It was the middle of 2013. I was reading the annual report of Ashok Leyland , the second largest commercial vehicle manufacturer in India after Tata Motors.
The company had reported a 3% decline in sales in the year ended March 2013, and profit had declined by 23%. The stock, as I checked then, had been punished and was trading at Rs 20 when I was reading its annual report. That was P/E of around 12 times, or an earnings yield (E/P) of 8%.
The company had done well in the previous years in terms of growth but was hurt by the overall decline in the commercial vehicle industry, and especially in its core business of medium and heavy-duty vehicles.
Anyways, the stock looked enticing then, not just due to its low P/E, but also because of its absolute low stock price of just Rs 20.
But wait, haven’t we learned all these years that a stock’s price does not matter as much as its intrinsic value? Yes, that’s true. And so a stock priced at Rs 20 can be expensive than one priced at Rs 20,000 if the gap between the intrinsic value and price of the former is less than the gap between intrinsic value and price of the latter.
But then, there’s also a leaf that may be taken out of Ben Graham’s Security Analysis where he writes that “if the price is low or high enough,” a conclusion may be drawn. As an example, if a stock, especially that of large, established company, is priced as low (enough) as Rs 20, you may be able to draw some conclusion on its attractiveness.
So, yes, Ashok Leyland looked great to me price wise, and because I had some understating of its business and knew that this wasn’t one that would go to zero, and the management was reasonably good too.
Despite this understanding, my focus was on the fact that the stock had corrected by 25% in the previous six months and that the industry still had some pain left. And so, I acted ‘smart’ and waited for the stock to fall further.
It did, as the bottom fell off the stock’s price. It corrected by another 25% in less than a month, to Rs 15, and then another 25% to Rs 12. So, my prognosis on the stock seemed right and I felt good about it.
But I still did not buy it, because I expected it to fall further. The first quarter results of FY14 (released in July 2013) were terrible. Sales were down 22% year-on-year and the company posted a loss of Rs 140 crore, compared to profit of Rs 150 crore in the previous quarter and Rs 70 crore in the first quarter of previous year.
I have always avoided reading too much into quarterly numbers. But somehow, I was fixated on Ashok Leyland’s terrible performance – both business and stock wise – and thus was still waiting on the sideline. After all, how could I buy a stock at Rs 12 when I thought it could go to Rs 5.
The story had a sad ending for me. Rs 12 was nearly the bottom for the stock. It has multiplied 10x over these past five years, and now I hate to look at the stock’s chart.
Ashok Leyland was a case of falling knife for me, and I did not want to get hurt catching it mid-air on its way down.
But I learned something about catching falling knives from this mistake of omission, which has helped me in my subsequent decision making.
The lesson is that it is sometimes good to catch falling knives. And how do you do that without hurting yourself much?
One, you bring your hand down as you catch the knife and at almost the same pace as the knife’s fall. Two, which is difficult, you time your catch to perfection by grabbing the knife’s handle. But your hand will still be in a downward motion.
Applied to stocks, when you find a good business selling reasonably cheap but is falling in price, you need to grab it even as it may fall further down, and you buy some more of it then.
However, some conditions apply here. One, the business must be good i.e., a good, long performance track record, long runway for future growth, having a reasonable balance sheet, and run by a competent and reasonably clean management. Such a falling knife is blunt and won’t hurt you much when you catch it in the fall mode.
So, if a stock that’s coming down due to the business’s temporary problems or due to the market’s overall decline, you buy it when you find it meets the above conditions and its valuations is attractive. Don’t wait for it to fall to the bottom (it may or may not, and as if you know when the bottom is) and don’t try to time your entry to perfection.
Howard Marks writes –
I’ve never considered it a legitimate goal to say you’re going to invest at the bottom. There is no price other than zero that can’t be exceeded on the downside, so you can’t really know where the bottom is, other than in retrospect. That means you have to invest at other times.
If you wait until the bottom has passed, when the dust has settled and uncertainty has been resolved, demand starts to outstrip supply and you end up competing with too many other buyers. So if you can’t expect to buy at the bottom and it’s hard to buy on the way up after the bottom, that means you have to be willing to buy on the way down.
It’s our job as value investors, whatever the asset class, to try to catch falling knives as skillfully as possible.
And then, this is what Seth Klarman suggests –
You must buy on the way down. There is far more volume on the way down than on the way back up, and far less competition among buyers. It is almost always better to be too early than too late, but you must be prepared for price markdowns on what you buy.
When it comes to stock prices, the key lesson from my experience of making such mistakes of omission and some of commission – and learning from them – is that it is foolish to try to capture the first and last part of a stock’s move.
If you are right in your analysis, and the long-term fundamentals of the underlying business are good (even if the short-term hurts), you can make a lot of money in the middle.
That’s the most peaceful part of the wealth generation process – in the middle, not on the edges.
What else do you want out of investing?
Good post Vishal. The million dollar question is how to be thorough in your analysis of company management. I have cut my hands(catching falling knives) in few small and big players both – Rcom, Kitex, Inox Wind. Is there any checklist you use to weed out such firms?
Kitex has a solid sustainable business model, it will be a multibagger in coming years.
Thank you, Vishal, this is a very helpful and timely post.
In the current market, with tech outstripping everything else, when one finds value opportunities they are typically companies with short-term issues, negative sentiment and still falling in price. Thinking of the long game (will the company still be around in 10yrs, does it have a history of reliable revenue and earnings growth, is debt low, is ROE good and is it run by good managers) helps to frame the short-term fluctuations against the longer-term prospect.
Also very much like your description of the “peaceful middle” – not a phrase I’ve heard before in investing but a very useful concept for us to remember.
Excellent thoughts Vishal.
It’s sure that No 1 can sell at Top and No 1 can buy at bottom.
It’s the evaluation of management capabilities and their business growth which will generate value for shareholders.
Ritesh Agrawal says
Very good post. Informative and re-assuring for value investors.
Very nicely written Vishal. I invested in AL at 33. However, it was never sure that the company’s situation would turn around, that was always faith in the management and the economy, or when they would be in black. But the faith in Vinod Dasari paid off. I am finding a similar case with Tata Motors India and its new MD or Escorts.
So just think, while a company may be undervalued based on its asset value or some such metric, the best bet is on the new management. Else if the old management is continuing, oftentimes all bets are off, unless it was purely due to economic conditions.
Instead of calling it catching falling knives, I like the label of ‘bottom fishing’ 🙂 .. I am a fan of bottom fishing because that is one place where you can find a lot of multi-baggers.. Few requirements to do this successfully IMHO.. 1) know the fundamentals of the co. 2) must have a strong balance sheet with lots of cash on hand 3) Avoid co. with huge debt that may be hard to service 4) average in gradually to build up a position.. Last but not the least 5) do not over allocate in terms of % of your total portfolio..
Even I missed buying AL @ 12. Somehow I got screwed up on JP Power which went down as like there was no bottom, could not muster courage to buy AL. Also went through some articles warning us to be suspicious about turnaround stories. Bought few Pharma scrips post FDA warning meltdowns but burnt hands. But over a period of time, issues of corporate governance, bleeding balance sheets, overcoming FDA warnings can be fixed. If a stock got hammered for any reason and it has large debt, I don’t get in to it even if it loses 99% of price.
Its better to buy a good stock which is falling than to be sucking your thumb
Vaibhav Palan says
Nice Read..!! I am trying to practice this with AB Capital. Lets see what lessons it teaches.
Now I have catched two knives, prestige estates and Eveready India. Let me see