Investing in special situations can help you tap opportunities that arise during adverse conditions, advises Joydeep Sen.
Illustration: Uttam Ghosh/Rediff.com
Clouds that gather over companies from time to time can rain profits for the smart investor.
The great ones like Warren Buffett have made a career out of these opportunities, when the vast majority scurried for cover at the very whiff of trouble.
The ability to see opportunity in adversity is what distinguishes investment greats from the average Joe.
A look at Warren Buffett's most successful investments will tell you that crisis investing can be immensely profitable.
In 2011, Buffett bought $5 billion worth of Bank of America's preferred stock, which would come with a 6% dividend.
He also negotiated the right to buy 700 million shares of the bank's common stock any time before September 2021 for $7.14/share, according to The Motley Fool.
At that time the warrants were worthless and the stock traded below the amount quoted.
This was the time when the world's financial markets were barely limping back to normalcy in the aftermath of the global financial crisis of 2008.
In the wake of Lehman Brothers going bust, investment banks were still a bad word.
The bank's share price has tripled since then and Buffett has made more than billion from this investment.
Cigar butt strategy
Buffett's mentor Benjamin Graham would call this the cigar butt strategy, which essentially means buying an asset at a throwaway price.
The markets often tend to beat down the prices of securities well below their intrinsic value.
It is for this reason that investors must learn to capitalise on crises.
Satyam is a great example of this cigar butt theory.
Its stock price fell to Rs 540 levels from Rs 650 in January 2009 after its chairman Ramalinga Raju admitted to an accounting fraud of over Rs 7,000 crore.
In April 2009, the company was acquired by Tech Mahindra after a bidding process.
The stock touched a low of Rs 66.15 by the end of 2010, an absolute return of -63.6% over 24 months.
Despite the accounting fraud done by the promoters, Satyam had a credible business.
It had customers in the US who were paying the company dollars for providing IT services.
Despite the fraud, there were plenty of companies who wanted to acquire the business.
Tech Mahindra was one of them.
It wanted to diversify its service offering, which until then was focused primarily on telecom.
If an investor had invested Rs 100,000 in January 2009 in Satyam's stock, it would be worth Rs 191,543 today, an absolute return of 91.5%.
Companies run into trouble from time to time.
These situations drag their stock prices down to rock bottom levels because the markets tend to overshoot in good times and bad.
There are several key factors that can lead to such special situations where the company's stock is beaten down to unrealistic levels.
Regulatory changes can be a big source of disruption.
A sudden change in the regulatory environment can cause the broader market to react negatively.
But once the uncertainty subsides, companies tend to return to normal.
A good example of this is the real estate sector, which is adapting to the Real Estate (Regulation & Development) Act (RERA).
It is a change, but one for the better.
It will be positive for large, organised players over the long term.
But till the sector readjusts to this new reality, stock prices may remain depressed.
Infosys shares went into a tailspin and fell 13% on August 19, 2017 when then CEO Vishal Sikka quit.
Nothing drastic had happened to Infosys; it remained a bellwether.
But management changes often lead to near-term worries.
Market participants pressed the panic button because everyone likes continuity and predictability.
The stock came under pressure as investors thought the company's future growth was at risk.
But with one of the founders, Nandan Nilekani, returning to the helm, it is business as usual.
Investors with a long-term orientation, who can stay focused, tend to benefit from such wild gyrations.
Infosys, for instance, generated 70% return between August 2017 and September 2018.
Mr Market can be very irrational and unpredictable.
But if investors can keep their emotions aside and look at situations rationally, they can benefit immensely from these temporary blips in the market, when one can buy great stocks at throwaway prices.
In the lifespan of a company, there will come a time when it is faced with a difficult business environment.
This can be structural or a one-off event.
For instance, Maruti's share price fell in 2012 after the strike at its factory in Manesar, but over the past three years the stock price has risen 286%.
Similarly, the shares of Nestle were beaten down to the Rs 5,000 levels from Rs 7,000 in June 2015 on news that there was excessive lead content in Maggi noodles.
From June 2015 to August 2018, its share price has risen 108%.
At times a new entrant can wreak havoc on existing players.
Hyper competition has severely crimped the profitability of existing telecom players in India.
Reliance Jio launched its 4G services at rock bottom prices and that has affected the financials and margins of incumbents like Bharti Airtel, Vodafone and Idea.
As a sector matures and growth moderates, consolidation follows, as is the case with telecom.
Given the size and scale of investments required in 4G, Vodafone and Idea saw the benefits of scale and chose to merge.
With the number of operators shrinking to three, the spoils of the market will be also shared by only these companies.
Indians will increase their consumption of data and over time prices will stabilise too.
Black Swan events
When Black Swan events like demonetisation happen, few have the foresight to look beyond the immediate news.
While this event impacted consumer goods companies, as cash was sucked out of the system, insurance companies, mutual funds and banks benefited from growing financialisation.
In future, too, some situations will cause discomfort to investors.
But these events will also provide opportunities to those who are comfortable going against the herd.
Be it the fallout of China's trade war with the US or the data revolution that is reshaping many Indian industries, opportunities will arise from adverse events.
If the trade war escalates and duties are imposed on Chinese goods, developed nations like the US will look for alternative markets from which they can source goods.
And India could well be a beneficiary of that disruption, as developed countries cannot create capacities overnight.
Rather than run for cover, look for special opportunities when a crisis comes calling.
- Sometimes a company faces a temporary crisis that causes its share price to plummet.
- Markets often overreact to such developments and sell shares indiscriminately.
- If your research tells you that the company can weather the crisis in due course, use such events as a buying opportunity.
- Accounting frauds and management changes sometimes cause panic.
- But if you feel that the core business is valuable and it remains intact, you may take advantage of the opportunity to buy the stock at an attractive price.
- Essentially, investors need to possess the ability to look beyond the immediate crisis, and not get swayed by herd behaviour.
Joydeep Sen is an independent financial advisor and founder of wiseinvestor.in