Keep eyes open while investing in risky stocks

Is Jet Airways going to make it? What does one do with the shares? Sell? Buy? Hold? It is very confusing. I have provided a graphic representation of expectations from different people (courtesy Yahoo! Finance).

What we read in the media is that the company is unable to meet financial obligations, which is leading to shrinkage in sales. And should this state of affairs continue, it would be curtains for this company.

If we go by the past tenyear financials, we can see that the company lost money since 2009 and only in 2016 and 2017 it made money. In spite of being an early entrant, it lost out to others. Since 2010, the company has had a negative net worth. In other words, the entire risk had already been passed on to the lenders and the shareholders stake was zero!

It still found lenders and companies to give it aircraft on lease. Clearly tells us that this is an industry of hope.

I am just giving the example of Jet Airways to show that the share price may not reflect the business of the company. It is merely a numerical expression of hopes and despair, when there is nothing in the P&L or balance sheet to suggest any value. One other feature is the zero-tax payout in the last ten years! Indigo seems to be the only listed one that has paid taxes! Neither Jet nor Spice have made any money to pay tax!

Like aviation, we also have our textile industry. Some make money, most do not and some companies are in a state of perpetual turnaround — from middling to bad to middling to bad.

As an investor, there are some industries that are characterised by uncertainties. When we choose to invest in these sectors, we have to be prepared for some interesting traits that are exhibited:

Stock prices swings are huge;

Long-term CAGR in share price is generally below the broad indices;

Long-term ROCE for this segment is generally in single digits;

Most companies have debt that never seems reduce;

Dividend sketchy;

Long term tax payout ratios are extremely poor;

The entire sector seems to be a troubled one;

Even after many decades, no clear leaders emerge;

Most businesses are asset-heavy;

Longevity is purely a function of cost management;

Debt levels do not seem to come down;

Valuation is more on balance sheet rather than on P&L;

Working capital needs keep increasing; and

The company forever seems to remain a small cap or mid cap company.

These are the dull dogs in business. Commodities, metals, construction are some of the industries where we see plenty of these.

As an investor, it is good to be aware of the pitfalls. These sectors are unlikely payouts to are to be amenable to a ‘buy and hold’ strategy. You buy these knowingly, aware of the high risk and bought at a time and price of choice. Here, we are merely trading in price. Once everyone climbs on to the bandwagon and the valuations start to get stretched, you know it is time to bale out of these stocks. Often, the best time to get out is when the noise is at its highest. When valuations to these are based on earnings growth that defy historical trends. Very often, this is the stage at which a lot of new investors from the retail segment get sucked in to buying.

To me, these are “speculative” bets and what quantum of your portfolio you devote to these, is your call. The risk of ‘permanent’ loss of a large part of the invested amount is possible. Stop losses are unlikely to work, since the poor liquidity in these stocks do not create enough two way trades. Most often, the trend is one way. Price circuits (upper and lower) are almost an integral characteristic of the small companies.

When the bulls are pushing these stocks, the argument is very typical. You question the past inconsistencies and the response is that now things have changed. It never does. I know that whatever one reads, these temptations are generally easy to give in to. It is good if you go in to these with your eyes open and an awareness that you are betting against the long-term odds. Write down your reasons for buying. Your anticipated returns and the time frame of your exit. And follow your rules.

(The writer is a veteran investment adviser. He can be reached at balakrishanr@gmail.com)