How Some Investors Make Big Money When Frogs Turn into Princes - The 5 Minute WrapUp by Equitymaster
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How Some Investors Make Big Money When Frogs Turn into Princes

Feb 14, 2017
In this issue:
» Apurva Sheth's Free Special Report!
» CPI Inflation at five-year low but Forget About Rate Cuts.
» Is the Great Indian Real Estate Bubble on the Verge of Collapse?
» ...and more!
00:00
Kunal Thanvi, Research analyst

Most of us are familiar with the fairy tale, The Frog Prince.

A magical kiss from a beautiful princess transforms a cursed frog into a handsome prince...and they live happily ever after. Well, at least that's the crux of it.

When it comes to the world of business, however, this story is horribly misinterpreted.

A new CEO believes he can turn around a struggling company...and fails.

The management of a successful company makes a foolish acquisition of a loss-making competitor. They believe they can turn it around...and fail.

In his 1992 letter to Berkshire Hathaway shareholders, Warren Buffett summed it up nicely...

  • I've observed that many acquisition-hungry managers were apparently mesmerized by their childhood reading of the story about the frog-kissing princess. Remembering her success, they pay dearly for the right to kiss corporate toads, expecting wondrous transfigurations. Initially, disappointing results only deepen their desire to round up new toads.

At the heart of this argument lies the simple fact of turnaround stories: Turnarounds seldom turn.

Why?

When a company gets into trouble, any number of reasons could be at play. Sometimes, the company may not be at fault.

The business could be suffering from bad economics (telecom, textiles, airlines). The industry itself could be becoming obsolete (electronic hardware). A slump in economic activity in the company's key market could be to blame.

In these cases, there's nothing much a great manager can do.

These frogs won't turn into princes.

Then there are company-specific issues. The issues are as numerous as the struggling companies themselves. These are the companies that can mesmerise investors and acquisition-hungry CEOs, when they believe a turnaround is possible.

But watch out: Turnarounds seldom turn.

This is a high-risk, high-return game. It's not for the faint hearted.

The historical numbers of such companies will look quite bad. A lot will depend on the management.

It's necessary to have a face-to-face meeting with the CEO. You would need to deeply understand his strategy for turning around the company. As a long-term investor, you will need answers to the following questions:

  • Has the management correctly diagnosed the problems?
  • Is the new strategy appropriate to solve these issues or is the management taking the company in a totally new direction?
  • What are the challenges the management faces?
  • How focused are they?
  • How will they deal with the competition?
  • Which key performance metrics will you keep a track of to monitor the turnaround?

No doubt, these are very difficult questions to answer.

But most importantly, you need to buy the stock before the turnaround happens. If you wait for the turnaround to show up in the numbers, the stock would have already run up.

This is why the aam investor has almost no chance of finding frogs that can turn into princes.

But Richa and her Hidden Treasure team have good news. They believe they have found one.

It's a small company that specialises in a very appetising niche in the food industry.

It ticks all the right boxes in our frog-to-prince checklist. Not only that, the management puts the interests of minority shareholders at the forefront.

Best of all, the stock is cheap compared to the long-term potential of the business.

Richa and her team believe they have found a big winner. They were so convinced, they didn't wait to recommend a buy on the stock. Hidden Treasure monthly reports usually come out on the 15th. They released the report on Saturday the 11th.

The stock is still trading below the maximum recommended buy price. However, it may not trade there much longer.

You can gain access to the report here (Subscription Required).

03:30

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------------------------------

03:45 Chart of the Day

Yesterday, Central Statistics Office (CSO) released Consumer Price Index (CPI) Inflation (retail inflation) data. CPI has fallen to five years low of 3.17%. The moderation in retail inflation is generally a sign of an of interest rate cut.

However, in the recently concluded Monetary Policy meeting, the Reserve Bank of India (RBI) kept interest rates unchanged. In fact, it indicated the current interest rates are at the bottom of the interest rate cycle.

CPI Inflation at Five Year Low


So the question is why no interest rate cut, despite the tepid retail Inflation?

Interestingly, the core inflation (non-food, non-fuel inflation) has risen sharply in the January 2017 at 5.1% against 4.9% in December 2016. However, this was offset by the subdued food inflation.

Food inflation accelerated by mere 0.53%. The benign food inflation was due to subdued vegetable prices which were adversely impacted by the demonetisation.

Given the low base and normalization in the food prices going ahead, the retail inflation can be expected to inch up.

We believe, given the strong growth in the core inflation and the normalization of the food prices, the central bank will be wary to go in for any further interest rate cuts.

04:20

Historically, sales in the real estate sector start picking from January and peaks between March & July. With a very dull environment in November-December (thanks to demonetisation), the developers were quite optimistic about the revival in January. However, that has not been the case.

Demonetisation has led to some correction in the property prices due to cash crunch. In fact, as per the recently concluded Economic Survey, prices can correct even more as investing undeclared income in real estate has become difficult.

After demonetisation we met various companies to see the on-ground situation. One of the worst hit sector was Real estate. This is what we said:

  • Here is What We Found:

    The company believes that the land prices in the area it operates are already seeing some softening before an ultimate correction of 20-35%.

    They also believe this will result in sector consolidation. And demand will bounce back on interest rate softening.

    Here is what We believe:

    We think that even if interest rates don't come down, the outflow of the unaccounted money from the sector will benefit organized companies with long track records and sound managements.

Interestingly, as per an article in the Mint, given the benign real estate demand across the country, real estate players are indulging in activities like: 1) Flexible payment options (Reduction in upfront payment); 2) Flexible Carpet Area; 3) Waiver of the Stamp Duties; 4) Focus on cash flows over profitability.

We believe, these are the early signs of correction in real estate prices in India. With a very subdued demand, inventory buildup and relatively difficult cash transactions can lead to a good correction in the real estate sector.

My colleague, Vivek Kaul written about the great Indian Real Estate Bubble. He has spoken out about the exorbitant real estate prices in the country which are now ripe for a good correction.

04:45

After opening the day in red, the Indian share markets have continued to trade on a negative note. Sectoral indices are trading on a negative note with stocks in the metal sector and consumer durables sector witnessing maximum selling pressure.

The BSE Sensex is trading down 8 points (down 0.03%) and the NSE Nifty is trading down 9 points (down 0.1%). The BSE Mid Cap index is trading down by 0.6%, while the BSE Small Cap index is trading down by 0.3%.

04:55 Today's Investing Mantra

"Long-term competitive advantage in a stable industry is what we seek in a business. If that comes with rapid organic growth, great. But even without organic growth, such a business is rewarding. We will simply take the lush earnings of the business and use them to buy similar businesses elsewhere." - Warren Buffett.

This edition of The 5 Minute WrapUp is authored by Kunal Thanvi (Research Analyst).

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