The stock market is like a pendulum that swings from one extreme to another. While it often comes to the center, rarely does it stay there for long before moving to either of the directions. This cycle of greed and fear is what generates attractive opportunities for value investors with a long horizon of 3-5 years. However, it is crucial to identify when the cycle for our stock is approaching the other extreme so that we are able to start taking money off the table. The absence of a disciplined selling strategy can lead to large drawdowns and one can get stuck for longer with sub-optimal returns.
The following few exit decisions illustrate how we emphasize this important parameter:
- Gujarat Ambuja Exports: The normalized operating margin for the maize segment has been between 12-14%, however recent margins were inflated at 18-21% due to an abnormal hike in product realization (starch) globally on account of supply cut from Ukraine as well as cheap maize inventory lying with the company ensuring GAEL enjoyed extraordinarily high spreads. While it is evident this is a one-off gain, the market generously took the stock to new heights as it even entered high-quality/coffee can portfolios. When you get peak multiple on peak margins, it is typically a good opportunity to start booking profits. We sold the majority of our position with 5x returns (held since 2017 translating into a ~38% CAGR) while retaining some to play the optionality (as the core investment thesis is intact).
- Dhanuka Agritech: We invested in Dhanuka in downcycle during late 2019 when nobody was interested in looking at domestic agro-chem, despite it being a good cash-rich business with high RoCE. Operating margins were beaten down to a decadal low of 15% while the valuation multiple on those depressed earnings had fallen to 12x from a high of 37x. We anticipated the earnings cycle to turn and we got lucky to get all three levers right – sales growth, margin restoration to 19% as well as PE multiple rerating. The stock quickly moved 2.6x within 18 months despite the pandemic. As our thesis played out and we saw headwinds from inflation and erratic monsoon to turn cycle again, we exited. Since our exit 18 months ago, the stock is down 25%, while we deployed proceeds to such newly emerged opportunities in companies/sectors which were at a similar stage where Dhanuka was in late 2019.
- Indian Energy Exchange: We opportunistically invested in IEX during COVID crash of March 2020 at an attractive valuation. In simple terms, our investment thesis in IEX revolved around the fact that this disruptive business had been leveraging technology to bring operating and financial efficiency in one of the most inefficiently run large sectors – power. The price discovery and operating ease offered by a power exchange stand to benefit the entire value chain – power generators, power distributors as well as power consumers. IEX has over 95% share in the exchange-traded power, which is 40% of short-term power which in turn is just 10% of overall traded power in the country. Rest 90% is still sourced via long-term (25-year) power purchase agreements (PPA). Over the next 18 months, the thesis started playing out with a 60-70% jump in sales and profits, however, market started extrapolating this to infinity and took the stock up 5x. We took most of the money off the table while retaining some position to play the long-term thesis. The stock is down about 50% since then.
The downside of this strategy
No strategy is foolproof. In the case of APL Apollo, we exited on similar grounds as we thought operating margins had peaked and the market was being generous in offering high multiples on those elevated margins. We were happy with the 5x returns we had made in a short span of 2.5 years. However, management continued to execute on that high base, grew sales, and maintained margins. As a result, the market continued to re-rate it further and the stock doubled even from where we sold it.
Tasty Bite is another case worth mentioning – we exited this at Rs 5,600 in 2017 (9x from our initial price of Rs 640 in 2015) despite the acquisition by Mars, US as the valuations seemed to have baked in all positives already leaving little scope of disappointment. Over the next couple of years, the stock continued to climb up to almost Rs 20,000. However, this wasn’t backed by earnings growth, rather entirely via re-rating. The market cap went as high as Rs 5,000 Cr for a 400 Cr sales company making Rs 40-50 Cr in profits. Although with no improvement in underlying fundamentals, the multiples have been coming down from the peak.
The idea is to do what works best for oneself. For us focusing on the process rather than the outcome has worked. Following disciplined exits has kept us in good stead. From every five exit decisions, there can be one or two cases like APL where we miss further upside, however, we also get saved from large drawdowns and opportunity costs of overstaying in other investments.
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