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The Relatively Unpopular Large Company

One more example, plus how to identify similar situations in the future (Continued from last week) Last week in this column, I identified two large companies - ITC and Lakshmi Machine Works (LMW) which, only a few months ago, satisfied Ben Graham's criteria for investment under the category of The Relatively Unpopular Large Company. Contrarian investors who bought stocks in these companies when they were perceived by the investment community to be in deep trouble, have earned superb returns on their invested capital. The Bata Story Bata Limited is my third example of a company which until recently satisfied Graham's criteria for investment under this category. Bata is India's largest footwear company with a 1996 turnover of Rs 590 crores. During the bull market of 1994, it's total market capitalisation touched a high of Rs 900 crores. But in 1996 the market cap fell to a mere Rs 123 crores - a drop of 86 percent. What went so wrong? Well, the main reason for the plunge in the market cap was huge losses declared by the company. In 1995, the company shocked the market by declaring a loss of Rs 42.16 crores. The reasons for Bata's poor performance and of its subsequent turnaround have been covered by a large number of business publications, so I will not bother you by repeating them here. I would, however, like to tell you how the financial press changed its opinion about the company in the last one year. All hell broke loose immediately after Bata's announcement of it's 1995 results. Financial newspapers and business magazines were awash with bearish stories on the company. For example in April 1996, immediately after the company declared it's results, Business Standard wrote: "It is no longer Bata by choice. Reforms have pitchforked shoe companies into a hot race, and Bata India, once a monolith, is stumbling all the way to defeat." In another article, also published in April 1996, Business Standard commented: "Bata India, beleaguered by poor financial results, may be heading for trouble, torn as it is between powerful labour unions and its Toronto-based Bata Shoe Organisation-led management," Anticipating an equity offering from the company to pay down debt, The Hindu Business Line reported in April 1996: "With a further dilution in equity likely, the stock markets may not be enthused . . ." Paradoxically, the fact that Bata's management planned to inject cash in the company reduce it's shortterm borrowings made an investment in its stock even more attractive than before. But, The Hindu Business Line missed this point. Predictably the market price of Bata's shares plunged from Rs 70 per share to around Rs 47 per share in a matter of a few weeks. An investment in 1,000 shares at that time would have costed Rs 47,000. The buyer would also be entitled to buy additional 1,000 shares at Rs 30 each in the subsequent rights issue of the company. The total cost of 2,000 shares would have come to Rs 77,000. The market value of those 2,000 shares today is around Rs 1,90,000. The contrarian investor who ignored the bearish reports on the
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company and bought the stock has more than doubled his money in a matter of a few months. And guess what? The financial press which was almost universally bearish on Bata in 1996 is almost universally bullish on the company in 1997. In April 1997 for instance, The Economic Times reported: "After a year that was easily its worst, the largest shoemaker - and the most famous - has begun its return to profitable ways." The point I am trying to make is that precisely because of the bearish attitude on Bata expressed by the financial press and stockmarket commentators in 1996, it's stock price fell to a level which represented a bargain situation in a Relatively Unpopular Large Company. Moreover, anyone who had followed the Bata story closely could have seen that the future of the company cannot be as bad as the market was predicting. The company was already taking actions which almost guaranteed it's eventual return to profitability. Four things come to mind: One, almost the entire top management team responsible for allegedly stealing money from the company and for foolishly diversifying into the low volume, high margin premium segment was replaced. Two, the company's promoter expressed it's intention of not letting the company go down the drain by giving it an interest free advance of 10 million dollars. It also sent a team of expert trouble-shooters to take over the management of the company. Three, the new management team quickly took wise decisions of getting out of the unprofitable segments of Bata's business and by starting negotiations with it's labour unions. Four, the company sold off its Calcutta head office for Rs 19 crores to pay down debt and to meet it's working capital requirements. Five, the company made a rights offering which was very attractively prices, which guaranteed the issue's full subscription. The proceeds were used to pay down debt and to meet working capital requirements. The consequence of these five points was predictable. In the accounting year 1996, Bata has returned to profitability. The company's current market cap (after considering the new shares issued) stands at Rs 488 crores. How the Press Changed its Opinion About Bata Publication Date Business Standard Business Standard Economic Times Hindu Business Line Business World Business India April 1996 April 1996 April 1996 May 1996 April 1997 April 1997

Headline

For Bata the Shoe Pinches When the Going is Bad From the Perch Bata Hits the Skids Shoe Bites Where the Shoe Pinches Better Days for Store in Bata India? Bata - Best Foot Forward

Tone of Article Bearish Bearish Bearish Bearish Bullish Bullish

Common Features In These Examples All the three examples given by me - ITC, LMW as well as Bata - had common features.

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One, all the three companies are the largest players in their respective industries. ITC is India's largest cigarette manufacturer, LMW is India's largest textile machinery manufacturer and Bata is India's largest footwear company. Two, all companies suffered from loss of investor interest because of wrong deeds of their managements. In the case of ITC, it was alleged excise duty evasion. In the case of LMW, the management was perceived to be dishonest and in the case of Bata the top management was perceived to be not only dishonest but also highly incompetent. Three, in all the three examples, the problems faced by the company were given wide coverage by the financial media and the press. All the cases appeared on the cover pages of the business magazines. Even general newspapers and magazines covered these stories prominently in their business sections. Moreover, almost all the commentators were saying that these companies will continue to go downhill. Four, in all the three cases, the investment community, probably due point three above, reacted to the bad news as a result of which the stock prices of all the three companies crashed in a matter of weeks. The crucial thing to note here is that the huge fall in the price soon after the bad news was made public can be attributed to the bad news. Five, in all the three cases, the actual fall in the stock prices was much more than was justified under the circumstances. In the case of ITC, the fall in it's total market capitalisation during the time when it's excise duty crisis was being given highest publicity was Rs 2,150 crores even though the total probable intrinsic value loss to it's shareholders was no more than Rs 500 crores. In the case of LMW, the market capitalisation fell by Rs 213 crores even though the maximum intrinsic value loss to it's shareholders was probably around only Rs 28 crores. And finally, in the case of Bata, the market capitalisation fell to a mere Rs 123 crores. You will agree that this price placed by the market on the entire ownership interest in one of India's largest retail businesses - one which operates a chain of over 1,000 retain outlets in prime locations - was absurdly low. The company's entire shares were available at an aggregate market value of around 100 flats in Mumbai. Six, the so-called stockmarket experts were not buying these stocks when their prices fell to absurdly low levels. They were selling them. For instance, Bata's rights issue prospectus reveals that UTI sold approximately 7 lakh shares of the company before November 1996. Moreover, most stockbrokers, investment analysts and market commentators were not recommending buying the stocks at their bargain prices - on the contrary, they were recommending their sale. Seven, and finally, in all the three cases, contrary opinion would have been very profitable. Those who bought these stocks have been rewarded exceptionally well for having had the courage to think rationally and to bet against the crowd. One important point is worth mentioning. Most people believe that these stocks fell because either there was a "huge selling pressure," or "there were only sellers and no buyers," or "supply was far in excess of demand." As I wrote in a recent column in Intelligent Investor such explanations are naive in the extreme. The stock prices of ITC, LMW and Bata fell not because more shares were sold than bought. (Simple logic says that the number of shares sold must have been exactly equal to the number of shares bought because for every seller of a share there has to be a buyer.) Rather the prices fell because of a change in the opinion of these companies in the investment community. Manic-depressive personalities create manic-depressive prices. If a large institutional investor changes it's opinion about a stock and expresses that opinion by transacting in the market, the price of the stock will change to reflect that opinion. Frequently, however, the change in the opinion is not justified by the
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underlying fundamentals which is exactly why market prices are much more volatile than underlying intrinsic values. The basic idea behind intelligent buying of stocks is to develop an ability to identify situations when the market has overreacted to some bad news and has created a bargain price - a price at which the downside risk is minimal and the upside potential is huge. Fortunately, Graham laid down the rule for investing in such situations. Here is what he wrote on the subject: "If we assume that it is the habit of the market to overvalue common stocks which have been showing excellent growth or are glamorous for some other reason, it is logical to expect that it will undervalue companies that are out of favour because of unsatisfactory developments of a temporary nature. This may be set down as a fundamental law of the stock market, and it suggests and investment approach that should prove both conservative and promising." How to Spot Similar Situations Here are a few standard rules which you can use to spot similar situations in the future. Rule 1 - The company must be a large one and preferably it should be the largest player in its industry. Graham thought this to be primary requirement for such situations. He wrote: "The key requirement here is that the enterprising investor concentrate on the larger companies that are going through a period of unpopularity. While small companies may also be undervalued for similar reasons, and in many cases may later increase their earnings and share price, they entail the risk of a definite loss of profitability and also of protracted neglect by the market in-spite of better earnings. The large companies thus have a double advantage over the others. First, they have the resources in capital and brain power to carry them through adversity and back to a satisfactory earnings base. Second, the market is likely to respond with reasonable speed to any improvement shown." Rule 2 - Something bad must have happened to the company for it to have become unpopular with the investment community. For example it may be involved in litigation. It may have suffered because of customer, supplier or employee dishonesty or even gross managerial incompetence. There may have been a fire which destroyed one of it's plant. A senior manager may have suddenly died. Or any number of other similar things. Rule 3 - The bad news must be widely reported in the financial media. In fact, if the bad news is reported on the front pages of general newspapers (as happened in the case of ITC), then that could be very good news for the contrarian investor interested in buying the stock at a bargain price. That's because the wider and the more critical the coverage, the more the stock price is likely to fall. Rule 4 - The stock price of the company must have fallen significantly in a matter of days or a few weeks after the bad news was made public. Here "significantly" is a highly subjective word but I would not consider looking into such a situation unless the price has fallen by at least 30 percent from the quoted market price before the bad news became public knowledge. Moreover, it is essential that the fall in intrinsic value, if any, should be much less than the fall in market price. I suggest that you calculate the total fall in market capitalisation of the company and then compare it with what you think is the justifiable fall in market capitalisation because of the bad news. If, for instance, market cap of a large company falls by Rs 1,000 crore simply because it's managing director had a heart attack, you must ask yourself if the fall was justifiable. Often when you look at the numbers in market capitalisation terms you will see just how irrational the market has behaved in response to the bad news. How should you calculate the justifiable fall in market cap? I have no easy answer to that question. But if you use common sense you are likely to arrive at the correct answer. For instance, in the case of ITC as well as LMW it was clear that total fall in market capitalisation should have been a fraction of the actual
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well as LMW it was clear that total fall in market capitalisation should have been a fraction of the actual fall. One hint which I can offer is that when estimating the justifiable fall in the market cap because of the bad news, think of the worst-case scenario. If under the worst case scenario, you estimate that the market cap of a company should fall by, say, Rs 200 crores, but the actual fall is Rs 1,000 crores, then you are certain that you are on to something. The above approach was applicable for relatively simple situations such as ITC and LMW. But in situations such as Bata, another approach is recommended. After you have seen the market price fall significantly, you should look at the upside potential. In other words you should estimate what the market price of the company's stock is likely to be a few months from now if the problem which caused the fall blows over. In order to be able to do that you have to identify solutions to the problem faced by the company and also to judge how likely is it that the problem will, in fact, be solved in a short period without much loss to the company's shareholders. The three most common solutions to such problems are (1) a change in management; (2) an injection of capital; and (3) the passage of time. In the case of Bata, for example, all three played a role. Almost the entire top management team of the company has been replaced. New capital has been injected in the company by way of an interest-free loan from the company's promoter (which was later converted into equity) and a subsequent rights issue. Money has also been raised by selling off the company's headquarters at Calcutta. Finally, the passage of time has also played a role by materially changing the perception of the company in the investment community. Rule 5 - Look at the debt position, especially short-term debt. Before committing yourself to buy the stock, look at the debt position of the company. If the company is highly leveraged, then a crisis is the last thing it needs. If short-term debt levels are high, then you have to be even more careful because the company's creditors can theoretically force the company into bankruptcy if it defaults on its promise to pay. In a practical world, however, this rarely happens. The creditors know that is it far better to wait for the company to return to profitability than to fight it in the courts. In the three examples cited by me, only Bata was a highly leveraged company. But two important developments took place which made the situation far less precarious than was perceived by the market. The first development was the company's Canadian promoter, Bata Shoe Organisation's decision to extend it a $10 million interest-free loan in order to enable it to reduce it's high cost, short-term debt. The second development was the willingness of the management to sell it's Calcutta headquarters and to utilise the proceeds to pay down debt and to meet working capital requirements. What I mean here is that a company may be highly leveraged but if you are certain that it's creditors will not try to liquidate the company, and if developments such as injection of fresh capital or a return to profitability, promise much lower debt-equity ratios then, there is little cause for worry. In other circumstances, you must not buy the stock. Rule 6 - Buy the stock when you feel that the price reflects a huge overreaction to the bad news. Usually this will occur when bad news is widely known to almost all the market participants. The price, in other words, is likely to be at it's lowest sometime after the bad news about the company has been widely reported by the media. Therefore the best time to buy is usually not when the bad news first breaks but sometime after it has been widely reported. It pays to wait until despair is all around to get rock bottom prices for such stocks. Rule 7 - Sell the stock when you think it no longer qualifies under the above criteria. In other words, you bought the stock because you thought that the market had overreacted to the bad news thereby creating a bargain price. For the same reason, you should sell the stock when you feel that it is no longer a bargain. What this means is that you should sell when either the market has corrected it's mistake by increasing the
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stock price or when you have found out that the fall in the market price was, after all justified and that it was you, and not the market, which had made the mistake. Rule 8 - Diversify, diversify. Investing in The Relatively Unpopular Large Company requires adequate, though not excessive diversification. Of course the extent of diversification should depend upon your level of confidence about the situations available to you for consideration. In relatively simple cases such as ITC and LMW, if you feel confident enough, then the need for diversification goes down significantly. But in circumstances similar to Bata where you are essentially looking at a potential-return-to-profitability situation, it will be prudent to exercise adequate diversification. Conclusion John Templeton, the master of contrarian investing once said, "If you buy the same stocks as everybody else, you will have the same results as everybody else." Buying stocks of companies which are widely popular at a given moment is usually not intelligent investing. Buying stocks of large companies which are currently out of favour for unjustifiable reasons usually is. Two more companies, in my opinion, fit into Ben Graham's Relatively Unpopular Large Company criteria. One is Shaw Wallace. Another one (very recent) is Century Textiles. What do you think? (Concluded) Note This article is submitted by Sanjay Bakshi who is the Chief Executive Officer of a New Delhi based company called Corporate Investment Research Private Limited. Sanjay Bakshi. 1997.

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