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

deccan1 zylog
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.

Learnings

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

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