The real support levels

A decade ago, when I still believed that there is some truth in technical analysis, I used to read recommendations from the Economic Times, with the similar mindset with which people read their astrological forecasts – knowing they are senseless – still trying to match the reality with the written word. There is one recommendation that I still remember. It said that Global Tele Systems, which was at 1,530 Rs at that time, faces resistance at 1,650 and again at 1,800. If it crosses this resistance level, it has another resistance at 2,400 and if it crosses even that, sky is the limit. The investors(!) are advised to keep a stop loss at 1,420 because if it falls, it can go all the way down to 1,200 where it has a strong support. If it falls below this support level, the stock will have a freefall and can hit a low of Rs 500.

I was amazed. The technical analyst[1] had given a forecast which couldn’t have gone wrong. The stock couldn’t have moved out of the range that included all possible price points including the ‘sky’. The stock couldn’t have gone up without breaking the so-called resistance levels. The recommendation, while being correct, was completely useless from investment point of view.

Making believable but meaningless recommendation is an art that is practiced in many spheres of life. There is a pattern in these recommendations. They include things you want to hear. They include the obvious truths. They include a jargon that you don’t understand. “Ganesha says it is a good time to get yourself acquainted to new skill”; “correction is long overdue”; “markets are facing strong headwinds”…

Let me tell you this honestly. The earlier you develop complete immunity to such banal talk, the better. A falling price is a result of both the supply and eagerness to sell exceeding the demand and willingness to buy at a given price. There cannot be any support at any price level unless buyers become willing to buy at that price and their demand exceeds the supply.

A mere statistical event like the stock touching its 200 day moving average or the stock making a specific pattern in the charts, will not induce more people to buy the stock. (unless, of course, the majority of investing population has become stupid enough to believe in nonsense).

Does it mean that there are no support levels for stock prices? Don’t we have levels below which the stocks will become extremely attractive to buy?

There are indeed the levels where the stock becomes attractive due to increased probability or quantum of returns. The following diagram depicts the relationship between the purchase price and probability of eventual loss. It is not a result of any mathematical equation but created just to highlight the link.



If you buy a stock above its intrinsic value, the risk rises exponentially. After a price it will be almost impossible to come out without losing money. On the other hand, if you were to buy a stock well below it net current assets after paying debt, you have little chance of losing money. You may profit even when the company goes bankrupt.

Although, the short term movements of the stock prices completely ignore these levels, these can be important in deciding your purchase decisions. More so, they help you realize the margin of safety you have and in figuring out whether to buy more of the stock if it falls.

These support levels are described below in the increasing order of their strength. For different companies their relative order may be different. For example, the discounted cash flow valuation may give a value less than book value if the company is giving poor returns.

Discounted Cashflow Valuation based on projected growth: Discounted cash flow (DCF) analysis uses future free cash flow projections and discounts them at a discounted rate to arrive at a present value of future cash flows. Simply put, if you were to give me 100 Rs today, its value is 100 Rs. If you promise to give me 100 Rs next year, its value for me is 90 Rs if the interest rate is 11%. If I fear that you may not fulfill your promise next year, the value for me is even lesser than 90 Rs. The discount rate takes into account the interest rate and risk premium.
The discounted cash flow model is theoretically sound but it is as reliable as the estimates of future cash flows, interest rates and perceived risk. Even a minor change in these variables can change the valuation by more than 50%. The higher the projected growth, the bigger is the risk. That is why you have to be very careful in investing based on future growth projections. You have to keep a margin of safety.

Book Value adjusted for quoted value of marketable securities: A company in its lifetime creates many subsidiaries to expand the business. These subsidiaries get listed on their own. If the stake in a subsidiary is more than 50%, the results of the subsidiaries are consolidated with the parent in the consolidated accounts. If the stake is less, these investments appear under the head called ‘investments’ in the balance sheet. These investments are carried at the book value and the market value of these investments can be substantially more (or less).

However, basing your valuation on the quoted value of marketable securities means you are assuming that the market is correctly valuing the investments. As the parent company has no intention of selling these investments, you should use the market prices of these investments just as a guide.

In 2004, I purchased Madras Aluminium Company (Malco) at Rs 25 levels (Rs 125 before split) because the market value of its stake in Sterlite was significantly more than the market capitalization of Malco. Malco itself was a debt free and profitable company. The decision turned out quite well for me and last year I sold the stock at around Rs 200. While I have a mixed record in investments in other holding companies, they continue to be my area of specialization.

Earning yield: Earning yield is equal to earnings per share divided by the stock price, i.e. inverse of P/E ratio. The earning yield calculated using the average earning for a few number of years can be a good number to compare with the returns from fixed income securities. The number of years must be carefully chosen to get a good idea of the company’s average profitability level. In commodity companies where the economic cycles cause large swings in earnings, the average earnings over the up and down cycle can be taken as average earnings. For the company where the revenues have risen substantially, average margins can be used to calculate average profits at current sales. For the companies with steady income like those in the FMCG sector, even one year’s earning can give good indication.

When the earning yield is significantly more than the yield from AAA rated corporate bonds or government securities, the shareholders as a group are earning better returns from business as compared to the prevailing interest rate. If the earnings are expected to grow from this point on, the stock should attract buying interest. In that respect, earning yield is an important support level.

Book Value: Things start getting interesting for value investors the day a stock dips below its book value. Book value is the value at which an asset is carried on thebalance sheet. In other words, the cost of an asset minus accumulated depreciation. It must be remembered that book value is an accounting notion. The actual replacement value of the assets depends solely on their capability to generate returns. For instance, the intrinsic value of Hindustan Lever is significantly higher than its book value of 6.6 Rs per share. This is because the book value doesn’t reflect the value of the intangibles like brands and intellectual property. On the other hand, the real value of Enron’s Dabhol power plant would be significantly less than its book value. Despite all these nuances, the book value is an important support level.

If you buy at book value and the company is able to generate returns at least few percentage points above the interest rates, your chances of losing money on the stock become quite low.

Dividend Yield: Although in the last few decades the importance of dividend yield has declined, it remains an important support level. The companies, by convention, try to maintain or grow the dividend payout. This ensures that a company will distribute only that part of its profits, which it thinks can be distributed without affecting growth and financial stability. This makes dividend yield an important criteria. I bought Wyeth Ltd at 430 in January 2008 when the Sensex was above 16000. In September, the stock gave me Rs 30 in dividend. Today when the markets have fallen by almost 50%, the stock still quotes at Rs 420. Even if the price goes down from here, I can keep holding the stock because it gives me a dividend yield quite close of the returns from fixed deposits.

Net Current Assets per share: Benjamin Graham, the first proponent of value investing, laid a great emphasis on buying the stocks below the net current assets per share. This metric, also known as liquidation value, is calculated by taking a company's current assets and subtracting the total liabilities (current liabilities plus debt). In the good times it’s rare to find stocks selling below their net current assets per share. However, in the times like the present, it’s not hard to find companies at this level. If a company is still making profits, you can aggressively purchase a stock if it falls below this highly important support level.

In September this year, I bought Archies Ltd. at two thirds of its book value. In the next two months the stock fell by 50% to a low of 42 when its Net current assets after deducting debts were Rs 44 per share. I had no other option but to buy aggressively at that level which I did. The stock later recovered above Rs 60.

Cash per share: This is the last line of defense. A company’s net current assets include inventories which may have been overvalued. They include the receivables which may turn out to be bad debts. If you want to be absolutely safe, you can wish to buy the company below cash per share. It must be mentioned that you still have some risk of losing money even when you buy the stock below its cash per share. These risks come from situations such as fraudulent reporting, contingent liabilities, etc. All the cash in the balance sheet can get siphoned off in a single fradulant transaction, like what Satyam's promotor's were planning to do with Maytas aquisition. In case of the companies which have recently raised money through IPO, the money lying in accounts is not free for distribution. This money will get deployed in the business in due course of time. In such cases, looking at cash hardly means anything. Similarly, loss making companies or the ones expected to do write-offs, may have an intrinsic value less than the cash in the balance sheet.

Although the support levels mentioned in the end are the strongest support levels, you may not find good companies when you search the companies based on these criteria.

The experienced investors like Warren Buffett and Charlie Munger have talked about the pitfalls of this approach. The biggest drawback of this ‘cigar butt approach’ is that under normal market conditions, a company selling at such distressed valuations may not be doing well in the business. You may have to wait for a long time in the hope that the market will price the company little more; however, it is highly possible that in the meantime the company may erode its networth and cash.

Focusing on only assets is as bad as focusing only on the earnings. Until you see both in conjunction, you will not get the clear picture of the company’s financial position.

Finally, as the graph shows, in the conditions of extreme overvaluation or undervaluation, the probability of loss associated with the purchase does not change much with the price. You have equally high chances of losing the money on a company selling at 1000 times the book value vs. the company selling at 2000 times the book value. But the expected value of the loss will be greater if you pay 2000 times the book value. It goes without saying that if you do beat the odds stacked against you, your returns will be lower if you pay high.

This relationship between the potential risk and reward is depicted using the red and blue marked areas where the red denotes the expected value of loss and the blue area denotes the expected value of returns and the yellow line in the middle shows the price paid. You can clearly visualize how dramatically your risk-reward equation changes when you buy at higher prices.


Notes:
1. My curiosity to find what happened to that analyst was rewarded by a search result which stated that SEBI has banned him from advising clients. Date: Jan. 22, 2007. Seven years too late].