Don’t write off businesses challenged by sunrise rivalry

Market players should take a rational relook at what such challenged industries are really worth

is managing partner at Breakout Capital.

It seems that over the past decade or so, a whole host of stocks and sectors have been written off by investors. Newspapers, linear television, thermal power, anything related to the internal combustion engine, offline travel agents—the list is long. However, in the real world, many of them are still ubiquitous. Take India’s newspaper circulation, for example. It has remained intact over the past decade. Over 75% of electricity consumed in India is still generated from thermal plants and over 99% of all vehicles on Indian roads still have internal combustion engines.

The disconnect between what we see everyday versus what markets perceive stems from the fact that investors have convinced themselves that in a few years, these stocks and sectors will cease to exist. They would have been replaced by a newer, better product or service that is being rapidly adopted. So digital news will vanquish newspapers, renewable energy will supersede thermal power plants and electric vehicles will render the combustion engine obsolete.

Stock markets have a tendency to get excited by shiny new things, extrapolate rapid adoption into the future and write obituaries of extant products and services. What follows is an investor stampede out of such challenged spaces, causing severe valuation contractions. In certain cases, explicit investor mandates prohibit investments in these challenged sectors, and that quickens the exodus.

Stocks and sectors being declared terminally ill is not a new phenomenon and markets are often right in their assessment of the future. However, if one were to correctly bet against prevailing wisdom with respect to either the extent or pace of decline, there is a lot of money to be made. Yet, most investors suspend any analysis of sectors caught in the throes of such stampedes.

A useful framework in such cases is a zeroterminal-value discounted cash flow analysis (DCF). Its main assumptions are that the company ceases to exist at a certain date in the future and returns the residual value of net assets to investors. Till that date, one assumes a decline in the market share of whatever it sells, and capital outlay that is just enough to service demand. All else is paid out to shareholders. This, of course, comes with standard DCF disclaimers but generally provides a good ‘worst-case’ value for such a stock.

At least a few investors seem to have done a similar analysis because shares of a newspaper company, an engine oil manufacturer and a maker of thermal power generation equipment have more than doubled in the past year. A combination of several factors seems to have contributed to this resurrection. Excitement over the meteoric rise of new challengers could have gotten tempered. As new challengers start reaching a larger scale, their growth inevitably slows down, which means that pace-of-decline assumptions in our worst-case DCF analysis start changing in favour of challenged companies. Just as predictions of a ‘Lehman moment’ far outnumber an actual Lehman moment, forecasts of disruptive ‘WhatsApp’ moments are often exaggerated.

In many cases, the challenged company’s leadership makes the right strategic moves that enables it to participate in the new trend while still retaining its solid old-business core. The successful pivot by The New York Times towards a digital model in the middle of the previous decade is a good example. On the flip side, though, some management teams panic and in a bid to stay relevant make outsized and over-priced acquisitions of shiny new things but only end up hastening their own downfall.

Importantly, most challenged companies start conserving cash as capital spends are limited. Faced with the very real prospect of declining demand, instead of embarking on new projects, they opt to return cash to shareholders by way of dividends and share buybacks. These measures enhance total shareholder returns. In a financial environment where interest rates seem to have peaked, such streams of steady cash become all the more valuable. Indeed, this free-cash yield, coupled with attractive valuations, has made investors sit up and take notice of this ignored corner of the equity market.

While the zero-terminal-value DCF approach approximates the worst-case situation, upside scenarios can present themselves if demand revives for products and services produced by challenged sectors. Typically, years of under-investment have led to negligible supply growth and weak players have either shut shop or been bought out at reasonable prices, leading to industry consolidation. A surprise demand revival in such a scenario would lead to parabolic price up-moves and a period of supernormal profits for incumbents.

The price of uranium over the past year or so is a case in point. After the Fukushima accident in 2011, investors wrote off nuclear power. A decade of under-investment in uranium mining followed, accompanied by investor apathy. Geopolitical events of the last couple of years, however, have re-awakened the world to the inevitability of nuclear power as a source of clean energy. After languishing for years, the price of uranium has almost doubled in the last year.

Investors should evaluate the forgotten stars of yesteryear. After all, when everyone was supposed to be going gaga over the cast of the Hindi film The Archies, it’s Bobby Deol who became the talk of tinsel town.

These are the author’s personal views.