»Profit Hunter by Equitymaster

On This Day - 24 JUNE 2021
The One Thing on Which We Will Never Compromise

Editor's note: Before you read this editorial, I would like to thank all of you who attended Tanushree's mega event on Monday - Forever Stocks - and made it a big success. In case you missed it, you can watch the video of the event here.


Over the weekend, I was reading one of the most talked about books in financial circles.

The Psychology of Money by Morgan Housel, a former columnist at Wall Street Journal.

Having read the book, I must say, it's by far the most practical and insightful book when it comes to learning about investing in the modern day.

There are real life insights rather than bookish concepts.

To prove a point on greed and when to draw the line, the author illustrates the insider trading episode of Rajat Gupta, the infamous former MD of McKinsey.

Rajat Gupta, was born in Kolkata and orphaned as a teenager. By his mid-40's Gupta was the CEO of McKinsey, the world's most prestigious consulting firm. He retired in 2007 to take on roles with the United Nations and the World Economic Forum.

From the slums of Kolkata, a classic rags to riches story. Mr Gupta's net worth when he retired from McKinsey was a massive US$100 m.

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Now that's huge.

He could have done anything post retirement, but the greed to get to the billionaire club, made him take positions on board of directors of top fortune 500 companies which included Goldman Sachs.

However in 2008, as Goldman Sachs was at the receiving end of the financial crisis, Warren Buffet planned to invest US$5 bn in to the bank.

As a board member, Gupta learned of this transaction before the public and immediately called his hedge fund manager friend Rajaratnam. He bought 175,000 shares of Goldman and made a quick profit of US$1 m dollars when the news became public.

Gupta and Rajaratnam were charged with insider trading and sent to jail.

Was it necessary to risk years of reputation and fortune when he had enough?

Morgan Housel tells us that luck and risk are siblings.

What if there was a quantitative way to measure luck and risk of a successful and an unsuccessful outcome?

To be more precise, is there a way to quantify much does luck/risk contributes to the stocks in your portfolio as they go up/down?

I am sure, your portfolio must be at or near all-time highs. The last one year has been blissful to say the least. Everyone feels they have the midas touch.

Now that's a typical quirk of a bull market. As my father use to put it, in Gujarati - In a bull market, elephants, horses and donkeys, all of them go up.

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What he meant was along with the blue chip stocks, which he termed horses and the good quality slow movers i.e. elephant stocks, the donkey stocks also go up.

These are stocks of overleveraged, bad-quality companies.

It's during such times we have to ask ourselves how much is enough? Are we overstaying our welcome in donkey stocks?

After all, the risk-reward equation is never favourable in such stocks.

Let me give you an example of how penny stocks are rising based on 'stories'.

In a bull market the word 'turnaround' is used very loosely. For every over leveraged poor quality stock which goes up, there is a 'turnaround story' attached to it.

The M&A deal narrative too is peddled very loosely to justify pumping the stocks beyond fundamentals.

In the table below, can you find the odd man out among the penny stocks?

The Odd Man Out?

Company 05-Apr 01-Jun Returns No. of days
Rattan Infra 5.9 30 408% 57
  21-May 21-Jun Returns No of days
Reliance Communication 1.7 4.6 171% 24
  24-May 21-Jun Returns No of days
Reliance Naval 2.9 6 107% 28
Source: Equitymaster

Reliance Naval which has doubled in less than a month has a negative net worth of Rs 165/share. I am sure stories of 'takeover' must be doing the rounds.

Reliance Communication too is in a dismal state. It had a negative net worth of Rs 172/share.

The question is, are all these penny stocks junk or is there actually a turnaround?

In this table, Rattan Infra has actually changed its business model completely and is a turnaround candidate.

Rattan Infra has launched electric two-wheelers under the brand name Revolt Motors. It closed its bookings within two hours of launch of its flagship electric motorcycle RV500.

That implies a sale value of Rs 500 m in 2 hours.

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Now this seems genuine.

But a historical analysis of debt levels and balance sheet will club Rattan Infra to the above mentioned Reliance stocks.

So let me answer the question, have penny stocks overstayed their welcome?

The long and short answer for a majority of them would be yes.

However, we could have exceptions like Rattan Infra whose business model has changed for good and so has the stock price (5x in less than 2 months).

So how do you separate the wheat from the chaff?

Now that's really difficult. Even if you take Rattan Infra and the two-wheeler electric vehicle story, it's extremely difficult to tell when it's enough.

The odds of a company turning around and reclaiming its old glory are miniscule. A one in a 1,000 chance. That's 0.1%. The odds of winning a derby race are higher.

Experienced investors and old timers in the market have always taught us to use a bull market to get rid of junk in your portfolio.

I am sure some of you might have at least one or two of these penny stocks, which have doubled, tripled or even quadrupled in months.

This insane rise without any fundamentals leads to bubbles in this part of the market. These stocks can continue to head upwards, but you never know when the music stops.

The whole story about Rajat Gupta and respecting the elements of risk and luck in investing is critical. We need to draw a line at when it is enough.

This is the reason, at Equitymaster, we emphasise on quality companies which meet our strong selection criteria.

And we will never compromise on that.

Warm regards,

Aditya Vora
Aditya Vora
Financial Writer

PS: A big thank you to all who attended Tanushree's Forever Stocks event on Monday. It was a big success. In case you missed it, you can watch the video here.

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