Tuesday, December 19, 2017

Bamboo Investing - The rise of Phoenix in Stock Markets

The title of the post is Bamboo Investing. It's not about investing in bamboo trees, let me clarify that first. It's about mental models way of learning. Also, there is no real phoenix in the context!

Bamboo investing

Before we get to the point, here is a small puzzle. Below are the share price charts of few companies over certain time period. What is common between them?

Company-1: Specialty chemical company

Company-2: Auto manufacturing company

Company-3: Shrimp exporting company

So having started with puzzle, now there is another anecdote for you. This is about Chinese Bamboo. For those who haven't seen it, the picture is below.

Chinese bamboo tree is very typical. It can grow vertically almost 90 feet (that's almost as tall as a building!!).

This is how it GROWS:
One waters the bamboo tree for four straight years and nothing happens - absolutely NOTHING..!! The seed remains in the ground.

Then suddenly miracle happens in the 5th year. The Chinese bamboo tree finally emerges from the ground.

Within matter of six weeks it achieves height of 90 feet....just 1.5 months after waiting of 4 long years..!!

Learning from the story...
This is the common theme of the initial puzzle. A good stock may remain dormant and boring for many years, and then it would accelerate to surprise everyone. As such this can happen for the entire sector or most of the stocks in any country depending upon triggers.

One should watch for improvement in business fundamentals and Earnings power. If the prices don't move and business is improving, that's the best ground to hunt.

So the answer to the puzzle is that all of the above companies were boring and dormant but accelerated to become multi-baggers in very short period of time. The companies were Balaji Amines, Maruti and Avanti feeds but that's not important here.

What are the triggers?
Now, the above outcome is bit surprising since we say that markets are efficient. Then is there any anomaly?

Well, I have tried to think through and found that there are mainly two broad factors that drive it: Rapid earnings growth and PE re-rating (Had discussed this in detail in my article: Investing in 100 baggers)

1. Sector and country re-rating: This can happen when there are certain key changes in the sector and country which can expand the PE multiple rapidly despite no change in earnings growth (mostly in anticipation of future earnings growth)

  • Entire Indian market got re-rated in 2014 after new government got majority in the elections
  • PSU oil companies got re-rated due to deregulation of fuel prices
  • Specialty chemicals and graphite electrode industry recently got re-rated due to shutdown of factories in China

2. Company is widening moat for long term: There might be instances when companies are spending in R&D, Brand building, building distribution network, trying to launch new product, trying to enter new markets, spending heavily to gain economies of scale or creating network effect etc. Basically, they are bleeding today to achieve sustainable long term growth.

This reflects poorly on income statement for short term but Earnings power of the company is constantly increasing which results in exponential long term growth.

  • Amazon hiring staff to increase future sales by making systems and servers more efficient
  • Thyrocare taking hit on the margins to quickly gain market share from lower prices and harness economies of scale in future
  • Ola/Paytm keeping 0% fees for partners (drivers/merchants) to achieve network effect
  • Tata Sky giving set-top box free/subsidized to new customers to bargain better with content providers in future 

3. Efficient Capital Allocation: When companies demonstrate ability of efficient capital allocation creating shareholder value, then it can get re-rated and further execution accelerates this.

  • Piramal enterprises sold part of Healthcare business to Abott in 2010 when it was trading at cash bargain, and now it has been rapidly re-rated due to efficient capital allocation (Read case study by Sanjay Bakshi: The grand strategy of Ajay Piramal)

4. Increased disclosure or market cap levels/low liquidity: There are several instances where disclosures for many small and midcap stocks are minimal. Also, some of these companies are too small to form part of mandate for large investors.

There may be very low liquidity for the stock. In these cases the stock gets re-rated very fast once it start falling under mandate of institutions or after improved disclosure levels.

  • Companies like Poddar Developers and Mold-Tek Packaging did a QIP which resulted in higher disclosure and comfort from institutional shareholding 
  • Companies like Veto Switchgear coming out from SME exchange and getting listed on BSE and NSE, thus constraint of many funds that cannot buy on SME platform gets removed

5. Structural turnarounds: Many companies could be showing lower earnings or losses due to some structural bottlenecks. But when this gets resolved, there may be turnaround in the fortunes of the company.

This may be triggered due to single event like debt repayment, management change, regulatory change, change in strategy, consolidation of industry, structural fall in raw material prices etc.

  • Indo Count industries changed its strategy and product lines after coming out of BIFR and it became 100x in ~2-3 years thereafter
  • Symphony changed it strategy from buying assets to becoming asset light and stock became multi-bagger

There may be several such factors which may result into multi-fold returns in very short period of time. But not every company which is dormant or boring will move like this.

One needs to ignore price movement and see if business is continuously improving. The lesson is one needs to stick to the original theme and if its intact or improving then just hold on.

Thomas Phelps in his book 100 to 1 in the stock market wrote that - Investors have been conditioned to measure stock-price performance based on quarterly or annual earnings but not on business performance. Ideally the focus should be on business performance.
Its important to focus on Earnings Power coupled with business strength.

How to identify such companies?
We can use TechnoFunda approach i.e. combination of Technical and Fundamental analysis. Some of the technical indicators like price-volume break-outs, momentum indicators, formation of trend lines are very powerful to identify such companies at inflection point.

Adding fundamental analysis on top of it can filter some of the false signals generated by technical and helps to identify and ride such companies with conviction and then again technical analysis can be used to determine Hold or Sell criteria.

Companies like BEPL, HEG etc. gave clear technical indications and this was coupled by fundamentals like ABS prices going up coupled with capex for BEPL and graphite electrodes prices going up for HEG along with shutdown of capacity in China.

See technical chart below for BEPL: There was price-volume break-out in Mar-2017 at ~25 and stock became almost 8x in less than 9 months. The capex approval came soon after break-out giving fundamental confirmation and conviction to hold. This was further accelerated by PE exit and promoter buying from the market.

For more on examples/approach you can see my presentation in article: Technical Analysis Overview

Thus, one must use TechnoFunda approach to identify such stocks and once these are identified correctly, just SIT tight until the story plays out and enjoy the Bamboo Investing way of wealth creation...!!

Disclaimer: All stocks quoted are just for example, these are not buy/sell recommendations.

Chart credits: Moneycontrol, ChartNexus

Also published in Transfin.
About the author: Vivek Mashrani, CFA
  • Vivek is CFA charterholder and MBA Capital Markets from NMIMS, Mumbai
  • Passionate about investing, books, travelling, swimming, yoga and meditation 

Follow on twitter @MashraniVivek