What Happens When You Don’t Buy Quality And When You Do? by Sanjay Bakshi
How I Made a Killing in the Stock Market
I’d like to start by telling you a story about a killing I made in the stock market many years ago involving a very cool risk arbitrage operation. By 2001, I had accumulated six years of experience in risk arbitrage with very satisfactory overall results because the arb spreads were very good as the competition was low.
So, in December 2001 this company announced a buyback at Rs 250 per share. I bought the stock at Rs 215, held it for about 40 days and then just prior to the tender offer, I sold it for Rs 240, netting a gain of Rs 25 on an investment of Rs 215. That’s a flat return of about 12% and an IRR of about 110%. Not bad at all!
Many well-known hedge fund managers are also philanthropists, and many of them have their own foundations. Seth Klarman of Baupost is one of those with his own foundation, and he invested in a handful of hedge funds through his foundation. This list of Klarman's favorite hedge funds is based on the Klarman Family Foundation's 990 Read More
What was the name of the company? Gee, I wish I could get away without telling you my trade secrets but I confessed today morning that I will tell you everything. The name of that company was MICO. Now, it’s called Bosch Ltd (NSE:BOSCHLTD) (BOM:500530).
Some of the dumbest things I have done have produced very high IRRs.
Let me now tell you about another fascinating experience with Graham’s low-priced common stocks theme.
Low-Priced Common Stocks
This is another one very cool Graham and Dodd strategy that works during severe bear markets. It really does.
Graham called it the “low-priced-common stock” strategy which involved selectively buying shares of companies selling at absolute low price (so called penny stocks) during severe bear markets and holding them for a few years. He cautioned investors against the typical penny stocks of dubious companies which were “pushed” by intermediaries who were incentivised by fat commissions. He wrote such penny stocks were not genuine at all and their pseudo-low prices were
“accomplished by the simple artifice of creating so large a number of shares that even at a few dollars per share the total value of the common issue is excessive.”
He recommended that investors should buy low-priced common stocks of the genuine variety which
“will show an aggregate value for the issue which is small in relation to the company’s assets, sales, and past and prospective profits under favorable business conditions.”
Using his approach of finding such companies, back in the scary days of March 2009, I came up with a few names which displayed the characteristics of the genuine variety of low-priced common stocks:
- Low absolute price;
- A huge drop in stock price from its previous high;
- A very low equity market in relation to size of company’s revenues (i.e. A PSR <20%); and
- A high cash flow yield (operating cash flow/EV > 20%).
Here’s what happened to two of those names over the next three years:
As the charts show, I would have been better off buying a Nestle (a far better quality business) instead of buying Finolex or Omax. Indeed, you can virtually take any number of much higher quality businesses than Finolex Industries Limited (NSE:FINPIPE) (BOM:500940) and Omax Autos Limited (NSE:OMAXAUTO) (BOM:520021) and you’d find that while Graham’s low-priced common stock strategy works quite well, buying better quality businesses would have worked even better.
Let’s now turn to looking at three of India’s well-recognised high-quality businesses.
Take a look at ITC Limited (NSE:ITC) (BOM:500875), one of India’s high-quality businesses. The chart below plots its stock price and P/E multiple since Jan 2002. The stock price (blue) is on the left vertical axis and the P/E (red) is in the right vertical axis.
As you can see the stock has done very well over the long term. Now take a look at the P/E part of the chart. The P/E of ITC has ranged from a low of 11 in March 2003 to a high of 39 in July 2013. Let’s ignore these two extremes and focus on the P/E band of 25 which I have highlighted in the red rectangle.
Now, think about this for a moment. Paying 25 times earnings is considered as very risky and speculative by classic Graham & Dodd investors, right? I mean, most deep value investors, who consider themselves to be disciples of Ben Graham won’t touch a stock with a P/E multiple of 25.
So, let’s see what happened to people who bought the stock at a P/E multiple of 25 in the past and held the stock till date. The table below highlights several such occasions.
See full PDF here.