December 15, 2013

Patterns of failure

Failure is a better teacher than success. This holds true in the case of investing too. I have been looking closely at some of the recent cases such as Arshiya international, gitanjali gems, CEBBCO, Kingfisher airlines, Zylog limited and some older ones such as reliance communications, DLF, SSI, aftek and many more.

These are extreme examples of spectacular drops in stock price of 80% and more. These examples are the exact inverse of multi-baggers and a few of such positions can decimate one’s portfolio. I have mostly been able to avoid such cases in the past (except SSI and zylog, which was self inflicted) and think it is important to avoid such extreme failure to make above average returns
Why analyze such cases? On that count, I am following these comments from Charlie munger on learning from failure

You don't have to pee on an electric fence to learn not to do it
Tell me where I'm going to die, that is, so I don't go there
It is not always fraud
I have seen an oversimplification on the cause of failure in the above cases. A lot of investors think it has been caused by management stupidity or greed. The reason for this conclusion is due to some high profile failures such as satyam.

It is easy to say that the management was unethical (Which is true in several cases) and hence the business failed. I think that is intellectual laziness. There are several other companies where the management is a bit suspect, but the company and its stock has not collapsed (though did not perform as well)

Some key factors
On going through all these companies, I am able to see some common threads. These factors may be present in combination in some cases or one of the factors could be dominant in others. In most cases, however it was the combination which sank the ship
1. Low return on asset/ equity due to commodity or highly competitive business (think airlines or telecom)
2. Low free cash flow (after taking into account Working capital needs and obsolescence risk/ business model changes )
3. Growth obsession funded by debt, resulting in high debt equity ratios (2:1 or higher
4. Cyclical industry with 1,2 and 3
5. Growth obsession with expansion into foreign markets (most likely from pricey acquisitions) stemming from management’s grandiose views of building an empire (rather than focusing on value creation)
6. Management failure/ governance issue (with diversion of funds into sister firms in some cases)

The steps to destruction
Let’s look at some kind of chronology of events leading to the eventual collapse in the stock price

1. Company experiences temporary success due to a cyclical high or tailwinds (look at the long term base rate to identify this situation). In some cases, success is from sales perspective and ROE and cash flows are still weak.
2. Management feels bullish and starts adding capacity/ businesses. In a lot of cases this is funded by debt or FCCB type equity.
3. In some cases, management goes abroad and acquires assets at high prices stemming from delusions of empire building (aka ‘Indian name’ in foreign lands)
4. Business encounters a hiccup or a cyclical downturn. The cash flows dry up and management finds it increasingly difficult to service the debt.
5. Management fudges the numbers for some time and tries to keep things afloat (bullish statements, confidence in the business inspite of worsening fundamentals such as negative cash flow, worsening debt service ratios etc)
6. The pack of cards finally collapses when the company defaults on its debt (openly or in private). When the market gets a hint of this, the stock price collapses almost overnight and the outside investor is left holding the bag

What to avoid
If you like the principle of inversion and think high cash flows and low debt is the sign of a healthy company, then one should avoid a company with poor cash flow and high debt irrespective of the story or future prospects (which are always rosy).
It’s quite possible, that you may miss some of the real turnaround cases, but on the balance I think it one would do much better by avoiding such companies

Bull market stocks
A lot of companies with poor cash flows and high debt did quite well during the previous  bull market and a majority of the investors choose to ignore the red flags. Why bother, when you are making money ?
It is during tough market conditions, that the chickens come home to roost, and a lot of investors (me included) get a lesson on risk.

Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions. Please read disclaimer towards the end of blog.


Prem Sagar said...

Thanks for the post Rohit. Enjoyed reading it.

Not only is failure a better teacher, success is sometimes a lousy teacher - esp when success happens early.

For guys like me who aren't as intensive as you are - this inversion principle is fantastic. I always have difficulty in choosing what to invest in, but have lesser difficulty in deciding what NOT to invest in. Your list is quite bang on - avoid high debt, poor ROE/ROA, poor cashflow, poor working capital discipline and frequent equity dilutions. This itself will serve any average investor well - avoiding the big mistakes.

That said, whats your take on cases where the company seems to be doing well on other parameters, but promoter has a few red flags.

Would like to know your opinion on it. (That too is a strong red flag to me irrespective of the returns that you may miss).

Anonymous said...

One of the major factors to include would be wild 'Government Policy changes' (Gold/Jewellery stocks, Mining stocks, PSU stocks, Sugar,....) in addition to 'Unethical Management' (most of Marwari/Baniya run companies, Ambanis, Ruias who have governments in their 'pockets', Ahmedabad/Hyderabad headquartered companies) regulators who do not regulate (SEBI, SAT,..) Lax laws. Not many companies left for us to invest in India?

Venkat said...

I was not able to avoid zylog and CEBBCO,may be i had an over confidence bias. After the loss i just raised the entry criteria to make sure i buy companies with good management background. Nice post and thanks for the list of items to watch out in an AR.

Rohit Chauhan said...

Hi prem
I personally want to avoid companies with a bad management. In the end I need not more than 10-12 companies why partner with bad management. it is tough enough with good business and good management.

I have filter now in place where I reject or sell a company if don't trust the is too short to have such aggravation


Rohit Chauhan said...

hi anon
yes ..agree with you. govt regulation is an issue too.

however how many companies does one need to build a good long term portfolio ? I would say 10-15 ..that is quite possible even with all the problems


Rohit Chauhan said...

hi venkat
same here with zylog ..I was got entinced with the cheap price.

I was rightly punished and have learnt my lesson. never partner with a bad management price is low enough. it can always be 0


Stock Lover said...

I already punished with Allied Digital so i escaped from Zylog.

Dhirubhai said...

Yep... suffered a 90% drop on Allied digital, a long case of going nowhere in Tata Elxsi and Hinduja global. Currently I am going through similar case with Tide water oil. At some point I need to decide which ones are worth the pain. A steady, consistent and growing dividend (hinduja global, tide, Balmer) usually prolongs the ordeal for me else I have learnt to cut losses and sometimes even save on my taxes.

BTW, nobody's talking about it but did you notice the Bakshi Effect in Indian Markets similar to the Barrons effect :-)

shiachin said...

I was able to 'duck under' all these debt traps. I simply walk away if company is making money from current operations but its debt keeps on swelling. Also thing to keep eye on equity capital, dividend yield and promoter holding to screen stocks for larger understanding.
For me the desire to grow bigger should be based on debt and loan.

Anonymous said...

IKF Finance - There is a rumor that a PE is going to invest in the firm at Rs 35 post delisting. Pls have a look at the company.

Rohit Chauhan said...

stock lover - we all have our scars. guess we learn and move on

companies like HGS or balmer will not go down the drain as they are generating a lot of cash and do not have debt. they can stagnate, but will not crash

yes, I have noticed the sanjay bakshi effect on some stocks, but the price comes back after some time. most people don't have the patience to hold a good idea

Rohit Chauhan said...

achin - cebbco did not have high debt to begin with. they got caught in a downcycle and could not service the debt. its a combination of debt and nature of business which turns out of lethal