Why a Suzlon Energy Investor May Not Like Delta Corp and Vice Versa

Virender Sehwag or Rahul Dravid?

Who do you prefer between the two? It is difficult to decide, isn't it? Both have fantastic track record, and both are legends of the game.

But what if I force you to choose one over the other? Who would you choose in that case? Some of you would prefer Virender Sehwag for his sublime skills and his risk-taking ability.

The others may pick Rahul Dravid for his dogged determination, his resilience, and his textbook technique.

I think it is difficult to arrive at a consensus on this topic. Each of us would tend to gravitate towards a player based on our own personal preferences and our preferred approach towards the game.

Make no mistake though. Both have been true match winners for India and one of the best in the business.

Just as there is the Sehwag style and the Rahul Dravid style of batsmanship, the investing world is also divided into two kinds of investors.

But here's the sad part.

Most investors are unaware which category they themselves fall into. And this is not good because if you don't know your kind, your long term returns from investing may suffer.

It is like running a race on only one leg.

So, how do you decide your kind? How do you decide whether you belong to the Sehwag school of investing or the Rahul Dravid school of investing?

Well, keep reading this piece and hopefully by the end of it, you will have your answer.

So, here goes...

Have you heard of the base rate fallacy by the way? If you haven't, here's a simple puzzle for you.

Shalini is 31 years old, single, outspoken, and very bright. She majored in philosophy.

As a student, she was deeply concerned with issues of discrimination and social justice, and also participated in anti-nuclear demonstrations.

Which of the following two sentences is more likely?

• Shalini works at an MNC.
• Shalini works at an MNC and is a social activist.

When a similar question was posed to students in the west, 80% of them answered option B. Do you also think it is option B?

If yes, then you are wrong my friend.

Simply because the universe of people working at an MNC is much bigger than the universe of people who work at MNC and are also social activists.

So, Shalini is more likely to be an MNC employee than both MNC employee and social activist combined.

I hope you are getting my point. There are more people working for MNCs than people who are both working for MNCs as well as social activists.

Now that I've warmed you up, here's another puzzle of a similar kind.

Would you rather invest in a company that is...

1. Consistently loss making, has high leverage but is believed to have a bright future and is also available at multi year lows.
   
   OR
   
   
2. Is fundamentally strong, is profitable, is also available at attractive valuations but is expected to face challenges in the future.

Let me repeat that. Loss making, weak balance sheet, stock price at multi-year lows and a bright future

Or a fundamentally strong company with strong balance sheet and attractive valuations but with a challenging future.

So, which one would it be? Company 1 or Company 2.

Try to use the Shalini principle here. What is more likely to make money for you?

Do loss making or highly leveraged companies create more wealth in the future if their future is bright?

Or do fundamentally strong companies available at attractive valuations, more likely to overcome future challenges and therefore prove more rewarding than the first kind of companies?

I believe that in aggregate, the companies of the second kind i.e. fundamentally strong companies are likely to be more rewarding over the long term than the first kind.

Put differently, if you take 100 companies of the first kind versus 100 companies of the second kind, there is a strong chance the second portfolio of fundamentally strong companies with a challenging future doing better than the fundamentally weak companies with a bright future.

But wait, there is another option as well.

You can very well adopt the Virender Sehwag kind of approach and throw the rule book and discipline out of the window.

You can say that I am going to rely on skill and judgement, and I don't mind investing in a fundamentally weak company provided I am convinced that it has a great future and I am getting the stock very cheap.

These are the kind of investors who manage to get into stocks like Suzlon Energy or even a Zomato at the bottom and earn big money from them.

They argue that these companies may have had a bad past but their future looks bright and therefore, it makes great sense to invest in them.

They are also likely to reject a stock like Delta Corp because they are not going by the numbers.

They are using their skill and judgement to figure out that Delta Corp's past may have been good, but it is facing a real challenge now and its profits would certainly take a beating going forward. It may even stop existing as a business.

The Rahul Dravid kind of investor on the other hand, will go by the rules and will follow a strict discipline.

For him, companies like Zomato and Suzlon Energy are not worth investing into because as a rule, he does not want to come anywhere close to a loss-making company.

Therefore, unless these companies do not show consistent profitability, they won't consider them no matter how bright the future. He is a stickler for rules and discipline.

On the other hand, he is likely to invest in a stock like Delta Corp provided there is a big margin of safety in valuations.

He would argue that he is not capable of figuring out the future profitability of the company but since the stock has proven itself in the past, it is likely to overcome the current challenge as well.

Therefore, it is worth investing in provided the price incorporates a sufficient margin of safety.

Please note that there are stocks like ITC, PSU defence, railway stocks, and even auto ancillary companies, that had a great past but people were wary of investing in them because they felt these companies will never be able to overcome future challenges.

So, it is really difficult to decide which companies would be able to meet future challenges and which ones would not.

The best solution here in my view is to assess their historical fundamentals and demand for a big, fat margin of safety in valuations. That is all you can do.

So, which category do you belong to? Do you like to take risks and buy loss making companies provided you believe that the future is bright and the valuations are depressed?

Or do you like to be disciplined and stick to rules and therefore, ignore loss making companies but buy stocks like Delta Corp because you believe it can overcome challenges?

I think both Sehwag type of investors as well as Dravid kind of investors can make money over the long term.

But please note that skill and judgement is harder to deploy than rules and discipline.

It is easy to follow rules and discipline and can be done even by the amateur investor.

Skill and judgement on the other hand requires lots of research and lots of experience.

A rules based or a disciplined investor will formulate rules and invest strictly within those rules.

These rules could be never investing in a loss-making stock, never buying a high debt stock, and never overpaying for a stock.

If even one of these criteria is missing, he will not consider the stock.

He may also not try to predict the future. He may protect himself against a potentially challenging future by seeking a margin of safety in valuations.

A skill based or the Virendra Sehwag kind of investor does not operate based on rules.

He will analyse each stock independently. He wont mind investing in a loss-making company or a high debt company as long as he is getting bang for his buck.

In fact, he may be even willing to buy a very expensive stock if he believes the stock has great growth potential.

You cannot keep him chained to procedures and standards. He is a free bird.

As I said earlier, a Virender Sehwag kind of investor will find Suzlon Energy attractive even if it is loss making and will ignore Delta Corp even though it is profit making.

The Rahul Dravid kind of investor on the other hand, will most likely ignore a loss-making company like Suzlon and will invest in Delta Corp if it falls to valuations where the risk-reward becomes attractive.

Therefore, before investing in any of these stocks, you need to figure out which category do you fall into. It will then be easier for you to come to any sort of conclusion regarding these two and many other stocks.

I hope was able to drive my point across. Do let me know whether it makes sense to approach investing this way.

Happy investing.

Warm regards,


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