Margin of safety works, IPOs (often) don’t: Key investing lessons from 2018

Buying stocks or securities at a significant discount to their intrinsic value (known as margin of safety) provides protection against something going wrong.

At the peak of the market last year, investors were piling into companies in chemicals, NBFCs, construction, electrode and graphite businesses irrespective of high valuations. Companies in the electrode industry such as HEG and Graphite India, which were trading at 19-20 times their FY18 earnings are now trading at about 13-14 times.

Many construction stocks have seen a severe valuation de-rating. Dilip Buildcon, which was trading at 30 times its earnings in May, is currently trading at 9 times its FY18 earnings.

During times of exuberance and excessive valuations in the markets, legendary investors like Warren Buffett have said that exercising margins of safety could help in avoiding losses and provide a cushion against any errors in judgement.

2) Stocks that look cheap can get cheaper

In 2018, share prices did not fall in a straight line. So, Kwality, Manpasand, Yes Bank, Infibeam, Punjab National Bank (PNB) and Vakrangee, among others, witnessed several bouts of correction. Some investors doubtless kept buying on the declines thinking they were getting good bargains.

To avoid this mistake, investors should, after a steep fall in the stock, step back and evaluate the business wholly in the context of price. For instance, PNB suffered a sharp fall when the Nirav Modi scam came to light; the stock was trading at 0.8 times book.

But the degree of the total loss became clear only after the bank reported a massive Rs 13,400 crore loss in March 2018 and another Rs 940 crore in June 2018.

As a result, the stock continued to take a beating, with book value halving further at 0.4-0.5 times at the lowest. The lesson here is the old market adage: Do not catch a falling knife.

3) IPOs aren’t a get-rich-quick scheme

It is a known fact that most IPOs come to the market when sentiment is at a peak, are excessively priced, and generally a bad long-term investing strategy.

The market’s frothy phase and the subsequent volatility bore this out, as several companies listed at premium valuations. For instance, Indian Energy Exchange, which came up with a Rs 1,000-crore IPO in October 2017, was a 100 percent offer for sale priced at 37 times earnings its FY18 earnings. A year after its listing, it trades at Rs 166, compared to a (split-adjusted) listing price of Rs 165.

BSE IPO index fell by about 10 percent and many newly listed shares have performed miserably post listing.

Similarly, Shankara Building Products, a home improvement retailer, was one of the most sought-after names at the time of its IPO. Given the high oversubscription, the stock listed at a steep premium of nearly 38 percent making a high of Rs 1,780 in January last year.

Since early September 2018, the stock has fallen consistently and currently trades at Rs 538 a share, which is barely 14 percent above the issue price of Rs 460. The company’s cash flows seem to have peaked out around the time of its IPO and working capital concerns came to the fore.

It is, therefore, important to evaluate each IPO carefully, as some companies (and their merchant bankers) try to take advantage of a booming market by selling shares at pricey valuations.

The strategy of trying to make a quick buck on listing works sometimes, but stay too long and the IPO party gets over before you realise it.

4) Corporate governance matters

Be it window dressing of accounts, the exit of auditors and CFOs, or deliberate fraud, the year 2018 brought to the fore a toxic mix of governance issues. PC Jewellers, once regarded as one of the most fundamentally robust stocks, was the biggest loser in the BSE 500 index, falling over 80 percent in 2018.

The company’s slide began when Vakrangee bought its shares from the secondary market. Investors speculated that PC Jewellers had a business relationship with Vakrangee, which then came under SEBI’s scanner for alleged manipulation of PC Jewellers’ shares. Vakrangee’s auditor, Price Waterhouse & Co resigned citing reasons such as inadequate information available about Vakrangee’s bullion and jewellery business.

Manpasand Beverages suffered a similar fate after the resignation of its auditor Deloitte. The auditor said the company did not disclose key data and information on some of its business activities. Investors started looking into the balance sheet and found several accounting gaps such as inflated inventory and receivables. The stock went down by a huge 80 percent.

What this drives home is corporate governance is important. But investors should also differentiate between an institutional problem created by errant promoters, or individual problems that can be addressed – such as in the case of former ICICI Bank MD Chanda Kochhar. Kochhar’s resignation in October 2017 lifted the overhang on the stock, which has since rebounded from Rs 307 to Rs 365.

5) Highly leveraged players seldom make turnaround stories

Debt-ridden Jet Airways has come back from the brink several times in the past. It appeared poised for a similar turnaround in the year 2018, with its share price topping out at Rs 870 in January last year.

But it only took a spike in crude oil prices to derail any turnaround plan the company – already struggling with high debt and operational efficiencies – may have had. The airline defaulted on its debt obligations and the stock fell to Rs 280.

Dairy product major Kwality is another such story. In January 2018, savvy institutional investors were betting on a turnaround story, following infusion of private equity money and portfolio rationalization by the company.

The company spent a lot of money to gain market share with the help of brand ambassador Akshay Kumar. But the debt overhang undid any such attempts to improve profitability.

The failure of the turnaround plan led to an over 90 percent correction in its share prices in the last year.

Betting on a turnaround is a highly specialised and extremely skilled investing strategy, which requires going way beyond the reported numbers etc. Retail investors are better off staying away from it.

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