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.

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