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Home / Money / Calculators /  When is a corporate disaster a value pick?

Investing in equity is a long-term affair. And often the road gets rocky. Besides the short-term market noise, occasionally you will find some real obstacles.

For instance, let’s take the example of the Volkswagen stock. The company has been a stalwart in the car manufacturing business since its start in 1937, and is known for its ‘German’ quality. Unfortunately, it all got murky when in September it was revealed that the company has cheated on its emission tests in the US using a special software; the count of cars affected by this runs into millions. As a result its stock price has taken a beating. On Germany’s DAX index, the share price of Volkswagen has fallen 37% from its closing price on 18 September till 2 October. What does the investor do in such a situation? Does she buy more of the 88-year-old company at a much cheaper price? Or sell out immediately?

Our own stock markets have seen similar events of fraud and information mismanagement leading to steep stock corrections. Who can forget Satyam Ltd and its massive accounting fraud. Unitech Ltd saw the start of a long re-rating, thanks to its promoter being named in the 2G scam and as allegations come forward, the stock price crashes further. And just two years ago, there was the 5,600 crore commodity market fraud involving National Spot Exchange Ltd (NSEL) and its promoter company, Financial Technologies (FTIL). The FTIL stock lost around 85% value in the days immediately after the matter came to light.

These are just some examples of how corporate indiscretion causes stock prices to correct abnormally. Despite all of this, these companies have remained going concerns, businesses are still generating revenue and there is value attached to them. So, are such corrections a buying opportunity or should you stay away?

When a disaster is a value buy

Recently, Amtek Auto Ltd’s inability to service its debt and lack of sharing information with rating agencies led to a downgrade in credit ratings. Subsequently this led to a sharp correction in the company’s stock price, which was down nearly 80% after the credit downgrade, i.e. 18 August till 8 September. However, despite the non-payment of dues, its share price has gained 50% since then. So, is this a case of value buying pushing prices up or just sheer speculation?

The first thing to consider is whether, despite going through an extraordinary corporate event, the business has value or not. There are two ways to look at this. Firstly, will the balance sheet of the company be able to sustain potential losses (penalties and loss of revenue) arising from such an event, and is there enough cash with it? Secondly, the impending impact on future earnings needs to be judged.

“Stock reactions are often a result of the event itself and also speculation by market participants. At times corrections can be steep and the stock price itself falls below the intrinsic value of the business net of the ‘event’ impact. Buying at such low valuations can result in potential multi baggers," said Kishor Ostwal, chairman and managing director, CNI Research.

Citing the Satyam example, he said that while there was a portion of fake revenue, there was a part of the business which was a genuine operation creating real revenues. “At one point, the stock price fell much below the value of the ongoing genuine business, that is when you know it is a value buy," said Ostwal.

The ultimate decision, though, depends on the fundamentals of the company. “If there is a sharp correction and the underlying business has value, there is merit in evaluating the opportunity. But the decision to invest depends on the fundamentals of the business and the people who run it, " said Soumendra Nath Lahiri, chief investment officer, L&T Investment Management Ltd.

While the value in the stock might be attractive, risks to future earnings need to be analysed if you want to buy into it as a long-term investment. In case of Volkswagen, for example, the company has a large cash balance. But what happens if there are more fines that might be levied in the future?

For a company that operates in more than one country, penalties arising out of such a fraud can pile up over a period of time. Moreover, damage done to the brand could result in loss of sales over a period of time.

According to Anoop Bhaskar, head equity, UTI Asset Management Co. Ltd, “Where the correction is due to an operational issue, the long-term impact is difficult to gauge immediately. Taking a valuation call is more a calculated risk, which can at best serve as a short-term trading position. To take a more long-term investment position, its better to wait till all the issues play out." It’s not just the brand damage, but subsequent regulatory issues as well one has to be watchful of, he added.

Brand is perception, and if that is hindered then future sales can suffer. The Maggi ban case, clearly shows that it matters how investors perceive not only the brand, but even the authority which has questioned the credibility of the product. Share price of Nestle India Ltd corrected around 20% after the product was questioned for lead levels. However, it is up at least 15% from the low point since then (till 5 October). Investors aren’t too perturbed. Experts point out the reliability of the tests done are questionable as subsequent tests in other countries showed contrary results.

Hence, it’s important to assess the nature of damage done. In case of an accounting fraud, it’s easier to take a view since the financial damage can be quantified. When brands and products come under question, loss of future sales is harder to predict.

Question of integrity

There are also instances where promoters of a company are found to be involved in unethical practices. In case of the NSEL scam, FTIL promoter Jignesh Shah, was subsequently arrested for being in the know of certain transactions linked to, what has since been identified as a premeditated commodity market fraud.

Taking a risk with the promoter’s credibility is not recommended under any situation.

“Where a company does not have good financials and the promoters are not credible, it is best to avoid owning such companies altogether," said Bhaskar.

Often when a fraud comes to light, the management immediately responsible for the situation is changed. This is exactly what happened to Volkswagen—yet such a move in itself doesn’t allay fears of the brand itself underperforming as a result of the events that have unfolded. Or as we saw with Satyam, the company gets sold and the ownership itself changes.

In such cases, one will have to wait and assess the credibility of the new management or owner. This can’t be a quick call where a change equals better financials for the company.

“Where a fraud is involved it doesn’t make sense for long-term investors to take the risk. You have to be certain about the management and its intent, but (in such cases) that can be hard to rely on," said Lahiri.

What should you do?

Where events like fraud, mis-information or promoter involvement in a scam have led to a sharp correction in stock prices, don’t jump in just because the stock is down 10%, 20% or 30%. If you are an existing investor, it is better to exit and re-invest if the core value of the business is not threatened.

There are two ways of investing. For value investors, if the stock is at a deep discount compared to the enterprise value, then sharp corrections following extraordinary corporate events present a good case to buy. On the other hand, for long-term investors looking for growth at a reasonable price, such opportunities come with costs attached which they may not be willing to risk. The quality conscious investor should stay away.

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