Stocks under stress: Buying opportunity or serious threat?

Every so often, companies across a variety of sectors get into trouble for all sorts of reasons with different authorities. Sun TV, Nestle and Jindal Steel & Power would be three recent examples of listed companies, in difficulties, each for a different reason and with different government agencies.

One could bring up a host of references to other such companies which have faced difficulty or controversy. Cairn, for example, has to deal with a huge income tax demand. ITC faced a similar income tax (IT) demand for many years, listing it as a contingent liability on every successive balance sheet. Satyam was hit by a gigantic fraud.

Many Indian pharmaceutical companies have been hit, at some stage or another, by bans from the US Food & Drug Administration, as well as legal challenges to their intellectual property rights. Infosys and iGate have been hit by sexual harassment suits.

More broadly, every telecom service provider has faced uncertainty due to the spectrum allocation scandal. Every company that received a coal block allocation under the United Progressive Alliance regime took a hit when the Supreme Court ruled that the allocations were all illegal. In both these instances, companies had to go through a second auction process, absorbing higher costs and changing their project timelines.

In every case, the listed companies suffered a loss of market value. The shares dropped the instant the bad news became public. Traders sold the affected stocks down and investors fled. In many cases, shares have subsequently recovered when the issue was resolved, one way or another. ITC, for example, or Satyam (now Tech Mahindra) have offered excellent returns to investors who bought during the crisis period or simply stuck to their investments.

Did those problems represent a buying opportunity or a serious threat? This is an interesting question. Both the answers could be true. If the problem proves temporary, the stock will see a recovery and the returns be especially high for an investor who has the guts to buy during the crisis period. However, if the problem is fatal or of very long duration, the business might not ever recover. In that case, the earlier the exit, the better.

Quite often, it is impossible to judge the possible timeline or even the likely final outcome. ITC, for example, faced an IT demand for many years and also the threat of a retrospective tax amendment after it won its case in court. Eventually, there was a settlement.

There is also a survivor-ship bias in making a judgment call. A company that sinks under the weight of such problems and goes bankrupt will be forgotten by the market. Only the 'winners', meaning those eventually survive, will be recalled easily.

The investor or trader must, therefore, make an accurate assessment of the real risks attached to the situation. That will obviously vary, case by case. The resources of the company concerned, its 'influence' with the department concerned, its ability to shape the public and legal narrative, links with the political establishment, etc are all factors to be taken into account. The legendary Dhirubhai Ambani used to refer these situations as "managing the environment".

Ultimately, this is about the company's ability to survive. In the worst case scenarios, can it absorb the damage and move on? Will it continue to run its business? This can be a very difficult call to make because it might be hard to quantify any of the variables.

In the instances mentioned above - Cairn, Nestle, Sun TV, Jindal S&P - it is likely that all the companies concerned will survive. These firms possess the internal resources and the linkages to do whatever it takes to get past the current issues. However, the damage could be quite severe and anybody who enters the stocks at these levels has to have the patience to hold for a long, undefined period.