I wrote about two companies in January – Deccan chronicles and Zylog systems (read here).

In case of deccan chronicles, the stock had  dropped more than 90% from its peak and a debt default and other allegations were already in the newspapers.

In case of zylog, my impression from reading the annual reports was summarized as follows

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 3 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

As part of the disclosure, I indicated in the post that I had a very small speculative position in the stock and in the comments section provided the following rationale for it

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

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.

A new update

On June 14th, SEBI barred the promoters (read here) from buying or selling any securities in the stock market

The key points in the news article seem to be the following

Sebi had, suo moto, carried out an examination in the scrip of Zylog Systems in view of surveillance alerts regarding variation in price. Sebi during examination of the scrip prima-facie observed that the company provided misleading information to the stock exchanges wherein it stated that its promoters have been buying and increasing their stake while actually the promoters were net sellers and their shareholding declined due to invocation of pledge by financiers. Similar misleading clarification was also given by the promoter of Zylog Systems, Sudarshan, to the media.

Sebi order said that Zylog Systems disclosed incorrect and false information in the quarterly shareholding pattern for the four quarters in the year 2012 to the stock exchanges by overstating the holding of the promoters and understating the quantum of shares pledged by the promoters.

Sebi also observed various instances of non-adherences to accounting standards and listing agreement in the annual report by Zylog Systems.

In addition to the above, the latest results show that the promoters have pledged close to 95% of their holding in the company (up from 75% in the previous quarter)

What next

As I indicated in the earlier post, I created a small tracking position to follow the company and confirm my thesis that the debt/ cash flow problems are temporary and should get solved.

I am not sure if the thesis will turn out to be correct or not, but the SEBI order changes the whole picture. I am fine with poorly performing businesses and will hold the stock for the long term if the management is competent and working on fixing the issues. However, if there are corporate governance issues, then all bets are off.

Although the position was small, a loss always pinches. In this case, I walked into it with open eyes – a case of self torture 🙂


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.


Charlie munger (warren buffett’s partner at Berkshire Hathaway) was recently asked about his views on macro and he said something to the following effect (in my own words)

“If thing are bad now, they will get better in time. If they are fine now, something will go wrong in due course. We don’t make money by predicting the timing. At Berkshire, we’re trying to swim well against the tide or with it, we just keep swimming.”

If you have not heard or read about Charlie munger, I would suggest that you read up anything you can find about him. He is one the smartest and wisest person you will ever come across.

Ignoring macro ?

It was fashionable among value investors to completely ignore the macro till the crisis of 2008 – they spoke about it as a badge of honor.

The pendulum has swung the other way since then. I see a lot of investors being cautious about macro, to avoid a repeat of 2008.

I think macroeconomic thinking can be broken down into two elements

– Understanding  industry dynamics and trying to evaluate the long term economics of the company

– Understanding macroeconomic variables such as inflation, interest rates etc and trying to forecast or guess so as to make investment decisions.

The first element is crucial in understanding the company and its profitability in context of its industry. One needs to be aware of the competitive situation in the industry to be able to figure out the long term outlook for the company.

The second element which is generally reported on by media and guessed by an army of pundits, soothsayers, forecasters and talking heads is a waste of time. Very few, if any can forecast any of these variables with any level of accuracy and no one gets it right in the long run (remember oil was supposed to go to 200$ / barrel in 2008 ?)

The comment by Charlie munger should be seen in context of the second aspect of macroeconomic thinking – there are variables such as interest rates, exchange rate etc which can impact your performance, but as they cannot be predicted , it is far better to concentrate your energy on understanding the company and its industry and learn to live with the other aspects of macroeconomics  (interest rates, inflation, exchange rates etc)

The capital goods industry

Lets look at an example. The capital goods industry is going through one of the worst cylical downturns in the last 10 years. The last time the industy went through such as patch was in the 2001-2003 time frame (I remember those times !).

I don’t think anyone can predict with precision when the cycle will turn  (although a lot of people claim to be able to do so), but one can be sure that the cycle will turn eventually.

If you can understand the economics of this industry and can find some high quality firms at reasonable prices, I am sure the returns over the next 2-3 years will be good. Let me give a tip – Look at a company like BHEL or blue star or thermax and ask these questions

– Are these companies likely to go out of business soon ? (current valuations seem to say so)
– Is it likely that these companies will do well once the cycle turns ? (though we don’t know the exact timing ?)
– Are these well managed companies with competitive advantages ? ( I believe they are)

The typical talking head on TV or broker needs to be right in the next 3 months. As an individual investor, I don’t have to play by the same rules. If I can find a company which will do well in the next 2- 3 years, I can ignore the near term outlook.


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)