Businesses that breach trust and indulge in bad practices are bound to fail. It will only be a matter of time before that happens.
Ten Commandments of Business Failure authored by Donald Keough is one of the books recommended by Warren Buffett and Bill Gates. According to Keough, who retired as CEO after 40 years with the Coca-Cola Company, one of the commandments for business failure is playing the game too close to the foul line. This means businesses that breach trust and indulge in bad practices are bound to fail. It will only be a matter of time before that happens.
While there are interesting lessons from the book for corporates, investors too have a learning opportunity. Recent fiascos linked to corporate governance where many promising growth companies turned into a trap for investors are worth analysing.
One such recent case is that of Manpasand Beverages. Once fancied by many savvy investors including large institutions, it was trashed after the resignation of its auditor, Deloitte over not providing key data and information on some of the tricky business activities. Investors then looked deeper into its balance sheet for more clues.
“Cash conversion cycle (inventory + receivables – creditors) shot up to 71 days of sales versus 35 at end-FY2017. Including other current assets and net of other current liabilities, overall net working capital cycle increased to 69 days of sales from 32 at end-FY2017. This is materially higher than other companies in the sector,” said Rohit Chordia, who tracks the company at Kotak Securities.
Investors who jumped in to make quick money have only lost. The stock which quoted at around Rs 450 a share in May crashed to around Rs 100 and then bounced back to current levels of about Rs 144 a share. Currently, it trades at 18 times its FY18 earnings as against a price-to-earnings (P/E) ratio of 55 times about a few months back. This example makes it clear that after one such event even if a company asserts a strong brand equity with the prospect of high growth it would hardly get a premium.
The other interesting point that transpires in these so-called high growths and promising companies is they are closely held, which means the mindset of a few individuals at the helm of affairs matter the most; leave aside a great moat or inherent growth.
A similar story brewed at Fortis Healthcare that was run by the Singh brothers. Despite its compelling business positioning in the growing healthcare market backed by some of the best assets it operates, the stock tumbled after the auditors resigned alleging siphoning of money by promoters or providing loan/monetary support to other group companies.
Only after the Singh brothers eventually resigned from the board did the stock price get some support. While these risks are visible in the balance sheet, the investors have to constantly choose whether to back a management playing closer to the foul line. As Warren Buffett says, “What the wise do in the beginning, fools do in the end.” Dancing to the music could be fatal.
A single mistake can make a great business topple swiftly. In most cases, particularly growing mid and small companies, if the management or promoters do not have the bandwidth to handle the growth, it can turn out to be a disaster at a later stage.
Dairy company Kwality is another example. Until last year in April, the US private equity firm, KKR backed Kwality that commanded a market capitalisation of Rs 4,000 crore. This has now shrunk to Rs 497 crore after an 88 percent correction in its share prices as a result of investors apprehensions about the debt-fuelled turnaround and a growing concern about its balance sheet and overlap of promoter’s interest. A bonus and buyback plan by the ill-advised management backfired due to a lack of investors’ interest. Management and investment bankers often use buyback as a tool to arrest sliding share prices while failing to understand the investors are more keen on value creation.
Illusionary cigar butts
Vakrangee, which bought a large chunk of PC Jeweller shares, crashed due to a stock price manipulation probe by the Securities and Exchange Board of India (SEBI) following the resignation of auditors due to lack of information on its election book and other businesses like bullion.
In the case of PC Jeweller’s stock though, investors got tricked by the illusionary cigar butt concept. Cigar butt investing is an analogy on picking up a cigar that has been smoked up mostly and has only a couple of puffs left. Investors in cigar butts look for companies where stock prices have nosedived due to unfavourable events but small bounce-backs give hope for some quick bucks. Illusionary cigar butts, on the contrary, mean you are caught on the wrong foot in such an investment.
This is what typically happens and had happened with PC Jeweller, which initially crashed from its peak of about Rs 600 to Rs 100 but bounced back to around Rs 250 as the company announced a buyback and clarified it had no connections with Vakrangee.
While at every fall, the stock became cheaper, intermittent price gains led investors to keep getting caught in an illusion that the bottom has been hit. Currently, at about Rs 86, the stock is trading at 6 times its FY18 earnings and continues to be a nightmare for investors. Vakrangee’s investors had an even more volatile ride as the stock had hit several upper and lower circuits.
This shows how trying to average an investment for a wrong reason is like catching a falling knife and often turns out to be a trap. It is easy to buy what is cheap; the real test is in knowing what is in the price and this is where most investors falter.
Market pays little attention to assets, brand equity, and other positive factors once the company comes under the scanner for corporate governance lapses. In such situations, those looking for value may get trapped as cigar butts may remain cigar butts forever.
Last year, investors such as Radhakishan Damani and Rakesh Jhunjhunwala cornered shares of Fortis Healthcare. Investors were banking on the hard assets of Fortis and potential to generate cash if they are bought or acquired. Eventually, even after a year nothing really moved. Its acquisition is yet to be concluded. Investors such as Jhunjhunwala and others have exited or partly sold as assumptions have changed. The share continues to trade at levels last seen a year ago.
Examples galore and investors better take a note of the same.For more research articles, visit our Moneycontrol Research Page.