I have an engineering background and a very quantitative/rationalistic lens of looking at the world (does not mean I am rational). What I mean is that when I am analyzing a company and valuing it, my assumption is that all investors will ‘objectively’ look at the numbers and value it in the same fashion.
This approach to investing has its merits and works most of time. However, it has limitations and overweighing it leads to problems.
The above is the performance of a company which by all objective standards has done reasonably well. It has grown topline at 14%, profits at 19% with an ROE of 17% over the last five years. However, the stock is down 70% during this period.
Now you may thinking that this company has some governance issues and there is something seriously wrong with its business model. Let me share the name of the company – Its Repco home finance. This is an old position and you can read the prior analysis here.
We closed the position in Dec 2016 when the company was selling at around 22 times earnings. The main reason for exiting the stock was that I was concerned about the quality of the book (NPA). How did the NPAs turn out?
I hate to say this, but I was right for the wrong reasons. The NPAs have risen in the last few years, but the rise has not been alarming, and it includes some of the worst periods for economy and the financial services Industry. Inspite of that the company closed FY20 with 4% GNPA (which is similar to most private sector banks).
The net NPA for the company is 2.8% which is not high and should improve going forward. So by all objective measures the company has done well but the stock is down 70%. It is selling at around 5 times earnings and 70% of book value.
We can all debate about what the future holds, but based on the past few years it is unlikely that it will be worse than the last few years. The above is but one example of how narrative often overwhelms the performance of a company.
A rationalist like me would say – Lets wait for some more time and the market will eventually recognize the true worth of the company. But the point is how long should one wait ? 3,5 or 10 years ? There is an opportunity cost of holding such a position
This kind of scenario has played out with a few of our other positions and has made me question the limits of fundamental analysis. This does not mean that fundamental analysis has no value and should be thrown out of the window. That would be equally foolish.
In order to account for such cases, I have become more sensitive to the narrative around a company and a sector. If the narrative does not change and the stock price does not reflect the fundamentals, then I am more likely to exit a position even if the numbers are fine. We can always re-enter the stock when the market starts changing its view.
Investing in the markets is not an engineering problem which can solved by logic alone. In the past I have failed to account for that to our detriment. The best way to manage this kind of trap is to have a time fuse for each idea. If market does not come around to your view inspite of no change in fundamentals, then one should just exit – No questions asked !
