Look out for the catalyst


Director, Banyan Tree Advisors

December 20, 2011

The key to a good stock-pick is to look for a catalyst that will drive it to a higher orbit.

THE WORD catalyst (cat.a.lyst: one that precipitates a process or event) tries to take one directly to the beginning of an event. It could be that little spark that caused a forest fire. Or the role of the matchmaker in a marriage. Some attempts at catalysing a process might fail (I am not sure whether Vajpayee’s bus trip to Pakistan did anything to catalyse the peace process). Some can trigger a wave of change.

With this brief prelude, let’s drive straight ahead to the highway we are supposed to be on — the investment highway. Most people who have got into the world of equity investment have had the experience of either investing in, or being left holding, a stock that looks cheap but does not move for years. I recently read that Jammu & Kashmir Bank (whose financials look pretty okayish) trades at a PE of less than 2 with a dividend yield of 11 per cent. Some others have also written about reasonably profitable MNC stocks that are quoting at ridiculously low prices. There are quite a number of other stocks in this category — Shriram Honda trades at a PE of 3, IDBI at a PE of less than 2 and Cholamandalam Finance offers a dividend yield of 17 per cent. This list even includes consumer products such as Timex and Phil Corporation.

My own experience with such stocks has been quite bizarre. About three years ago, I was doing some diligent work on how to pick up value stocks and I had made a list of some of them. At that point, Gramophone Company was flushed with the success of ’1942 – A Love Story’ and ‘Hum Apke Hain Kaun’ and yet the stock was trading in the mid-30s. I bought it then, sure that these movies which boasted of several musical hits would have the music major’s cash registers ringing for some time to come. But imagine my consternation when, immediately after I bought in, the stock went into the sub-20s.
Completely dejected, I exited the stock. Within two years, thanks to the media boom and Zee Telefilms taking off, it reached dizzy heights of Rs 2,300.

Worse still, on exiting Gramophone, I bought into Premier Auto Electric, which was quoting at one-fifth its book value, a dividend yield of almost 20 per cent and a PE ratio of less than 2. Over the next two years, the company, which had a 25-year track record of paying dividends, decided to cut dividends and the stock promptly halved! How’s that for luck!

Three orbits. The funny thing about the stock market is that it might not be as efficient as the pundits claim. Stocks can quote in three categories — or to borrow a term from science, three different orbits. The lowest orbit is the bearish phase, when stocks (despite being moderately profitable) are quoted at silly valuations (a PE ration of less than 4 or so). The next orbit is the acceptable orbit (PE of 10-18 or so) and the third is the really bullish orbit (with a PE far in excess of 30).

Take the case of Wipro. In 1997 (by which time Infosys was quite popular with the market), Wipro was trading at a PE of less than 8. Within six months, when the market realised that Wipro was also in the software business, the stock was re-rated upwards to a PE of about 20. Over the next 18 months, it went on to touch a PE of 800-plus.

Stocks need a catalyst to change orbits, and it’s a good idea for investors to keep an eye on potential catalysts. Take, for instance, HDFC, which was quoting at a PE of 6-8 for almost two years. Many people claimed that the stock was expensive at even those levels. Then HDFC launched its mutual fund and the government announced concessions to the housing finance sector, and the stock today trades at a PE of over 15.

The need to have a catalyst in sight could simply direct you to the right choice of stock among all the sub-3 PE stocks or all stocks with a dividend yield of over 12 per cent. If you list all the penny stocks in the market, you will easily line up more than 200. Now, instead of buying the first stock you see at a PE of 3 or a dividend yield of more than 12 per cent, choose a stock where you see a catalyst that could kick the stock to a higher orbit. This could potentially give you a 100-bagger, for these stocks come not from earnings growth but from a dramatic change in PE ratios.