Friday, 9 November 2007

Inefficiency and the Perils of Inaction

A lazy afternoon opened my eyes to the perils of inaction in the investments business. When going through some of my old files, I came across a company that I had identified about a year ago (October 06). I had done all the hard work, done the numbers, saw the opportunity…and did not do anything. I share some valuable lessons in this post with the company as the protagonist. This story is about Gujarat Narmada Valley Fertilizers Company (GNFC)

Inefficiency manifests itself
GNFC is engaged in the Fertilizers business. What was so special about a company operating in a regulated, commodity business where no one player seemed to enjoy a strong ‘moat’? There were better investment opportunities elsewhere in other industries. I don’t disagree. As a Buffett follower, I wouldn’t have touched this company, never mind the price…But as a part believer in Benjamin Graham’s ‘cigar butt’ type stocks, I couldn’t pass this company over after what I saw…

Cigar Butt stocks: A discarded cigar butt allows the smoker one last puff…but the last puff doesn’t cost much. Cigar butt stocks are those where there isn’t much steam left…but the prevailing price makes the proposition an ‘easy picking’.

The thing that drew me most to GNFC was its strong fundamentals. The operational performance stood out glaringly when juxtaposed with its similar sized peers. GNFC had seen 4 consecutive years of expanding margins and was steadily repaying debt. A very good sign. The glorious fallouts of this were gradually showing up in the numbers. A company was getting stronger…and nobody seemed to be looking…Table time..

Prices are as of October 20, 2006; the day I carried out my analysis.

In the table, I have compared GNFC with two of its similar sized peers in terms of revenue. Starting from the top, the difference in profit margins is self-evident. Strike 1. Moving on to the balance sheet, one can see that GNFC had the strongest balance sheet in the group. Its debt/capital ratio was very comfortable, while the other two had as much debt as equity. Strike 2.

GNFC had the best Return on Capital in the group. (ROC is my favorite metric. Personally, I spend more time on it than on any other metric when analyzing businesses. ROC tells you how much return a company is able to generate out of all the capital that it takes in (in the form of Debt and Equity. I look for companies that have enjoyed high returns on capital over long periods). What I saw warmed my heart. In an industry where most players were struggling to get into the early teens, here was a company that was achieving ROC in the high teens. Strike 3. GNFC came out tops on Return on Equity (too!). Strike 4.

While Chambal Fertilizers enjoyed a higher dividend yield, GNFC wasn’t too far behind. Now, I turn my attention to one of those beauties of the market. Mispricing.

To give a little background about the trend leading up to 2006, GNFC had expanded margins fron around 5% in 2002 to 14% in 2006. It was also consistently reducing debt and expanded its ROC. All positive signs. The other two in the meanwhile had increased debt and saw their margins either staying flat (Coromandel) or heading southward (Chambal). Both negative signs.

Given this background and GNFC’s current standing, one would have been rewarded for asserting that GNFC ought to trade at a premium to its lesser peers. Hmm…And one would have been wrong. The ‘efficient’ markets had apparently forgotten GNFC’s existence and shunned it to hell. And so an anomaly was born…waiting to be exploited.

Did the anomaly correct itself?
One year is a reasonable time frame to expect these glaring anomalies to correct themselves. Did it? Let’s take a look.

To give a 1-year perspective, prices for the above table are as of October 22, 2007. Prices in INR.

The markets had recognized their folly after all! Suddenly GNFC was in the limelight, and the other two were shunned. (Well not really, they did appreciate too!). But the Atlas had won…after all! The margin of return was more than twice the other competitors. A classic value pick.


Cut to 2007
Below I present figures for the same companies, for the same metrics…but for fiscal year 2007.

To give a 1-year perspective, prices for the above table are as of October 22, 2007.

Hmm, the industry seemed to have made life tough for all companies, GNFC included. All the companies witnessed a drop in margins from 2006. But the relative levels were unchanged. GNFC still Struck! Strike 1. After 4 years of debt reduction, the company increased debt in 2007. But so did the others. In Chambal’s case, debt had now become twice as much as equity. Strike 2 to GNFC.

Not surprisingly, the return ratios fell for the group as a whole, as most had to grapple with an increasingly alien business environment. While Chambal and Coromandel slipped into single digits, my friend GNFC still continued in the high teens. Strike 3.

This time around, one would have been rewarded even more handsomely for stating that GNFC now ought to trade at a premium to its brethren. Hmm…And one would have been wrong. Again. While the P/E and P/B for the group has expanded, GNFC still seems cheap relative to its peers. The other two seem overpriced considering their current operational health. So if somebody put a gun to my forehead and forced me to buy one company’s stock in the fertilizers business, I would pick my friend. But…

The line between ‘Relative’ and ‘Absolute’ valuation
This is where an investor needs to weigh carefully the approaches of relative valuation and absolute valuation. While a stock may look attractive relative to its peers within the industry, it may very well be expensive when compared to other businesses. Ultimately the underlying economics of the business ought to take precedence over standalone valuation. Faced with the prospect of choosing between two equally strong companies, I would choose the one which operates in the ‘stronger’ business. By ‘strong’ business, I mean a moat that keeps competition at bay. Where a new fellow coming in would find himself running into Atlases, not Lollipops.

GNFC is an example of an Atlas company operating in a mostly Lollipop business. So there may well be better opportunities elsewhere.

One question that may be linger in your minds is, “If this guy really saw all this, what did he do sitting on his...well..?” Answer: I take full responsibility for inaction. This brings me to the second part of the title of this article.

The losses from inaction far exceed the losses from wrong investment decisions.

It’s far easier to eat ones ego and reverse a bad decision than watch an identified easy pick go through the roof. In GNFC’s case, I was somehow not convinced of the then prevailing price. It still seemed a tad over-priced to me. I made a mental note of buying into it if it ever came to INR 90…and I kept waiting. (The price did come close to 90 once…but I was caught napping…)

In my experience, in the long run, I have seen stocks of Atlas-like businesses return far more than Lollipops. Very often though in a Bull Run, the Lollipops tend to trade at a premium to Atlases. The observant value investor has the world at his feet, literally, for there are Atlases for the picking…at a fair discount to their true worth!

I vow NEVER to ‘nap’ again!!!

I do not hold GNFC or the competitors mentioned above. The article should not be viewed as a solicitation to buy, sell or trade any of the stocks mentioned. There is immense risk of loss in blind-man-buff investing.