My decision to sell L&T in 2003 (after holding for 4 years) has been my worst investment decision till date. Although my cost basis was 190 odd (pre-divesture) and I sold at 230 odd (again pre-divesture) and did not lose money on it, I consider it to be one of my worst decisions because of the following reasons

1. The stock has since then become a 10 bagger (sells at around 2250 without considering the value of cemex)
2. I sold off because I became exasparated with the management. Between 2001 and 2003, they would constantly pay lip service to divesting the cement division and would then drag their feet on it. What I failed to realise at that time was that the Kumarmangalam birla group would be able to force the management to divest the business eventually.
3. Did not appreciate the importance of the business cycle. The E&C sector was in doldrums at that time and as a result L&T (E&C) division profits were depressed. The E&C sector turned around big time after 2003 and every E&C company has benefited since then
4. Did not do the sum of parts analysis – basically that the sum of value of the various L&T divisions was more than the complete entity.

In the end, my regret is not that I missed a 10 bagger. What clearly pricks me is that my analysis was sloppy and I did not evaluate all the factors clearly. I was looking at the company with a rear mirror view (the Margins and the ROE were poor then and I expected it to continue).

However, I have tried to learn something from this disaster. So here goes

• understand the sector dynamics when investing in a stock.
• Appreciate the importance of business cycle. Although predicting it is not critical, but a basic understanding is a must.
• Focus on sum of parts versus looking at a company as a whole, especially if the company has various different businesses.
• Have patience
• Try to avoid a rear mirror view.

Have you had such an experience?

As a value investor I have always been concerned about a value trap. A Value trap is a company, which remains cheap forever, and you are not able to make any money out of it.

Now a company can be a value trap for a variety of reasons, which can be

1.The company performance keeps deteriorating and as a result the intrinsic value keeps going down
2.The market just ignores the company and the sector because there is nothing exciting happening in that sector and most of the companies are hardly glamorous
3.Management action can result in a value trap too. The management keeps blowing away the excess cash into unprofitable diversification instead of returning it to the shareholders

So how does one avoid a value trap. I think this is a very important consideration of value investors especially if one is investing in ‘graham’ style bargains. A ‘Catalyst’ is something which one should look out for to avoid a value trap.

A catalyst can be any of the following

1.Likely management action such as buyback, bonus etc
2.Likely asset conversion opportunities such as LBO, de-merger, accquisitions (think L&T for an example of de-merger)
3.Likely shift in demand supply in favor of the company due to changes in the business cycle – steel and commodity companies in the last few years come to mind.
4.Regulatory changes – Banking comes to mind
5.Unexpected earnings increase
6.Finally time – However one should have a defined time horizon in which one would expect the investment to work out.

So when I look at value or deep value stock, I tend to look beyond the numbers. Is there a likely catalyst, which would unlock the value, or am I getting into a value trap? and how long will it take for the catalyst to be play out. That would define my expected returns too.

Ofcourse this concept of catalyst is not some original concept of mine. It is referred to frequently by Mario gabelli and Marty whitman.