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

 
 

images

Wish you all a very happy new year

 
 

Mid-caps and small cap stocks have an average standard deviation of around 18-20% per annum. The implication of this factoid is that these stocks can drop or rise by 15%+ over a year for no fundamental reason at all.

Anecdotally most of us have seen a drop or rise in the stock price by 15% or more within a quarter, even in absence of any stock specific news. One can say that the stock price in such cases is being driven by noise.

What is noise?

In layman’s term, noise is variation without any underlying cause. In other words, the probability of the upside or downside is around 50%, which is the equivalent of a coin toss (random event). So if you expect a 15% variation due to noise, the probability of increase or decrease is the same with the expected value being zero ( expected value = 0.5*upside+0.5*downside)

Trading on noise

If your trading or investing strategy involves a 15-18% upside on the current price within a year, it is quite likely that the stock price may rise for no reason other than random fluctuations. In such a scenario, you may end up making money for no specific reason – though you may think that it was the result of your accurate analysis.

The risk of making money in such a way is that one ends up with the wrong conclusions, even though the real  cause of success was sheer luck (for further understanding of this phenomenon , you should read the book – fooled by randomness).

In addition to a faulty understanding, the long term returns can turn out to be sub par as the expected value for a series of such trades is essentially zero (upside and downside being equally likely).

Financial news is all noise

I am sure most of you have watched the financial news channels. Almost 90% of the time is spent on explaining the fluctuations during the day, which for the predominant part is just noise. Ofcourse you will get some information or insight if you spent the entire day watching this circus, but it is like chewing a ton of grass to get a litre of milk.

There are far more efficient and easier ways to get the required information – annual reports or magazine articles being some of them. One should watch these channels for entertainment and not for information.

Noise trading quite pervasive

IF you think that trading or investing on noise is a rare occurrence, you may be mistaken. I am sure most of you would have seen analyst reports or talking heads recommend some stock with a 10-15% upside in the short to medium term.

If the random fluctuation of stocks is 15% or more, then some of the recommendations will achieve this upside for no reason at all. The unsophisticated investor would erroneously consider the analyst to be skilled at picking stocks and may start following such people or worse, even pay for such advise.

How to see through such tricks?

I will suggest a simple set of rules to ignore analysts and their stock picks if the following is true

–          A price target with a 15-20% upside within the year

–          A success rate of 55% or less in terms of success rate (preferably over a year)

–          Completely confident and sure of the picks (no allowance or probability of error)

Now, you may be thinking that the above is an unrealistic and harsh set of expectations. Let me ask you this – In your job or business, does your boss or customer give you a raise or money for being wrong more than 50% of the times?

As far as I know, if someone goofed up 20% of the times or more, he or she will be out of a job or business. Why should the expectations from an analyst be any lower?