The Adani Correction: An Opportunity of a Lifetime? 

Hello everyone, Rahul Shah here, trying to make investing accessible and profitable for the average investor.

Until a few days back, the word 'Hindenburg' was closely linked with a brutal, manmade disaster.

Wikipedia tells me that in 1937, a German passenger airship called LZ 129 Hindenburg, caught fire and was destroyed during its attempt to dock at a Naval air station.

The accident caused 36 fatalities and was one of the most widely publicised disasters of its kind. So much so that it totally shattered public confidence in airships and marked an abrupt end of the airship era.

Well, the term Hindenburg has once again returned to torment people and to shatter their confidence.

This time though, the source of such torment is not an airship. Instead, it is the shares of the Adani group companies.

Mid last week, Hindenburg Research, a firm specialising in forensic financial research, dropped a short note on social media, accusing the Adani Group of brazen stock manipulation and accounting fraud over a course of 20 years.

In fact, the note was backed by in-depth research that involved speaking to dozens of individuals and reviewing thousands of documents.

All-in-all, it appeared that Hindenburg Research had left no stone unturned in their analysis.

As expected, the note spread like wildfire, leading to a selling frenzy in Adani Group shares.

By the time the market closed, Hindenburg had punched a US$ 10 bn hole in Adani group companies.

Gautam Adani's personal wealth erosion stood at a massive US$ 7 bn.

Although some of the Adani group stocks have recovered since then, there are others that still continue to bleed.

You see, back in 1974, Paul Slovic, a world class psychologist did some research around the importance of information on decision making.

He wanted to find out whether more information led to better decision making. Therefore, he bought together a group of people who bet on horse races and kept feeding them more and more information.

Did more information lead to better prediction on which horse would win the race? Yes, it certainly did. But like most things in life, even information is subject to the law of diminishing returns.

Slovic realised that after a point in time, more information only led to more confidence but did nothing to improve accuracy. The accuracy remained the same after receiving 40 pieces of information as it would after receiving 10.

In stock market parlance, you won't be at a huge disadvantage if you decide to buy or sell a stock based on a limited but important pieces of information.

Burning the midnight oil may not improve your strike rate while investing although it can certainly give you more confidence in your decision making.

My whole idea of pointing out this study is that one need not put in the time and effort like Hindenberg Research did, to arrive at the conclusion that there was a bubble brewing across a lot of Adani group companies.

I believe in the methodology of Paul Slovic where I am looking for less information but the most effective information.

In other words, I am looking at a technique where I don't have to do deep research like the people over at Hindenburg research did to decide whether Adani group shares are investment worthy or not.

I don't want to spend thousands of hours poring over documents and reports. I want to be able to decide in just a quick couple of hours whether a certain company or a group of companies will make for good investments.

Well, luckily for us, there does exist a technique of this kind. And it comes from none other than my favorite investing guru, Benjamin Graham.

Yes, that's correct. Using this technique, you can decide within a few minutes whether you should invest in Adani group companies or any company for that matter.

And if the answer is no, you can quickly move to the next stock without wasting a lot of time.

In fact, I have covered this technique in my previous videos but let me discuss it again here.

You see, there are two definitions of investing proposed by the investment great Benjamin Graham.

One of these is very famous while the other not so much.

Here's the definition of investment that's very famous.

• "An investment operation is one which upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative."

I think this definition is a work of pure genius. It summarises sound, sensible investing in the most economical terms possible and with the least amount of ambiguity.

I don't think anyone else has been able to come up with a better definition of investment in as many or lesser number of words.

Let us move on to his second definition of investment which is not that famous but is equally effective in my view.

His second definition is...

• "An investment operation is one that can be justified on both qualitative and quantitative grounds."

Now, what is qualitative and quantitative? Let us find out.

Graham was of the view that an analysis of any stock or bond is of two types. Qualitative analysis and quantitative analysis.

Quantitative analysis consists mainly of a study of the financial statements of the company. These are things like the debt-to-equity ratio, the earnings growth and the earnings power, dividend history, assets and liabilities and operating statistics like the return ratios and the profit margins and others.

Qualitative analysis on the other hand, consists mainly of the nature of the business, its future prospects mainly, and the quality of the management.

So, if I were to take some of the best companies in India say like Page Industries or Asian Paints or even Titan Industries for that matter, their historical growth rates, their return ratios, their margins will all come under the quantitative analysis.

However, their future prospects, the quality of their management and their competitive advantages will all form a part of their qualitative analysis.

Now, the question is, which one of the two should you give more importance to? Qualitative analysis or quantitative analysis?

Well, it goes without saying that quantitative analysis is more analysis friendly. The data is easy to find, they are fewer in number and one can draw reliable conclusions from the quantitative analysis of a business.

On the other hand, factors for qualitative analysis like the future prospects, the moat of a company or even the quality of the management are not that analysis friendly.

They cannot be quantified and even if you end up quantifying them, there is no way to tell whether your numbers are biased or are a true reflection of the qualitative strengths of the company.

Put differently, if you think the fair value or the intrinsic value of a stock is Rs 100 per share based on its historical performance i.e. using a quantitative approach and you want to pay a 50% premium because you think the future prospects are good and the management is of great quality, there is no way to know whether the 50% premium is adequate or whether it should be higher or lower.

Benjamin Graham was of the view that in the absence of any mathematical controls, investors tend to get carried away and end up paying a huge premium for prospects and management quality.

In fact, I think that stock price bubbles are formed precisely because of this reason.

Since qualitative factors like management quality and prospects are hard to quantify, one can give any PE multiple to a stock under the garb of these factors.

And gullible investors often become a victim of this game. They are the ones who usually end up holding these stocks at very high PEs.

And therefore, when the reality strikes and it turns out that the premium paid for quality was way too much, share prices crash and these investors lose their shirts.

Ben Graham had a brilliant solution to save investors from this disaster.

As his definition of investment suggests, an investor should not invest in a stock unless it satisfies both the quantitative as well as the qualitative criteria.

A stock that is still loss making but has a great management team and a great future, is not investment as per Graham because the quantitative basis of approval is lacking.

Likewise, if a company has a sound financial history but a poor outlook or has a bad management team then one should reject the stock as it fails on the qualitative parameters. It is sound quantitatively but qualitatively it is not up to the mark.

Thus, for a stock to be considered as an investment, it should clear both qualitative as well as quantitative parameters

Now, let us see where the Adani group companies stand with respect to both these parameters.

This is the slide where I have considered a few important quantitative parameters of the group companies. There's history of the company's earnings, latest debt to equity ratio, the five year average ROEs and of course, the valuations in the form of the PE ratio.

Now, if the number is coloured green, it means that it is a healthy metric and if the number is coloured red, it is an unhealthy metric.

So, if a company has a negative EPS or earnings per share, it is an unhealthy metric because it signifies a loss and therefore, it is coloured red. Likewise, a debt to equity ratio of more than one, a five year average ROE of less than 12% and PE ratio of more than 25x-30x are all coloured red.

I believe that a debt to equity ratio of more than 1x, a return of equity that is below 12% and paying a PE ratio of more than 30x for a company are all signs of danger and such companies should be avoided.

As you can see, Adani Ports is perhaps the only company where all the metrices are coloured green except for the DE ratio which is borderline red.

All the other Adani group companies have at least one red mark against their names or significantly more than one.

This means none of the Adani group companies are investment worthy based on quantitative analysis where the upper limits or the rules were set by me.

Yes, that's correct.

Although the idea that you should do quantitative analysis was recommended by Graham, it is up to an individual to decide the parameters and also fix an upper limit for them.

The rules that we applied to Adani group stocks were my own rules based on my own experience in the stock market.

You can of course have your own rules. Some of you would be comfortable with a higher debt to equity ratio while others may be fine with paying a higher PE multiple if you believe strongly in the company's future prospects.

So, do not forget to do your own quantitative analysis based on your own rules and then decide whether the stock deserves a deeper look.

As far as my quantitative rulebook is concerned, I don't think I would be an investor in any of the Adani group stocks just yet.

Companies like Adani Ports and Adani Wilmar could be considered in the future if their valuations fall below my upper limit ceiling.

For now though, I am steering clear of Adani group companies.

One last thing, I did quantitative analysis and not qualitative analysis. So, where's the qualitative analysis? After all, didn't Graham recommend to do both?

Well, yes, he did. But he also said that you should invest only if both quantitive as well as qualitative analysis give you a green signal.

As we just saw, almost all the Adani group companies did not clear the quantitative hurdle and therefore, there is no point in doing qualitative analysis.

This is why I skipped it. Hope you got the answer.

This brings me to the end of the video. Hope you liked it. I will see you again next time. Good bye and take care.