What is the history of the company and management?

Before starting the analysis, you have to look at the company’s background and management. You need to know what is the business of the company in terms of its infrastructure, the number of factories, branches, retail outlets, etc.

History of a company

Understand the culture of the organization. For example, everyone knows that the Tata group has a certain culture. Irrespective of any Tata company, the group brings a certain culture, whether it is a commitment towards employees, society contribution, etc. These aspects indicate the long-term commitment of the company. You need to understand how long the company has been in business. It is a good idea to look at companies that have been in operation for 15-20 years, this ensures that the company has seen at least two business cycles. Oftentimes in the Indian context, we may have third-generation or fourth-generation running the business, and it’s even better. The promoters may be involved in the day-to-day operations or have professionals run the business. You have to ensure that promoter has skin in the game and has a majority of his/her wealth tied to the prosperity of the business. It may be a good idea to look at the financials of the company over the long term. It is a good idea to look at 5-10 years of the financial history of the company. You can look at two data points to start, the first information you can look at is the return profile of the company. Then you can look at the sales growth numbers of the company. Once you are satisfied with the return and growth, you can look at cash flows to ensure the money is coming to the business and not tied to the working capital. A quick search on broker reports, TV interviews, and google searches will provide insights on the management, business outlook, any fraud company committed in the past, resignations, etc.

Disclaimers

• Investment in securities market are subject to market risks. Read all the related documents carefully before investing.

• The securities quoted are for illustration only and are not recommendatory.

• Registration granted by SEBI, membership of BASL (in case of IAs) and certification from NISM in no way guarantee performance of the intermediary or provide any assurance of returns to investors.

Details of the advisor

• Advisor: Ankur Kapur

• SEBI RIA No.: INA100001406

• BASL Member ID: BASL1337

Special situation investing

Joel Greenblatt’s book “You Can Be a Stock Market Genius…” beautifully explains event-driven investing also called Special situation investing. The core idea of special situation investing is not valuation but an event that drives the share price.

Special situation investing

Special situations have a clear and often a catalyst, so the outcome is often binary i.e., either it works out as expected or it doesn’t. Most of these situations revolve around the transactional aspects of a corporate event. Due to time sensitivity, these investment situations are quick and not like typical value-based investing. An announcement by the company is not an opportunity unless there is a higher probability of closure. The investor’s task is to understand this probability. Merger arbitrage In a merger, one company takes over another one by paying a certain sum in cash, stock, or a mix of both. There can be a gap between the offer price and the market price. This gap is usually due to regulatory approvals, shareholder approval, fake offer, etc. The more uncertainty, the more may be the gap. Unlike a value-based investing approach, here an investor should avoid being contrarian. For example, regulatory approval is pending, and you decide to invest. Eventually, when the regulatory approval comes (HDFC Bank and HDFC limited), sure you will make a good return but if the regulator poses a challenge (IHH and Fortis), you may incur losses. Therefore, reduce the probability of loss as much as possible. The potential return reduces but the probability of success increases. The time frame for these transactions to close is 3 months to 12 months, depending on how complex the transaction is. During the merger process, the spread can be quite volatile and driven by the flow of news/rumors. This might present more than one opportunity to enter/exit the trade. The opportunity has to be evaluated at both target’s and the acquirer’s end especially if there is a stock-based transaction. At the time of the HDFC and HDFC Bank merger, an arbitrage opportunity (~2%) existed to buy HDFC limited and short HDFC Bank due to the difference in the transaction. Spin-offs In a spin-off situation, the company is divesting part of its business into another company. The company also distributes its shares in the spin-off on a pro-rata basis to the current shareholders. Reliance plans to separate its retail, telecom, and oil business. The shareholders will be given shares as per the value assigned by the company to each of the businesses. But where can an investor make money? In case the spin-off business is small, most of the institutional investors will sell their stake in the small business. The logic of the sale is not value, but institutional investors are not allowed to hold. The size of institutional investors' funds often becomes a very high portion in the small company, and these investors don’t want to participate as a majority shareholder in a small company. This creates significant selling pressure right before/after the transaction. This might offer a chance to play on the eventual rebound. Another key to look at is the senior management allocation in small businesses. If the promoter is keeping a significant stake in the smaller entity, there is a high chance of spin-off success. Buyback A buyback offer is announced when a company intends to buy a part of its outstanding shares. This can be done for various reasons, such as capital return to shareholders or maybe management simply thinking that shares are very cheap now. Usually, the consideration comes in cash, and to incentivize participation, the offer is done at a premium to the share market price. Participation is often high when the offer price is at a premium, making the investment proposition weak. If you buy shares intending to tender but eventually the company does not accept due to the size of bidding, the share price can drop. The probability of success depends upon the acceptance by the company. Lesser participation in the offer indicates a higher likelihood that upper limit prices may be reached. Asset sale Often companies own land or buildings on their books. Accounting rules require these assets to be shown at their cost price, which may be quite low. A ballpark assessment of the value of land/building can indicate a fair value of the asset. Many companies trade at a significant discount to its sum of the parts valuation and have their assets undervalued by the market. In such cases, an asset sale could become a catalyst for the share price increase as when the assets eventually get exchanged into cash, the market is much more likely to start recognizing that value. Rights offering The rights offering is a way of raising equity while giving the priority to current shareholders. Each shareholder is allowed to acquire a certain amount of shares and to incentivize participation, new shares are offered at a discount to the market price. Participation by the top management is a positive indicator. Rights offering should be of reasonable size and not a very large portion of the overall market cap. Warrants A warrant is giving the holder the right but not the obligation to buy the stock at a certain price, quantity, and future time. Warrants need to be exercised before the pre-fixed date. If you don't exercise warrants before the pre-fixed date, then the warrants lapse. The special situation investment opportunity in these instruments arises when it is much more profitable to buy the warrants of a company rather than buying the underlying shares.

Disclaimers

• Investment in securities market are subject to market risks. Read all the related documents carefully before investing.

• The securities quoted are for illustration only and are not recommendatory.

• Registration granted by SEBI, membership of BASL (in case of IAs) and certification from NISM in no way guarantee performance of the intermediary or provide any assurance of returns to investors.

Details of the advisor

• Advisor: Ankur Kapur

• SEBI RIA No.: INA100001406

• BASL Member ID: BASL1337

How to identify turnaround investments

Investing is all about the unknown future. More unpredictable the future, the better maybe the investment returns. Often an investment strategy of investing in high-quality companies is promoted by media and/or fund managers. There is a lot of merit in investing in high-quality, cash-generating businesses. The problem is the price. These businesses are quoted at very high valuations.

Turnaround investment approach

Price is what you pay, and value is what you get

Justifying any price for a quality business is not the right approach. You wait for bad news, a bad quarter, margin pressure, etc. In the short term, markets often react and may provide an entry price. Note that the right time will be filled with pessimism and uncertainty. If you have a good understanding of the business, you will be able to make a contrarian decision. There are only 50-60 high-quality businesses in India that are often high-priced. What other option can you evaluate where the price you pay is substantially less than the value you get? One such strategy is to identify turnaround businesses. These are businesses that have gone through a certain turmoil in the recent past. A piece of negative news often beats down the share price. The idea is to find businesses that are equipped to handle the crisis to become profitable again. Some of the areas where you can find these businesses: Recently changed management Top management is key in turning around businesses. If there is management restructuring, especially CEO/MD, be on the lookout. Follow the company to understand the changes the company is doing. This analysis is often done over 2-3 quarters. You are trying to assess whether the changes generate any improvement. Margin expansion cost control, and revenue focus is often the strategies that the top leader would focus on and turn around. Business Strategy The company may reflect on a broad business structure and get rid of loss-incurring projects or businesses. It may be looking at the product level strategy, cost reduction options, etc so that margins improve. Quarterly earning calls can be a key input for this assessment. Managing cash flows One of the key aims of business strategies is to improve cash flows – the net of operating expenses and revenues – by cutting costs and/or selling businesses not important to the core business. So, on one side, there may be signs of cost reduction and on the other side, revenue improvements. It takes a few quarters before you see the company becoming profitable. Approach The company’s worth is future cash flow discounted to the present. When the market is not able to see cash flows, the share price may often be under stress. It is a good strategy to allocate 0.5-1% and gradually build or exit the position. It takes a while, a few quarterly reviews, listening to management, talking to customers/suppliers, etc. before you can build a high conviction in the business.

Disclaimers

• Investment in securities market are subject to market risks. Read all the related documents carefully before investing.

• The securities quoted are for illustration only and are not recommendatory.

• Registration granted by SEBI, membership of BASL (in case of IAs) and certification from NISM in no way guarantee performance of the intermediary or provide any assurance of returns to investors.

Details of the advisor

• Advisor: Ankur Kapur

• SEBI RIA No.: INA100001406

• BASL Member ID: BASL1337