This expression is used when one buys a stock where the price is spiralling down. The expression implies that if you try to do that, you will get hurt.

I have seen this expression used indiscriminately. If the price of a stock is dropping, it does not mean that it is a falling knife scenario. There are a few conditions one must look for to avoid such a situation

– The core business is hurting and the company is losing money. However at the same time the business model is also broken and the company may not return to profitability in the future
– There is a crisis of confidence in the company. This in turn impacts the company’s ability to raise capital. This is true in case of banks and other leveraged instutions.
– There is a likelyhood of fraud or other manipulation and as a result one does not know the underlying situation and cannot arrive at the business value

There have been a few such situations in the US (Global trust bank is one example I can remember in india), especially with financial firms. Banks and other leveraged companies operate on trust. A bank is technically insolvent and is able to operate based on the trust that the depositor will get his money back when he or she requires it. If the stock price or credibility starts dropping, it can become a self-fullfilling prophecy. If depositors panic, the bank can be driven to bankruptcy. Case in point: Lehman brothers, Indymac, Wachovia etc in the US.

I would personally never invest in such situations, especially if the institution is highly leveraged. It does not matter what the facts are as perception trumps reality. If everyone thinks the bank is toast, then it is toast. Once the stock price drops to a low value, say 3-4 dollars, then it becomes a matter of bankruptcy or bailout for the bank.

Another example : Citigroup has dropped by more than 60% in the last 2 weeks. The US government will not allow it to go bankrupt as it too big to fail. However equity holders may get wiped out. I never want to invest in such situations. Such situations are akin to a call option on the company. There is a low chance of the company recovering and one making good money out of it. So it is almost like a lottery.

The case where one can look at investing in such situations should be the one where the company’s survival does not depend on its stock price and the company does not require outside capital. In such cases, the managers have time to fix the business and bring it back to profitability. If the company has an underlying franchise, all the better. Examples of such situations were Mcdonalds in 2002-2003, GIECO and AMEX in late 70s where buffett got into these situations.

Another way of playing the above cases : Buy put options on the company. The key is to be able to identify and time such opportunities before the market prices it into the option.

I recently received a few questions on value investing via comments. I thought these questions would be best covered via a post

1. If you buy a stock at 50% or less of instrinsic value, what makes the stock reach its intrinsic value ? if the traders are not buying, how does the undervaluation go away ?
2. If everyone practised value investing, will the market not become efficient and will value investors not be out of business?
3. Ashok leyland had a 50% drop in sales last month? What are your views on it ?

In addition let me add a few questions and answers of my own

1. If value investing is so obvious, why do so few investors follow it ?
2. You always mention about a long term view. What is long term ? 1,2 or 5 years ? should one wait indefinitely for the market to recognize the stock ?
3. Is a macro view point inconsistent with value investing ?

If you buy a stock at 50% or less of instrinsic value, what makes the stock reach its intrinsic value ? if the traders are not buying how does the undervaluation go away ?

This question has been asked of several value investors and frankly there is no scientific explaination (yet!). The best explaination for this question comes from the dean of value investing – Benjamin graham who said ‘The market in the short term is a voting machine based on the emotions of investors. However in the long run, it is a wieghing machine driven by the underlying value of the company’

If you are new to value investing you have believe the above on faith, as I did initially, that the market eventually corrects the undervaluation,. However over a couple of years, you will see for yourself that the market does recognize the undervaluation and corrects it. However don’t expect the correction to be in a uniform straight line.

For ex: I invested in companies like concor or blue star in 2002-2003 time frame. The undervaluation in these companies was corrected by 2005-2006. This correction did not happen in a uniform fashion. On the contrary I have seen the correction happens very quickly with the major gains spread over a few weeks.

Ofcourse after the correction happens, the traders get excited as they can see volume strength and momentum and all that. They jump into the stock if the correction was swift and the stock is appearing in their filters. The stock gains further and now the analysts latch on it and start recommending it. Finally when everyone and his uncle is onto the stock, CNBC and our smart talking heads start recommending it. That’s the time to sell !! ..just joking, but you get the point.

If everyone practised value investing, will the market not become efficient and will value investors not be out of business?
And
If value investing is so obvious, why do so few investors follow it ?

Value investing is not new. The bible of value investing – security analysis by benjamin graham was published in 1934 ( I would recommend you to read it, multiple times). Most of us practise value investing in real life. If a TV is on sale, we go ahead and buy it.

However, very few do it in stocks. The reason is two fold. First, most of the investors cannot or do not want to evaluate the intrinsic value of a stock. So they really cannot be sure if a stock is a bargain or not. As a result they ‘outsource’ their thinking to others such as analysts, CNBC etc.

The second reason is temprament. It is difficult to stand away from the crowd. Think of it – how many investors out there think that this is a good time to buy. Most of them are ready to to accept the notion that now is not good time to buy and one should wait till the future is clear.

When is the future clear ? Was it clear in Jan 2008 when everyone thought the sky was the limit? If in hindsight it was not clear then, it is not clear now and it is never going to be completely clear ever. Investing is all about probabilities and of putting your money into situations where the odds (valuation) favor you.

So value investing is intellectually easy to understand, but emotionally diffcult to practise. You have train yourself to get excited when the stock prices drop and not get too thrilled when they shoot up.

You always mention about a long term view. What is long term ? 1,2 or 5 years ? should one wait indefinitely for the market to recognize the stock ?

I do not have a fixed holding period. As a long as the current stock price is less than the intrinsic value and I don’t need the cash to buy something cheaper, I will hold the stock. However if after 2-3 years, the stock price remains at the same level , I will analyse my thesis again to see if I am missing something. One has to be patient, but not stubborn and stupid.

Is a macro view inconsistent with value investing ?

I cannot speak for others, but I am not good at macro forecasting. I would never invest in a cement company based on the total expected cement volumes in Q3 of 2009. My approach is to look at a good company, with sustainable competitive advantage and available at an attractive price. If I find one, I will buy it irrespective of the macro forecast.

If the macro situation worsens, a strong company will do better than competition and would be available cheap (time to buy more). When the macro situation improves, this company will do well too and the investment will work out.

So I do not worry about what the exact macro, GDP etc numbers are. If one can find a good company at good valuation, good things will happen over time for the investor.

Ashok leyland had a 50% drop in sales last month? What are your views on it ?

This is an example of the macro situation worsening more than expected. However there has been no damage to the business model. Both tata motors and ALL have suffered steep drops in sales due to the macro situation. Unless one believes that Ashok leyland will go out of business due to this drop, I do not see any reason to change the investment thesis.

That said, I have underestimated the cyclicality of this business and hence have reworked to the intrinsic value from around 60-65 to around 55-60.

Side note : I must be writing interesting stuff if some of my friends come up to my wife and tell her that they enjoy reading my blog and ofcourse her reaction to it, is that this blog is a nice excuse to avoid helping her 🙂

If you were to ask someone about his favorite stock, the odds are that the idea would be a company with high growth prospects. This extreme bias in favor of growth is quite pervasive. You will it in analyst reports, on TV and on discussion boards too.

The flip side is that if you mention a company with low or poor growth prospects, the other person is completely surprised. It is like you have belched in a social gathering!!

The problem is that almost everyone favors growth without really thinking about it. It is almost a herd like behavior where we have been conditioned to prefer companies with high growth prospects.

Is growth always good?
Growth in a company is usually a good thing, though not always. It is not written in stone that if you buy a high growth company, you will make good returns. There is more to investing than just growth. The value of a company depends on the following factors

– Does the company earn more than the cost of capital? More the better
– How long will the company earn more than the cost of capital? This is known as the competitive advantage period. Longer the better
– If the company earns more than the cost of capital, growth is good and adds value.

Mental checklist
So anytime you look at a company with high growth prospects, think of the following points

– Is the company earning more than the cost of capital and how sustainable is it? remember that companies earning high returns with high growth rates attract a lot of competition. Competition in turn drives down growth and return on capital
– How sustainable is the growth of the company?
– Does the valuation discount the growth already? I have seen a lot of people miss this point completely and overpay for growth most of the times.

The above factors are quite subjective and not really quantifiable. As a result high growth investing is not easy, requires more experience and judgment and there is a bigger chance of getting it wrong

Missing other opportunities
The flip side of focusing on growth alone results in missing opportunities where the growth of company is low or non-existent. Low growth industries are characterized by a lower competition, moderate competition and fewer companies with some enjoying a dominant position in the industry.

It is far easier to find a mispriced company in such situations as there are fewer investors following these companies.

I recently got a comment which raised the following points

– You seem to have done badly when the market went down and well when the market went up. I don’t see any special skill in that.
– The picks you have shared have not convinced me that these picks will do better than what I can achieve via indexing
– A lot of people seem to agree with your analysis. However if the stocks you have analysed do badly then the market is right and not you or the entire group, which agrees with you.

I have responded to the comment, but wanted to discuss these points via a post.

Special skills or not ?
The first and most important point for the readers of this blog is this – This blog is about ‘learning and applying value investing principles’. This blog is not about my performance or how good or bad an investor I am. Value investing is a commonly used approach to investing and my attempt has been to learn and share my learnings with everyone. My own performance (good or bad) do not change the principles.

My personal focus always has been to take publicly available data, analyse it and present the conclusions. It is not a sermon I am preaching from mount olympus. I am providing my viewpoint and analysis and opening it up for discussion – for and against it. If you are expecting stock tips or some kind of portfolio management, then you will be dissapointed.

I have never disclosed my performance on this blog and will not be doing it via this blog. My personal objective is to beat the index by 3-5% on a rolling 3 year basis. I have done that by a decent margin with low risk. I try to lose less than the index during bear markets and match the index during the uptrend. Till date, I have been able to achieve that.

You may have a different risk reward objective and may find this level of outperformance poor. Well, to each his own. Remember the following fact – A 3-5% outperformance is an annual return of 16-18% which is not easy to achieve. Over long term, this kind of annual return can add up to a decent amount. However over the last 3-4 years (till 2007), a lot of investors came to expect a return of 40% as a minimum.

How will the picks do?
How do you react when the price drops, but the company continues to perform well ? Do you think that you are doing badly?

If yes, then your approach is different from mine. My yardstick for performance is business performance. If the company does well, it is only a matter of time when the stock price will catch up with the underlying value. Sometimes it takes a few months and sometimes a few years.

A valid counterpoint can be – how are you sure that the price will converge to value ? It is based on my personal experience and based on what I have read about the experience of other value investors.

The other way of analysing performance is to compare the returns of your portfolio with the index on a long term basis ( I use rolling 3 years as 1 year is too short and more than 3 years is a bit too long). If you cannot beat the index, then you should look at passive indexing and not pick stocks. I have always maintained a mutual fund and index portfolio as benchmark to see how I am doing. Till date the results are good.

Finally, I am not trying to convince anyone with my analysis. I am presenting my analysis and opinions. It is upto to the reader to agree or dis-agree with the analysis.

Group think
I have never derieved satisfaction with how many people agree with me or not. The success of my picks will depend on the quality of my analysis and not how many people agree or disagree with me. I personally prefer counterpoints to my thesis as it helps me in improving the quality of the analysis.

I evaluate the success based on a single criteria : Is the business performing as expected or better ? If the business is performing well, I will hold the stock even if the price has not followed the business performance in tandem as price eventually follows value. I don’t judge my ideas based on short term swings in price. However if my assumptions or analysis are wrong, I have exited the position irrespective of the price in the past