Essar Shipping’s Delisting Sinks, Drowns Prisoned Stockholders


Essar Shipping’s stock sank yesterday on news of the failure of the tender offer to take the company private under SEBI’s Delisting Regulations.

In a cryptic-sounding message, the company informed the following to the Mumbai stock exchange:

“Essar Shipping & Logistics Ltd has informed the Company pursuant to the approval of the shareholders for delisting of equity shares of Essar Shipping Ltd (“Target Company”) from Bombay stock Exchange Ltd (“BSE”) pursuant to SEBI (Delisting of Securities) Guidelines, 2003, The Essar Shipping & Logistics Ltd had made a Public Announcement for making an offer to the Public Shareholders of the Target Company in terms of the Guidelines.

The Reverse Book Building Process (“RBB”) closed on March 16, 2007. As the aggregate number of shares tendered by the Public Shareholders was less than the number required to reduce the public shareholding of the Target Company to fall below minimum public shareholding determined as per the provisions of the Listing Agreement, the Delisting Offer has failed in terms of the Guidelines and no securities can be acquired pursuant to such Delisting Offer.

In light of the facts and law stated above, the Target Company will continue to remain listed on BSE. The shares deposited in the Special Depository Account of the trading members during the RBB will be returned to the respective public shareholders in accordance with the Guidelines.”

If you were a shareholder in Essar Shipping, your situation was analogous to that of one of the prisoners in the famous game of prisoners’ dilemma. You could either sell your shares in the market, or you could tender them to the offerer.

If you tendered, then the offerer would return your shares if the total number of shares received were less than the minimum required (this is what happened in this case) or if the book-built price arrived at after the tender was over was rejected by the offerer as too high. (this is what happened in the Blue Dart case a few months ago).

Both these outcomes take place AFTER the tender offer is over, by which time its too late to sell the tendered shares in the market (in the absence of futures trading) because you don’t have them with you. So, a failed offer, typically results in a crash, as the above chart depicts.

Viewed from your own perspective, the correct strategy is to sell the stock in the market rather than tendering it – the above chart shows that those investors who followed this advice would have fared well.

The problem, of course, is that if everyone follows this advice, then the tender offer must fail!

A nice little prisoners’ dilemma embedded inside the SEBI’s Delisting Regulations…

The Journey from "Value" to "Glamour": Two Examples

In October 2001, SRF (SRF@IN) appeared on my radar screen as a deep-value stock. At that time, the stock price of the company was Rs 14 per share. The company was deeply out of favor in the stock market for many reasons.

First, the company was in the business of making CFC gases many of which were required to be phased out under the Montreal Protocol.

Second, the company was also in the business of making Nylon Tire Cords (NTC), an input required for making cross-ply tires as opposed to radial tires. Cross-ply tires need much more NTC than radial tires. As India was expected to move from cross-ply tires towards radial tires just like other developing countries had in the past, the SRF’s NTC business was perceived to be a declining one.

Third, a family whose record in matters of corporate governance was nothing to write home about, controlled the company.

Fourth, the company was highly leveraged due to over expansion with debt in the past and was perceived as risky because of this reason.

So, there were many things going against the company and the stock: sunset industries, poor management, leverage.

However, a few things intrigued me. At Rs 14 per share, the market cap of the company was Rs 910 million. Debt was Rs 3.4 billion. So the enterprise value was Rs 4.3 billion. Over the previous three years the company’s operations had generated cash of Rs 1.9 billion a year. The enterprise value was 2.3 times cash flow. Moreover, the average cash flow from operating activities (after payment of interest) over the same period was a hefty Rs 1 billion a year so the shares of the company were selling at less than one times cash flow! Simple backward thinking showed, that for this valuation to be correct, the company must go extinct very soon. How likely was that? Extremely unlikely, I figured. For many reasons.

First, the company was de-leveraging its balance sheet and the stock price was highly sensitive to debt-reduction (which is the most sensible allocation of capital decision in such cases).

Second, even though the company was in business activities perceived by markets as sunset industries, the company would continue to be around for a long long time. In my view, the markets had over-discounted the negative aspect of a declining industry and under-recognized the benefits that go with such cases (low competition, high returns on capital, plenty of free cash flow since depreciating productive capacity wont be replaced).

Third, the company had acquired a NTC plant from Du-Pont for a song. Du-Pont was exiting the business, and sold it to SRF at a ridiculously low price in relation to the amount it had spent to build that plant. Moreover, along with the low-priced plant came accumulated losses, which SRF could use for shielding its profits from taxes. And SRF could, and did, turn around the plant with little effort and expense (by changing it to make a product that was in high demand as opposed to continue to making a product for which there was little demand and for which the plant that originally been erected by Du-Pont).

Fourth, the company was receiving compensation under the Montreal Protocol, for phasing out the production of some CFC gases. Indeed, what astonished me was that the amount of money to be received was more than the then prevailing market cap of the company! Such was the negative perception of the market that it was unwilling to see how cheap the stock had become.

Fifth, at Rs 14 per share, the company was paying a dividend of Rs 2 per share. The dividend yield was an unbelievable 14%. Normally in such cases when one sees such a high historic dividend yield, the future dividend is cut. I figured that given the healthy cash flows and the low amount of cash required to maintain dividend, this was extremely unlikely to be the case. With the benefit of hindsight, I can now say I was right.

Convinced that I had identified an extremely cheap stock, I bought it in large quantities.

Fast forward to 2006. See chart below:The chart above gives a vivid description of what happens to a stock when it moves from “value” to “glamour”.

By March 2006 – less than five years after I identified it as a deep value stock – the stock price had soared to Rs 360 per share – a twenty-five bagger (ignoring dividends which would make it look even better).

I sold off my shares long before it hit Rs 360 because when it moved out of my “value” range I no longer understood it. I sold and moved on to what I thought were greener pastures.

What’s more interesting for this discussion is that by time the stock hit Rs 360 it had become a “carbon credit story” which in early 2006 was considered as “glamour”. The company was in possession of carbon credits and more were in the pipeline and the markets were seduced into putting a very high market value on these credits. As the carbon credit story melted soon after, the stock has since declined to Rs 120 indicating the risk of investing at high prices in glamour stocks as opposed to the risk of investing in deep value stocks at non-glamorous prices.

In August 2004, I added to my holdings in Heritage Foods (HTFI@IN) because the stock had declined from Rs 70 to Rs 50 level for what I thought were wrong reasons.

At Rs 50 per share the market cap of the company was Rs 500 million. Total debt was very low at Rs 230 million. The stock was yielding 5.5%, which was very attractive because in India dividends received by investors are treated as tax-free income.

Heritage makes packaged milk, a product where penetration rates are low because most of the milk in India is sold in loose form. Given that India is the largest milk producing country in the world, the potential for growth in this business is huge.

However the stock price of the company, at Rs 50, per share, did not reflect this. In effect, at that price, one was getting the future potential growth for nothing.

Over the previous 10 years, Heritage’s revenues had grown at 35% p.a. and EBITDA had grown at 36% p.a. Moreover the reported earnings of the company were real earnings, which showed up in discretionary cash instead of fixed assets, inventory, or receivables.

I also liked the management of the company, which was focused on growth without sacrificing stockholders’ interests. For example, the company had completed a stock buyback program recently.

Despite having a good business (with superb returns on capital), excellent growth prospects, a solid balance sheet (low debt in relation to cash generating ability), an owner-oriented management, a low price in relation to underlying value, the stock had declined from Rs 70 to Rs 50. The chief reason for this, in my view, was the poor recent showing of the company.

Heritage buys milk from farmers, processes it in its milk processing plants, packages and sells it under its brand. Milk procurement prices had recently increased due to shortfall of rains (less rains means less fodder which results in less milk supply) as well as intervention of state governments in fixing prices of milk to be paid to farmers. In addition, the state governments also control the retail prices of milk and they were kept low, which forced the company to absorb cost inflation. As a result, the company’s margins had fallen dramatically from their long-term average.

I thought this to be a temporary phenomenon. I have strong faith in “reversion to the mean” mental model. If you flip a coin ten times, you may easily end up with eight heads and two tails. If you flip it twenty times, the proportion of total number of heads to total flips should reduce from eighty percent. If you flip it a thousand times, the proportion of total number of heads of total flips will almost certainly revert to fifty percent, which is the probability of landing a heads if you flip a coin.

In the above example, the mean of fifty percent acts as a strong magnet pulling the average towards it.

What works in coin flips works in a whole lot of other things around us. For example stock returns are mean reverting but stock prices are not. In the case of stock returns, the magnet that pulls the returns towards it is the underlying return on equity. Hence the truism of that famous quote by Mr. Buffett: “Bull markets and bear markets can obscure mathematical laws but they cannot repeal them.”

I figured that reversion to the mean was the appropriate model to use in the case of Heritage for many reasons.

First, the company had staying power to ride out temporary adversity. A strong balance sheet and a high cash generating ability of the business indicated this staying power. Second, the rise in milk procurement prices would produce the incentives for farmers to direct more capital towards production and sale of milk. And third, the politicians had reduced the sale prices of milk in retail markets to gain some temporary political mileage, which was needed by them to win some elections.

All in all, I figured that the reversion to mean in Heritage would, in all probability, restore normal earning power of the company and deliver me with more than satisfactory returns.

Did I get those satisfactory returns? The chart below shows that I did.But, did the returns come because of the mean reversion? No, they did not. Over the next two years, even though the company’s revenues grew significantly, the margins did not grow. Then what caused the stock to rise from Rs 50 in August 2004 to Rs 440 in February 2007 – a nine bagger in just two and half years?

The company announced its intentions to go into real-estate development. Since the company was in possession of some real estate, and real estate was “glamorous” in late 2006 and early 2007, the markets became excited and lifted the valuation of the company in a very short while. By the time the stock hit Rs 440, the company was more of a real-estate company, which also sold milk, rather than the other way round!

I had long ago sold my holdings before the stock hit Rs 440. As was the case with SRF, when the stock went above Rs 170, I could not understand it anymore. It was no longer a value stock but was about to become a glamour stock. (The stock has since fallen to Rs 225 as markets have become a bit more sanguine towards the real estate sector).

I can give you more examples of similar transformation of value stocks into a glamour stocks. But that would be unnecessary I think. What I want to do here is to list out the similarities in such situations.

Almost certainly, the near-term outlook in such cases looks horrible. And markets assume that recent trend is destiny. More often than not, markets are proven wrong. So, betting against the market in such cases is likely to be a winning strategy.

In a famous academic paper, the authors De Bondt and Thaler explained that investors tend to extrapolate past earnings growth too far into the future, assume a trend in stock prices, over-react to good or bad news, or simply equate a good investment with a well-run company regardless of price.

For any or all of these reasons, some investors get over-excited about stocks that have done very well in the past and they buy them and then these “glamour” stocks become over-priced.

Similarly, many investors over-react to stocks that have done very badly, and they become excessively pessimistic about them and sell them at lower and lower prices and as a result these out-of-favor stocks become under-priced.

According to De Bondt and Thaler, contrarian investment strategies work because contrarian investors invest disproportionately in stocks that are under-priced, and under-invest in stocks that are over-priced.

My own experience shows that De Bondt and Thaler were right. When you buy a value stock, lots of good things can happen to you- things, which will deliver you more than satisfactory returns. Even though your original thesis of buying into a value situation may prove to be somewhat inaccurate, the chance that more good things are likely to happen to you than bad things becomes a real friend. In contrast, when you buy a glamour stock, you run major risk of a permanent and sudden loss of capital because by its very nature glamour is a fair-weather friend – here today, gone tomorrow!