The Best Way to React to the Fall in Hero MotoCorp Stock

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One of the hacks that I have found extremely useful in my 15-year career as a research analyst, is to think of a company's profits as bond coupons.

Just as bonds have a yearly coupon, one can assume the yearly profits of a company as being coupons to its shareholders.

There is an enormous benefit to approaching investing this way. The biggest of all is that it makes the process of valuation quite simple.

Allow me to explain with an example.

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If the future is an exact replica of the past, then company A is easiest to value out of the above three.

All you have to do is slap a multiple to its EPS per share and voila, you have a reliable estimate of its intrinsic value.

Let's say this multiple is around 18x, which you give to a decent sized, fundamentally strong company in India. This gives us an intrinsic value of Rs 1,800 per share for company A.

In short, you will buy the company if it's available at Rs 1,800 per share or lower and reject it if the price is significantly greater than that.

What about company B? Is that also easy to value? Well, I'd like to think so.

But in this case, we need to take its average earnings over the last few years since there is some variation in it. Well, this turns out to be around Rs 150 per share, giving it an intrinsic value of around Rs 2,700 per share, using the same PE multiple of 18x.

However, there is a small twist here. I'm not willing to buy the company at Rs 2,700 per share.

As the earnings are less predictable than company A, I insist on a margin of safety. In other words, to protect myself from incurring a loss, I will buy the stock at Rs 2,025 per share, translating into a margin of safety of 25%.

If the stock falls to Rs 2,000 or below, I would get interested in buying it. But I'd stay away if the price is significantly higher than this.

One look at the earnings of company C and it's clear this one would be a tough nut to crack. Its earnings have moved all over the place. There's very little that we can infer on what its future earnings may look like.

There are two options given this state of affairs. You either insist on a much bigger margin of safety than stock B or else, avoid investing in the stock and move on.

If you think the company is big and is still going to be around few years from now then you can certainly invest after taking into account a big margin of safety. But if you are not sure of this then you need to move on.

Here's the interesting part. Company A is a figment of my imagination whereas company B and company C, are as real as they come.

Company B is none other than Hero MotoCorp while company C is domestic steel behemoth SAIL.

The whole idea of pitting SAIL against Hero MotoCorp is to give you an idea about the stark contrast in the underlying quality of earnings.

You know what, when it comes to Hero MotoCorp, I am going to follow my own valuation of the company.

If the stock price goes below 2,000 per share, the risk-reward equation from a 2-3 year perspective will turn in favour of the investor in my view.

At its current price of around Rs 2,200 per share, it is still a tad expensive in my opinion.

I know what you are thinking. Hero MotoCorp has come in the eye of a storm. There have been IT raids on the premises of the company and its management. Instances of irregularities and illegal business expenses have also come to light.

I think it was Warren Buffett who once said that it takes 20 years to build a reputation and five minutes to ruin it. If the allegations against the company are proven to be true, the company's reputation is in a serious risk of getting tainted.

There are investors who've held the company's corporate governance standards in high esteem. They would certainly be disappointed if the company is found guilty of irregularities.

However, where does this leave the shareholder of the company or a potential investor for that matter?

Well, your choice on what to do next depends on what kind of an investor you are. The situation is indeed tricky if you happen to be a long-term investor. One who adopts zero tolerance towards management integrity.

Should you consider this as a rare mistake, a lapse of moral judgement, forgive the management and move on, as long as they're willing to accept the mistake?

Or should you just exit the stock irrespective of how this whole issue pans out?

Well, to be honest, the ball is entirely in your court here. You'll have to take a call based on your own approach and framework.

As I said at the start, I'm more of a quantitative than a qualitative investor. For me, most companies are attractive and worth buying at a certain price and expensive at another.

Does this mean I'm willing to recommend any attractively valued stocks even if the management is outright dishonest?

Absolutely not.

But I also believe in giving the management a long rope till the time the accusations are proved. Especially if it's a good quality business like Hero MotoCorp.

And in between if the stock price falls to below my estimate of its intrinsic value, I may consider recommending it.

We did the valuation exercise for Hero MotoCorp earlier in this piece and argued that the stock may become an attractive buy at Rs 2,000 per share or thereabouts.

Thus, my way of reacting to this whole Hero MotoCorp saga is to be a buyer below Rs 2,000 per share and exit within 2-3 years when the price reaches Rs 2,700 per shares or higher.

Alternatively, you can consider a still higher margin of safety and have your buying point close to Rs 1,800 per share.

The choice is yours. This is not a recommendation.

I think the whole game is first about figuring out what kind of an investor you are and your expected holding period.

Only once you have clarity about this, can you have a rational approach towards investing in the company's shares.

Warm regards,


Rahul Shah
Editor and Research Analyst, Profit Hunter

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