After The Deluge : A Prescription For Bad Times



The topic for this month’s column would have to be obvious, given the recent collapse of the markets. I am now faced with 2 choices for this month’s column: one, I could sensibly explain the mechanics of how it happened and why it was inevitable; or two, I could look to the future and try and give out my prescription of a future strategy for those left relatively unscathed by the recent tsunami in the markets. I will choose the second option.

Declaimer: This article written was originally in June 2006 and some of the data points may be outdated.

First, the bad news: if you’ve got your head underwater and are looking to average out your costs, DON’T. The shift in valuations is fundamental and will lead to new paradigms. For example, if you were in those stocks that were being driven by liquidity flows and momentum, then please don’t try to average your holding costs. The Risk Premium on Capital has gone up and the same stocks, with the same earnings projections, will see a sharp drop in valuations. The horizons over which the market is willing to discount earnings will also drop, the focus now being on current earnings rather than 2 years forward.

Higher local interest costs, falling liquidity, and the unwinding of the Yen carry trade, will ensure that there is going to be persistent pressure on those stocks (i.e., real estate, infrastructure, Capital Goods, Auto, housing/ construction, and maybe even cement) that were in the middle of the recent rally. The crater in the middle of the market is not going to get filled any time soon, because the overseas flows that were looking to get into India have done a clear about-turn.

Now, the good news: this is the time to start hunting for the 30-baggers. The place to find them would be in the cyclical and the “economy-independent” sectors. Start thinking of the economy in distinctive component sectors.

One segment, usually the cyclical, is driven by the liquidity trends resident in the economy. This is typical of the “all boats rise with the tide” trend you often see. The bottom of a business cycle is populated with the following clear observable phenomena.

Interest rates are at their highest. Some sectors have had huge capacity overhangs during the down cycle. For example, in the last down (business) cycle of 1996-2001, steel contributed the largest component of bank NPAs, while sugar was another major contributor. On the upcycle, these 2 sectors have contributed the most multi-baggers, with the worst companies in these sectors being the biggest multi-baggers and so on.

There is a logic to this. There must have been other sectors that have also contributed to the NPAs, but they would not have had one further confirming factor, ie., these sectors were also on a bank (incremental lending) blacklist. Neither loans were available for these sectors, nor equity. Empirically, you would find that actual investment flows into these sectors had either slowed to a trickle or were non-existent. Net capital accretion (i.e., net depreciation) for the sector was actually negative. Only the best companies were reinvesting their limited profits into these sectors (eg, Tata Steel in steel and Balrampur in sugar, for example).

So, Rule No: 1: where was the biggest over-investment binge in the last boom, and where is the biggest (liquidity) backlash? These are the sectors with the biggest (perceived) risk indicators, but which, in hindsight, will probably turn out the biggest and surest forward returns.

What is the best way to find out? Collect a set of marketmen, both in equity and debt markets, and tell them that you are putting your shirt behind such companies. If they certify you insane, you know you are on the right track.

So now you have both (left-brain) data and (right-brain) emotional indicators in place. If they both tell you the same thing, i.e., DON” T invest, then go right ahead and do precisely that. Now this is the most difficult part of investing. If you find you are short of breath when you call the broker, and better still, if your broker refuses to take your order (“for your own personal safety”), then you know you are the next millionaire.

There are other confirming indicators, too numerous to go into just now. But the big question is: where has capital dried up, either for physical reasons or sentimental ones?

The second value-picking strategy is often credited to Warren Buffet: look for great companies that are “economy-independent”, either because of their business model or because of management quality……..and buy them at a good price. The good price for such companies would be an “earnings yield” about equal to the now (high) cost of debt. So in this on-coming downturn, if you see interest rates peaking at 15% (say), you should look for great companies with a P-E of, say, 7 or around. A great company is a company that has a 15-year average ROCE above 20-25%, RONW> 25%, with just 1-2 outlying down-years and enough growth potential to hold its track record over the next 10 years.

Another way to find great companies is to look for ‘society-changing’ businesses, like healthcare, retail, personal consumption-driven, minor agri-businesses, and some kinds of tech companies (like these new EDS and autocomp companies). These companies may grow forever, but their current valuations might reflect only the current reality. This is actually a very easy strategy, just perfect for the amateur retail investor.

It requires no finely-honed timing skills, no sense of market (liquidity) trends, no estimation of interest rate turnarounds, etc. You can start as early as tomorrow, keep buying through the downturn with a fixed amount of your savings every month, and still end up with a fairly low average cost. If your investment horizons are sufficiently long, you will get your 30-bagger very safely. For one lifetime, you just need 2 such decisions to be able to afford your 4 Mercs and a wife, or vice versa if you so prefer.

A third strategy is slightly more difficult. Look for troubled companies with high Operating Leverage and high Financial Leverage. These are best found in troubled commodity sectors and are really pure plays on the commodity (prices) themselves. For safety, look for valuable non-business assets and decent corporate governance, without which you are taking excessive risk.

As these companies pay off expensive debt, they will get high reinvestment returns on their profits, for the same turnover levels. Usually, these are not spectacular multi-baggers, unless accompanied by a commodity price upturn, e.g., Arvind Mills after the last downturn. Being large companies, they often give out an impression of insolvency which is much worse than is actually the case. Through a series of restructurings, they often pull through. You make money because the market always factors in a Risk Premium much higher than is warranted.

But this last one takes a fair amount of skill and I wouldn’t recommend it to a retail investor.

Another minor strategy is to look for large one-time write-offs taken from yesterday’s failed business strategies. These are often good, honest companies, which are capable of sending out clear negative messages to the market. They are usually MNCs, where the incoming CEO will want to start with a clean slate, dumping all the past losses on his predecessor. In the past 10 years, I have twice made money on Bata with the same underlying philosophy. Such events often take place at the start of, or in the middle of a recession.

And last, but not least: Look for sectors ignored by the last boom. You can cherry-pick some great movers out of those sectors that had a bad reputation the last time around. However, this needs a good understanding of the “principle of reversion to the mean”, which should be the subject of another column.

Readers who can point out companies they know well, which fall into any of the above categories, can write to me if they want help in cleaning up their thinking. The above list is merely representative, not exhaustive.

If nothing else, we could learn together.



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