Polycab India: Value Buy or a Value Trap? 

Hello everyone, Rahul Shah here, trying to make investing accessible and profitable for the average investor.

While traveling to foreign countries with as little cash as possible is quite commonplace today, do you know who was the pioneer of this trend?

Well, it was none other than American Express. With a growing US population and rising interest in air travel, the traveler's cheque from American Express was convenience personified.

It almost eliminated the need to carry large sums of money or travel with a letter of credit, which was a slow and a boring process.

Soon, American Express became synonymous with traveler's cheques and the company earned a stellar reputation. In fact, AmEx leveraged on its strengths and tapped into other segments like credit cards, which became the foundation for its future growth.

Needless to say, the company's business boomed, and it became a hot stock on the market.

Then came the Salad Oil scandal in 1963.

The word has it that a vegetable oil trader who went by the name of Anthony De Angelis cheated 51 companies by borrowing money and pretending to have huge holdings of salad oil. It however turned out that the tanks had salad oil floating only on the top. Underneath, they were full of water.

Not surprisingly, De Angelis' loans went bust and one of the subsidiaries of American Express got caught up in this scandal.

Spooked by this turn of events, Amex shareholders started dumping the stock left, right, and centre, leading to an almost 50% crash in the stock price in no time. This is when an investor in his mid-thirties swooped in and bought a significant 5% share in the company.

His rationale was simple. He noticed that there was no permanent dent to the image of the company and that people were still using Amex cheques and cards as before. This led him to conclude that the company's brand name is intact, and he was getting the stock at a bargain basement price.

He was eventually proven correct as the stock recovered and went on to give 10x returns over the next 10 years. If you haven't guessed by now, the investor is none other than Warren Buffett and American Express was one of his most profitable investments.

The reason behind narrating this story is simple. It is to ask whether a similar future awaits investors who are thinking about investing in Polycab India, India's leading manufacturer of cables, wires, and consumer electrical products.

You see, like American Express, Polycab India has also had a dream run on the stock market until this crisis.

The company has more than doubled its topline over the last five years while its bottomline has almost quadrupled during the same period. The performance has not gone unnoticed by the market, making the stock a huge 10-bagger before this crisis unfolded.

The last few days however have been quite hard on the stock. It has seen its share price erode by a huge 30% from its top and there could be more losses in the offing.

The decline is a result of the company coming in the cross hairs of the tax authorities. Apparently, the Income Tax Department has detected unaccounted cash sales of about Rs 10 bn after it recently raided the group.

It's further reported that a large number of 'incriminating' evidence in the form of documents and digital data have been seized during the raids.

Although the company has denied any wrongdoing, the shareholders are having none of it. After falling around 7% on Tuesday, the stock fell a whopping 21% on Thursday as more bad news surfaced.

As highlighted earlier, the stock is now down 30% from the top. So, the question that begs itself is whether one should do a Warren Buffett here and turn greedy when everyone else is fearful? Or is the stock akin to a falling knife, where trying to catch it may lead to bad consequences?

Well, we need to approach the whole situation in a structured manner.

The very first question one needs to ask is if at all the company gets implicated in the scandal, will it be fair to invest our hard-earned money in a stock where the management honesty and integrity has come under some serious cloud?

Well, different investors are going to approach this situation differently. Some would completely stay away from the company under the pretext that if a management has done it once, it is likely to do it again. Therefore, it is better to stay away from such stocks.

Then there are others who believe that everyone deserves a second chance and there's no harm in being a part of such a solid franchise where long term prospects are quite bright.

Hence, to each his own. Your decision will depend on your preferred approach between the two.

Then there's the question of whether the franchise or the business quality itself will take a beating from now on and whether growth will be severely affected. In the short term, there's going to be a lot of uncertainty around how the accusation will pan out.

However, if you think positive about the long-term future of the company and believe that Polycab India would be creating new profit records in 5-7 years, then the stock certainly merits a serious look from long-term investors.

On the other hand, if you think that the IT raids have caused a permanent dent on the business prospects of the company and it will be difficult for the company to reclaim its lost glory, then it is better to stay away.

Last but not least, the valuations...

You see, even after the 30% drop from the top, the stock still trades higher than its long-term average PE ratio of around 34x. Right now, the PE stands at around 36x.

Although the stock is trading close to its long-term PE and also lower than its recent PE of 50x, I believe the current situation demands a big margin of safety in terms of valuation multiples.

And this margin of safety should at least be in the range of 30-35% if not more, to take care of any huge negative surprises that may be yet to come.

Using this number brings the PE multiple below which the stock can be considered for investment at around 25x. Of course, different investors may use different levels of margin of safety and their ideal PE multiple may vary accordingly.

So, that's the roadmap to investing in fallen angels like Polycab India. The idea is not to go ahead and invest merely because the stock price has crashed. The situation should be approached with a calm head and by asking the right questions.

Questions like whether the management deserves a second chance if found guilty, is the business capable of bouncing back post the current adversity, and the amount of margin of safety you should demand while arriving at the stock's intrinsic value.

These questions will force you to put on your thinking hat and prevent any knee-jerk reaction that you may come to repent later.

That's all from me today. I will see you again next time. Happy Investing.