Prof Aswath Damodaran Explains Why Buying “Bad Companies” Makes A “Good Investment”

Profile of Prof Aswath Damodaran

First, we have to quickly familiarize ourselves with Prof Aswath Damodaran’s profile.

The Prof hails from Chennai. He is presently a Professor of Finance at the prestigious Stern School of Business, New York University, where he teaches corporate finance and equity valuation.

The Prof is a prolific author and has penned a number of books such as The Little Book of Valuation: How to Value a Company, Pick a Stock and Profit, Damodaran on Valuation etc.

The Prof is highly regarded by the intelligentsia as an authority on valuation of businesses and stocks due to the success of these bestseller books.

Paradox of why good companies can be bad investments and why bad companies can be good investments explained

Prof Damodaran has written an elaborate piece in which he has argued that “good” companies can become bad investments if they trade at too high a price. Per contra, “bad” companies can become good investments if they are bought at a low price.

He also explains that while separating good companies from bad ones is easy, determining whether companies are well or badly managed is slightly more complicated. However, defining which companies are good investments is the biggest challenge.

To make the investment process simple, the Prof has provided a ready-made template which sets out all the permutations and combinations.

The best case scenario is where great companies with great managers are available at a great price. However, as this is practically impossible to find, the alternative is to buy a company in a “bad business”, run by “indifferent managers” but at the “right price” which factors in all the disadvantages, Prof Aswath Damodaran says.

Howard Marks’ theory of “fundamental risk” vs. “investment risk”

At this stage, we have to also bear in mind the theory formulated by Howard Marks, the Billionaire investment-philosopher on the distinction between “fundamental risk” and “investment risk”.

Marks explained that while a good company’s stock may not have “fundamental” risk, it carries an “investment” risk if we overpay for the stock.

Vice-versa, while the stock of a “bad” company quoting at a rock-bottom valuation may not have an “investment” risk, it has a “fundamental” risk.

“The bottom line is simple: the riskiest thing in the world is the widespread belief that there’s no risk. That’s what most people believed in 2006-07, and that belief abetted the careless behavior that brought on the Great Financial Crisis. Only an understanding that risk was high could have discouraged that behavior and rendered the world safe. I call this “the perversity of risk” Howard Marks said.

Shankar Sharma also advocates buying “bad” companies where the expectations are low

Shankar Sharma has formulated five mantras for finding multibagger stocks. These are:

(i) Find stocks that are languishing at multi-year lows;

(ii) The stock must not be profitable but must be making losses;

(iii) The stock must occupy a low weight in its sector. It must not be the sector leader or be a part of the Index by any stretch of imagination;

(iv) The stock must not be well covered and if it is, the consensus opinion should be negative;

(v) There must be the expectation of a tiny “spark” which will ignite the stock and send it rocketing into orbit.

Prima facie, Shankar Sharma’s theory appears to be in consonance with that advocated by Prof Ashwath Damodaran and Howard Marks.

Porinju Veliyath also draws distinction between “great businesses” and “great stocks”

Some vigilant observers were quick to point out that Prof Ashwath Damodaran’s theory is an endorsement of a theory earlier formulated by Porinju.

Great recent post by Ashwath Damodaran.. @porinju been recommending an approach on similar lines for a while nowhttps://t.co/tP07gJjFKe

— Niraj Shah (@_nirajshah) March 24, 2017

Porinju has openly admitted that he has built his entire empire worth several hundreds of crore by buying so-called “bad” stocks which are quoting at throwaway valuations. He also claimed to have earned an impressive CAGR of 32.89% over 12 years for his PMS by investing in such “bad companies”.

I love 'bad companies' by perception, but 'good stocks' – helped me to do reasonably well in Indian markets. pic.twitter.com/JtMdrdrDNF

— Porinju Veliyath (@porinju) July 15, 2015

Porinju has also given practical examples of stocks that are “good companies” and of those which are “good stocks”.

Page is over-priced unless govt makes it compulsory to wear 2 underwears, like superman 🙂 https://t.co/OVTovP99Lq

— Porinju Veliyath (@porinju) August 14, 2015

Great Cos may not be Great Stocks:
Ashiana was 'Great Company' at ~325 in Feb, while I was buying Ansal Buildwell, a 'Great Stock' at ~70

— Porinju Veliyath (@porinju) August 17, 2015

Sad that amateurs are chasing success stories at wrong prices; I have been warning about Page, Kitex, Ashiana, Atul Auto, Symphony, KSCL etc

— Porinju Veliyath (@porinju) August 17, 2015

According to Porinju, companies like Page Industries, Eicher Motors, Symphony, Kitex etc are “great companies” but cannot qualify as “great stocks” because their exorbitant valuations does not leave much room for upside.

In November 2015, Porinju launched a scathing and no-holds-barred attack on certain unnamed gurus and called their advice to buy high P/E stocks “the biggest trap“:

“I hated these stocks in the last one year because there are no values left, they are great companies ….

This was the biggest trap and people are losing 20-40 percent by doing that kind of safe investment.”

Bad quality stocks can be transformed into good quality stocks

Porinju opined that there is a transformation in India happening because of which “bad” companies will perforce have to become “good” companies.

“What does quality mean? You can find bad quality stocks which then get transformed into the quality league, and that is where we make big money. In India, fortunately, we have a large number of such companies in the midcap and smallcap segments. We always used to discuss about turnarounds happening in various aspects of a business and in most cases the changing attitude of the promoter, which is how some of these so-called penny stocks have come into the quality league. They become multibaggers and they change the space where they belong to. That is why we have many penny stocks becoming smallcaps, many smallcaps becoming midcaps and many midcaps getting into the league of largecaps. That transformation is very special to India. It is very special to India considering the number of stocks getting into that league and we do not see many smart investors are money in this space.”

He also opined that the crackdown on black money, digitization etc will force bad managements to willy-nilly reform themselves because the paths to siphon of their ill-gotten gains are now blocked. This will result in a re-rating of these companies, Porinju said.

Conclusion

It is obvious that we cannot turn a deaf ear to the authoritative pronouncement of Prof Ashwath Damodaran that so-called “bad” companies may actually make a good investment if the price factors in all the risks. We will have to go back to the drawing board and rework our investment strategy and launch a search for these so-called “bad” companies!