A good case study to learn about uncovering dubiousness
Yesterday I came across Arrow coated products while running a stock screen looking for companies with high ROCE, High Margins and high growth. this company really stands out on all basic parameters and if you give a cursory glance at the business it is in everything sounds great - great space to be in with good future runway for growth.
Moment you start digging in you start getting questions. Even before I got into the AR i went to the VP thread on this (Arrow Greentech (Old name: Arrow Coated Products) - Anybody tracking) and our resident sherlock @varadharajanr had already picked up quite a few hole sin the story. Many others had raised similar doubts after their interaction (or lack of) with the management.
This was enough to raise reasonable doubts for me to stay away from this. It may turn out to be a great business and a multibagger for others but it is not for me. I would never rue others making money from this - I don’t need too many ideas to invest in anyway - looking at smaller cos better to miss the bus than lose money. Reminded me of some of the ideas from Prof. Bakshi’s great post on Risk (The Eventual Consequences of Risk Seeking or Risk Blind Behavior – Fundoo Professor) . As Munger says if I know where I am going to die I will not go there. Surely we do not know where we will die but we know where there are higher probability of dying.
following excerpt from the post is useful.
psychologically astute people like Buffett and Munger have a no-fault rule when they get invited to auction situations.
The rule is: Don’t Go.
Now let me tell you something about no-fault rules. The idea behind having a no-fault rule to prevent horrendous losses from risk-seeking behavior like the one described above, even though following such a rule may result in a few lost opportunities. The cost of missing those opportunities is reckoned to be minuscule as compared to likely losses from indulging in risk-seeking behavior. This is an important philosophical point to keep in mind
Coming back to Arrow Coated I went ahead and read the AR as an exercise in forensics and to figure out if there are red flags a starting investor can pick without the expert advice of people here. Few things that stood out
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No dividend has been declared and all profits are retained. Many good cos do (it may be good capital allocation for some cos in excellent businesses) this but in small cos a consistent dividend payout can give some indication you that real money is being made. Pair this with the management salary, which seems low, and you wonder where the promoters are making their money.
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coming to P&L and Other expense is the biggest cost item - material cost is only 18%, employee cost 11%, man exp .only 7%. the other expense also varies wildly - down from 7.7 crores to 3.6 crores while the revenue has gone up. This fall is due to 3 cr. of Product research expense which is 0 in 2015!!! totally mindboggling for a supposedly IP led company. Maybe there are some accounting policies changing that causes this and I have not yet read about it but there are enough alarm bells ringings to wake up Kumbhakarna
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Inventory is down from 3Crores to 0.7 Crores!!
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Come to revenue and you have real kicker. Revenue from Sale of products is only 25% and rest is some Royalty income → this would be first question that you would need to resolve if you are interested in this company. also 2/3 of this Royalty was classified as some consultancy fees in 2014 which is 0 now!
This was definitely a good exercise and the learning is that while looking at undiscovered stocks or ideas probability of permanent loss is very high. I would personally stay away from such situations. Others can draw their own conclusions but be aware of the risks associated with such an investments
Disc: not invested 