How buying into two recent scandals enriched contrarians
In earlier articles in this column I have written that stockmarkets display a tendency to overreact to bad news and, therefore, when the news about a company is bad - very bad - often it means that it's stock should be bought not sold. In his book, The Intelligent Investor, the dean of value investing, Benjamin Graham, called this contrarian strategy as investing in The Relatively Unpopular Large Company. Others call it Scandal Investing. Whatever the name, the fact remains that there is a method of making money in certain stocks, which, for some reason, are currently out of favour with the investment community.
In India, during the last one year or so, there were at least three companies (there may be more but I could readily identify three) which satisfied Graham's criteria for investment under this category. All three are large companies which were splashed on the front pages of business newspapers and on the covers of business magazines for all the wrong reasons. More importantly, in all the three situations, because of unfavourable developments, the financial community as a whole downgraded its appraisal of each company so that it's stock crashed in a matter of weeks. Nevertheless, canny investors who bet against the crowd and bought these stocks at panic prices have, in a short period earned enviable returns - and that too in a bear market.
In this week's column, I will discuss two of these three investment situations. Next week, I will discuss the third situation. I will also tell you next week what was common in all the three cases and how you can train yourself to identify similar situations in the future.
Scandal Investing In ITC
In mid-February 1996, the market capitalisation (total number of outstanding shares multiplied by stock price) of ITC, India's largest cigarette manufacturer, was approximately Rs 7,300 crores. The company, it was widely known, was involved in pending excise litigation for the last several years. It was also known that if at all ITC will have to pay up, the amount involved will run into several hundred crores. Yet, when the company was ordered by CEGAT (the appellate tribunal for customs and excise disputes) on 15 March 1996 to deposit Rs 110 crores on or before 30 April 1996 and a further Rs 240 crores in the near future, panic broke out in the ITC counter. In a matter of days, the financial community's opinion about the worth of ITC's stock changed materially for the worse and it's stock price crashed. The market now placed a value of approximately Rs 5,150 crores on all the shares of ITC which translated into a loss in the company's market capitalisation of Rs 2,150 crores.
There is a good reason why I give the above figures in terms of total market capitalisation and not in terms of a fall in ITC's stock price. That's because it is only when one calculates the loss in terms of total market capitalisation over this short period that one begins to see how irrational the fall in ITC's stock price really was. The market, in effect, was saying that ITC is worth Rs 2,150 crores less than before because of CEGAT's order. It was a typical case of overreacting to bad news. The total probable intrinsic value loss to ITC's shareholders was nowhere near the figure of Rs 2,150 crores. There were many reasons for this conclusion.
One, it was a well known fact that the total demand made by the excise authorities on ITC was around Rs 799 crores which was well below the loss in its market cap.
Two, the market forgot about the concept of time value of money. ITC was not required to pay Rs 799 crores immediately but over a number of years. The present value of those future cash outflows was, therefore, significantly less than Rs 799 crores.
Three, the market also forgot about the tax deductibility of the excise claims. ITC is a hugely profitable company and in 1994-95 had paid direct taxes amounting to Rs 158 crores. If ITC was required to bear a loss because of CEGAT's order, then that loss being a business loss would probably be allowed to be deducted from it's future taxable income. Therefore, the present value of future probable tax savings on account of this business loss should have been seen by the market but it was not.
Four, over the years ITC refused to acknowledge any liability for the dispute, and accordingly, it did not make any provision for the same in it's accounts. In-spite of that, the company's auditors did not qualify the accounts but instead, only made a reference to the matter in their report. To me this means that the auditors, after having studied the matter in detail came to the conclusion that there was a very good chance that ITC will not have any liability in the matter.
After considering all the above four factors, it was clear that the present value of the probable loss on account of the excise duty litigation was significantly less than Rs 799 crores. In other words, so long as one could be sure that ITC's short-term liquidity was not in question (which it never was), the Rs 2,150 crore fall in ITC's market cap was a huge overreaction to bad news and, therefore, it represented a huge buying opportunity. At that time, however, if you remember, almost all the financial publications were of the single opinion that ITC was going to continue sliding downhill. Many money managers were also expressing their doubts about the future of ITC which is precisely why the stock became a screaming bargain.
ITC's current market capitalisation is more than Rs 10,000 crores. The contrarian investor who chose to ignore what the "experts" were saying about ITC in March 1996 but instead focused on common sense and bought ITC stock has more than doubled his money in a short span of a little more than one year.
Scandal Investing in LMW
Lakshmi Machine Works is the largest textile manufacturing company in India and one of the largest in the world. The company until a couple of years ago was considered to be the bluest of the blue chips available in India. At one time, not so long ago, it's stock price was quoting at Rs 17,000 per share. However, in 1996-97, the stock price crashed to a low of Rs 3,500 per share. This translates into a fall in the company's market cap from Rs 1,036 crores to Rs 213 crores in just two years. Something really terrible must have happened which made LMW's market cap fall by 80 percent. Exactly what was it? I think there were three reasons for the fall.
One, the company's monopoly position was threatened because of cheap imports of second-hand textile machinery. This adversely affected it's short-term profitability.
Two, the company foolishly diversified into all sorts of unrelated businesses such as oil palm, floriculture, granite and steel.
Three, LMW had long owned a 100 percent stake in its subsidiary, LMW Investments Limited. This subsidiary owned investments which had a cost of Rs 9.22 crores and a market value of Rs 28.67 crores. LMW's 1995-96 annual report disclosed, however, that LMW Investments Limited was no longer it's subsidiary.
While the fall in the stock price of LMW can be attributed to all of the above factors, it is the last point relating to LMW Investments Limited which caused a furore in the stock market. The promoters of the company were accused by the financial media of stealing the subsidiary from the minority shareholders of LMW. The financial press virtually blacklisted the company and within months, the company's stock price fell from about Rs 7,000 to Rs 3,500 per share.
The LMW case was, like the ITC case, a typical overreaction to bad news. No doubt the promoters of the company acted in a dubious way. But the market which now valued all the shares of LMW at Rs 213 crores forgot two crucial things:
One, the transaction which the financial media was hollering about was not very material from a valuation standpoint. Even if LMW gave away all its shares in LMW Investments Limited for free, which it most certainly did not, it's total loss would not have been much more than the market value of the investments held by that company. These investments, as mentioned above, were worth Rs 28.67 crore. So, even if LMW gave away for free it's stake in LMW Investments, the total fall in the former's market cap should have been in the range of only about Rs 28 crores or so.
Two, LMW did not gave away it's stake in LMW Investments for free. Rather, it simply opted not to subscribe to an offering of shares made by the subsidiary. As on 31 March 1996, the total number of shares held by LMW in LMW investments were still the same as before. Only now, LMW Investments was no longer a subsidiary of LMW. While it is quite possible that shares were allotted by LMW to outside shareholders at a price well below their intrinsic value, the market should have realised that the maximum possible loss to LMW's shareholders could not exceed Rs 28 crores or so.
This maximum possible intrinsic value loss of Rs 28 crores translated into a per-share loss of Rs 460. But the market price of LMW's shares surrounding this development had fallen by Rs 3,500 per share. Therefore, it was clear that the punishment accorded by the market was not at all commensurate with the gravity of the crime committed. In other words, the market had hugely overreacted to bad news, thus creating a buying opportunity for the contrarian investor. An investor who bought shares in LMW at around Rs 3,500 each has seen them appreciate by more than 70 percent in a matter of few months.
(To be continued)
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.