The midcap index is down by around 7% since the start of the year and the small cap index is down by 9% during the same period.  That is quite a drop in a span of 45 days and it still does not represent the true carnage which has occurred in a few stocks which have dropped by 20% or more in the span of a few days.

The standard prescription

The standard prescription is to follow the fortunes of your companies like a hawk and to buy and sell the stock based on short term expectations. This approach helps you jump in and out of stocks and be ahead of the market at all times.

This prescription works well for highly cyclical stocks such as cement or steel where one needs to time the buy and sell decision to get above average results. The same approach is a disaster if applied to companies with above average economics (high return on capital with good growth prospects) at the hint of the slightest slowdown

I have personally paid the price for jumping in and out of stocks based on short expectations – such as with asian paints and marico (and more). I purchased these stocks in 2000 and sold them off in bits and pieces from 2006 and onwards.  The opportunity loss in all such cases has far exceeded the actual losses from all my failed stock picks

I won the battle (short term), but lost the war (long term).

How to handle such times

It is easy to preach rationality and follow it during times of rising markets. It is however a different ball game to be rational at a time such as now, when stocks can suddenly drop by 20% or more in a matter of a few days.

One way to prevent knee jerk reactions is to avoid checking your portfolio everyday.  One needs to turn off the financial channels and stop tracking the portfolio on a minute by minute basis. I really doubt the long term returns of one’s portfolio are dependent on any breaking news, which by the way is generally some useless piece of information

In addition to the above, one needs to have an appropriate level of diversification in the portfolio. I  general limit each position to around 5-7% in the portfolio to dampen the volatility. A higher level of concentration and the associated returns are thrilling when the market is rising. However during market swoons such as now, the momentum can suddenly turn and make a lot of individuals nervous. A focused portfolio is of no use, if you exit your positions at such times.

Finally, it is important to analyze the fundamentals of the company and try to look at it with a fresh mind after each quarterly result. It is important to avoid anchoring the thought process to the buy price and the original thesis and one should  look at the company based on the current price and its future prospects

What if I am wrong ?

One certainty about investing is that you will be wrong occasionally. The super investors are wrong less often than the less successful ones, but still make wrong bets.

In my case, if one of my picks crashes or the company comes out with a really bad set of numbers, the first thing I do is to avoid looking at the company for a few days – no I am not joking. The reason I avoid looking at the company is to prevent myself from reacting emotionally and taking a hasty decision. It is quite possible that I may lose 10-15% more on the position, but overtime I have realized that a calmer mind helps me in taking a more rational decision.

Once the panic dies down, I generally try to look at the results and key indicators of the business and try to see what I am missing (which the market sees). In several cases, I may conclude that the market is over-reacting and may decided either to do nothing or even add more to the position. Sometimes though, I have realized belatedly that I have messed up and  that the best course of action is to exit (and feeling like a fool at the same time).

A few months later, I will come back to the mistake again and analyse it further to avoid making the same mistake again (new ones will still happen!)

What next?

It is quite likely that things could get ugly before they get better. I personally have no way of knowing the future and my investment approach is not based on getting the short term right. I prefer to look at the 2-3 year prospects of the company and if the company is moving in the right direction, I would rather just buy and hold the stock (or buy more if the stock gets cheaper).

 
 

We are deep into the quarterly result season and most of the channels and papers are talking about the X% growth or drop in the profits of companies. It almost feels like a fashion parade J

A few years back, the stock market reaction to quarterly numbers was not too high and stocks would rarely move by a few percentage points. Now a days, it is quite common to see a 5-10% swing in the stock price, based on whether the company has beaten or fallen short of expectations. Most of the times, the expectation is around the net profit with minimal analysis beyond the reported numbers.

If you can keep your emotions in check and look beyond the headlines, you can make some sensible investments during such emotional reactions

Homework

For starters, one needs to have done his or her homework before hand. You have to constantly look for new ideas and analyze them in detail on a regular basis. A lot of times, the company could be performing well, but priced for perfection (high valuations).

In other cases, the company could be going through a cyclical downturn and the stock price would be reflecting the near term bleak prospects (though the long term could still be good)

In all such cases, one should do a detailed analysis before hand and have a trigger price in mind. If you are lucky, a excessive reaction to the result could give you an opportunity to act.

Digging through the results

Once the annual / quarterly results are announced, it is important to analyze the results in detail and look beyond the obvious numbers.

For starters, look at the lead indicators. For example, in case of banks and financial institutions, disbursements / approvals start rising before the topline and profits pick up. If you keep a track of this indicator and see it rising, it is a good indicator that the performance of the company is likely to turn around soon.

If the price is right and the lead indicators point in the right direction, it may make sense to start a new position in the stock.

Have a sense of the business cycle

In addition to the obvious indicators, one needs to have sense of the business cycle too. You don’t have to predict the exact timing of the turn, but a general sense will help. This is relevant for the cyclical industries such as capital goods or materials (cement, steel etc) and banking too.

The quarterly results could give you a sense of the drop from peak to trough (drop from the peak profit levels) and can be used as a rough guide to plan your purchase.

Read /listen to the conference call

The conference call is unique source of information which is not available through any other channel. One should read the transcript or better yet, listen to the conference to gauge the thought process of the management and the direction of the business.

All the above suggestions may sound fuzzy to you and do not provide a clear buy signal at any point of time. The problem is that by the time the signals are clear and loud, it obvious to everyone that the company is doing well and the price starts reflecting the same.

If one wants to generate above average returns, then it is crucial to keep your emotions in check and look for the faint signal in all the noise. One needs to look at the results holistically and digest both the quantitative and qualitative information to arrive at a conclusion (which often means doing nothing). It is not as difficult as it sounds, but requires a different mindset and practice to have some success at it.

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.

 
 

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