make 200% of capital.

The company performed extremely well in 2010. Net profits were up by 100%, Net margins hit 14% and this was inspite of the company carrying a large amount of cash on the balance sheet. I was feeling pretty smart about it.

The slow slide
 

The price action from the peak in 2009 shows only part of the story. The company has increased its sales from around 900 Crs in 2010 to around 1550 Cr in 2012 at a CAGR of 30%+. The net profit  however dropped from 130 Crs to around 106 Crs in 2012 and may drop further to around 80 Crs in the current year.

I kept buying the stock during this period, anchored to the earlier levels of profitability.
The company has thus been able to grow through a combination of organic initiatives and acquisitions, but saw a drop in profitability due to lower margins and lower capital turns. In effect, the growth came through, but the economics of the industry has deteroriated during the same period. The company has gone from above average profitability (20%+ROE) to below average levels in the current year (single digit ROE)

The lessons
There are two key takeaways from the above loss.

The first lesson is that if the initial expectations on the economics of an industry do not play out, one should accept the reality as soon as possible and act on it. The second lesson for me is that I should give a higher weightage to the qualitative aspects of the business and not focus too much on the valuation. In case of HGS, the large amount of cash on the balance sheet (and corresponding low valuation) distracted me from the deteriorating economics of the business – A value trap.

The blind spot problem
I have looked at the various companies in the past and have wondered why others keep buying/ recommending it when it is obvious that the company does not have above average profitability and cannot be a good long term investment.

The thing with blind spot is that the same issues are not visible to yourself, where one may keep rationalizing your own decision for a long time.

It is not easy to accept a mistake, especially a slow one , resulting in the boiling frog problem. Hopefully this lesson will stay with me for a long time and prevent me from making the same mistake again (new ones will however happen)

12 comments:

Anonymous said...

Rohit,
any soft signs that one can keep track of to escape such a value trap?
Thanks,
Vinay

Pradeep said...

Hi Rohit,

Good post.

One question. How do you differentiate between minor blips in profitability (which can be buying opportunities for value investors) to a structural shift in the business economics? i.e. How not to throw the towel early? :)

Pradeep

prasanna sabat said...

This is one of the worst company in terms of work ethics,HR Policies,a close relative was working there.I wonder how such companies run their business. But the more worrisome part is the Indian IT companies are moving in that direction slowly, check here:http://www.prasannasabat.com/2013/04/wake-up-call-for-software-professionals.html

Anonymous said...

Very Well said Rohit. I have faced similar issues with Deccan Chronicle where I bought it at around 30s and did not exit at high 160s and then bought more during share buyback by mgmt and existed at Rs.9.
I wish you threw more light on the bias of adding to your investment which proved to be profitable before. I tend to do this mistake over and over again. Did this with Ador Fontech, Mayur Uniquoters and now somewhat with Atul Auto. When a stock you bought at a wonderful price appreciates say 70% or 100% in the next 3 months and it then comes up with a wonderful quarter, we tend to buy more of that stock (endowment bias,recency effect and also Vividness). To avoid this inbuilt bias in us, we need to evaluate each buy decision in its own light without considering what we bought it before and how it performed. I think that has been one important learning for me in the recent months.
I have a question for you on something else. While it is easy to say one should sell when the business returns less on our investment (ROE) or when the fundamentals have changed or we made some mistake, it is difficult in practice to do that. For example, I bought VST Industries at such price that my dividend yield is now 13%. I knew that the market priced it way higher than its earning potential when the net profit went up substantially (knew it cannot repeat it year on year), however I did not exit because I liked the business and wanted to ride it as long as possible. I know the long term earning growth potential of this stock is around 6 to 8% max (on an average). So, if the PE remains same (which may not be the case as it is high now), my expected return based on my previous buy price is 13% (div) + 8% (growth) = 21%. However, I think this is wrong way of looking at it because I need to look forward and the actual expected total return is 4 (current div yield) + 8% = 12%, which is not crossing my expected hurdle rate of say 15%. So, If I am rational, I should sell VST and invest in an oppurtunity where I can get something close to my expectation. What I am confused is, should I compare VST current valuation with my hurdle rate or should I see if I can find an alternate investment for VST which would earn more than 21% ? Which one is correct? Offcourse as of now I do not have an alternate solid idea (with minimal risk) that would generate that kind of return now. If you assume that you are in this scenario, what would you do?

Regards
Ravi

Anonymous said...

Hi,

I have recently got hold of old Warren Buffet transcript where he makes a fantastic comparison between AT&T and Thomson Newspaper. You should read that because HGS looks like AT&T.

CEO , CFO are human beings and make disastrous Capital Allocation mistakes esp when there is large cash. (I have heard from chetan parik's interview that Cash on the books is future goodwil)

But there are some obvious red flags (in their Annual Report they give chart of how many companies they have acquired in 2-3 years).

But the decision behind investing in HGS is not bad given the amount of data/information available at that time (during 2008). We will never know what CEO / CFO are going to do with cash.

Regards
Vishnu

Rohit Chauhan said...

hi vinay
there no quick formulae for it. for starters one needs to see if the expectations in terms of industry and company profitability are being met ...one or two quarter is ok ...but more than one year is an issue

the second is capital allocation. does the management keep investing and still generates below average returns ..if yes, then one should look at exiting

rgds
rohit

Rohit Chauhan said...

hi pradeep
thats the million dollar question :) i dont have an easy answer. the best i can say is that one needs to understand the industry deeply, but in the end it is the heart of investing.
in some cases, it is possible to use porter's models or clayton christensen's models to get an idea. in other cases you will realise it well after the fact

rgds
rohit

Rohit Chauhan said...

hi prasanna
i am talking of the company as an investor and not an employee.so i cannot say anything on that count

rgds
rohit

Rohit Chauhan said...

hi ravi
i think you have more or less answered your question.
the price we buy and the gain we have made frankly should not have a bearing on the subsequent decision. that ofcourse is easy to say. most of us get anchored ...me too

in case of vst you mentioned dividend yield of 13% which is on cost basis. i dont think you should look at cost. look at what future returns you can get from the current price including current div yields as any new investor would look at. is it better than the alternatives

you will be surprised by the answer you get to this question sometimes

rgds
rohit

Rohit Chauhan said...

hi vishnu
yes decision in 2008 was not bad,but by 2011 it was becoming clear that the industry was going downhill and the accquisitions were not giving high returns.
it was a mistake on my part to get anchored to earlier fundamentals and not sell sooner

rgds
rohit

pooja said...

Well 3 years may not be long term for a company? While it wasn't a good investment in past three years in terms of stock price, the stock still gives dividend to you while you wait, So isn't it worth waiting and may be these guys will pull it off?

Rohit Chauhan said...

hi pooja
true ...but every investment has an opportunity cost. by waiting, i have raised the cost even further...question how confident one is about the future prospects of the industry

rgds
rohit