A Star Fund Manager is Bullish on this Former Blue Chip...but I'm Not

Jul 6, 2020

Rahul Shah, Editor, Profit Hunter

Investing in a potential turnaround stock has a certain charm to it.

Perhaps it has to do with the thrill of swimming against the tide. You are alone in a crowd of many.

Thus, when you succeed, you are hailed as a true hero, the one who saw the opportunity well ahead of others.

But I always keep in mind the following words of wisdom from Warren Buffett when thinking of recommending a potential turnaround stock.

  • In a chronically leaking boat, energy devoted to changing vessels is more productive than energy devoted to patching leaks.

Looks like Buffett has a totally different take on the issue. Investing in turnaround stocks is not all that glamorous as per him.

To help throw more light on this delightful Buffettism, here's an earnings trend of two companies. Note that EPS stands for earnings per share.

To Patch or Not to Patch a Leaking Boat

  Company A Company B
Year 1 EPS 9.5 1.3
Year 2 EPS 4.0 2.0
Year 3 EPS -1.9 1.5
Year 4 EPS 1.3 1.6
Year 5 EPS 1.2 0.9
Year 6 EPS 2.9 1.3
Year 7 EPS -4.2 1.2
Data Source: ACE Equity

One look at the table and it is evident which one of the two companies is a potential leaking boat.

Not only are company A's earnings all over the place, it has incurred losses in two of those seven years.

Company B's earnings on the other hand are certainly much more consistent.

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Company B has also done a much better job in terms of capital efficiency. Its average ROE (Return on Net Worth) is 25%.

It's 6 times better than Company A and also better than that earned by most Indian companies.

As far as the last piece of the financial puzzle i.e. balance sheets are concerned, both the stocks have rock solid balance sheets with debt only a small fraction of equity.

Under normal circumstances, the valuations of the two stocks would have played a decisive role in selecting one over the other.

However, the financials for company 'A' are bent so out of shape that it will be too risky to buy it irrespective of the valuations.

Now here comes the big reveal...

Company A and Company B are not different companies. They are one and the same stock but across different time periods.

Company A is domestic power equipment major BHEL between FY14 and FY20.

Company B is also BHEL but between FY97 and FY03.

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You see, back in 2003, I would have gladly invested in BHEL as not only were its financials impressive, it even traded below book value for a while, my preferred buying zone.

And guess what? I would have been rewarded handsomely. The stock went up 5x over the next two years.

I am not sure the stock can give similar returns based on its current fundamentals represented by Company A in the table.

Of course, its current valuations are almost half of what they were back in 2003. However, it is a boat that has developed a lot of leaks.

I might as well look for a different vessel rather than watch the management work frantically at patching the leaks.

A leading fund manager does not share my opinion though. He believes the stock is a strong 'Make in India' bet and has bought a huge chunk of shares for his portfolio.

He is certainly counting on this boat to regain its lost glory pretty soon.

I will however wait for the improved performance to start showing in the numbers before I can start counting on it too.

What do you think?

Good Investing,

Rahul Shah
Rahul Shah
Editor, Profit Hunter
Equitymaster Agora Research Private Limited (Research Analyst)

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2 Responses to "A Star Fund Manager is Bullish on this Former Blue Chip...but I'm Not"

Sid

Jul 7, 2020

Bit af a tÍte-a-tÍte always exciting and quite engaging here Rahul.

Only side-eye could be that while rare, few niche heavy industries may struggle with spells of lumpy demand for prolonged cycles.

But then yes its only prudent to make safer picks when upside is as best based on a single & as yet confounding factor

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Ravish Channe

Jul 6, 2020

On Friday, I took a buy call on BHEL (5000 nos) at Rs 37. Turned out to be good. I understand your concerns on financials but what do you think about momentum considering current restrictions on China trade? Is it worth to HOLD for some time or sell off?

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