Most stocks valued cheaply by the markets are valued so for a valid reason.
The stock of M M Forgings – a South India-based forging products manufacturer for the automotive industry – was notably volatile over the past decade. The stock rose from ₹100 to ₹300 per share between November 2016 and August 2018 (the prices are adjusted for bonus issues). After remaining mostly unchanged at ₹300 per share for four months, the stock began to decline from January 2019 onwards, and finally bottomed at ₹100 per share by July 2020.
The stock quickly recovered from the July 2020 lows towards ₹400 per share by October 2021: a 300 per cent gain in less than fifteen months. For the next two-and-a-half years, the stock traded rangebound, between ₹400 and ₹500 per share. A sharp move towards ₹600 per share in the first half of 2024 was soon corrected in the second half. Today, the stock trades at ₹350 per share, down 42 per cent from its all-time high of ₹600 per share from August 2024.
Its earnings, too, were highly volatile during the decade. M M Forgings’ operating profit declined from ₹75 crores in FY15 to ₹54 crores in FY17; it increased to ₹122 crores by FY19; declined almost 50 per cent to ₹64 crores by FY21; spiked to ₹141 crores next year (FY22); and have gradually inched up to ₹215.90 crores in FY24. However, despite the volatility, revenue and operating profit have tripled over the past decade.
M M Forgings has superior and stable gross profit margins, though disquietingly, they have been declining over the past six years, from a median of 58.3 per cent five years ago, in FY19, to a median of 54.1 per cent in FY24. Hopefully, though, gross and operating profit margins have expanded consistently over the past five quarters.
M M Forgings’ business is capital-intensive; it has consistently relied on borrowings to finance its capital needs, both working and fixed capital. However, the extent of reliance on borrowings has declined over the past five years. Five years ago, borrowings financed 48 per cent of the company’s capital needs; today, it is much lower at 15 per cent.
Another unsettling aspect about M M Forgings is its stagnant capital allocation. M M Forgings has two avenues of capital allocation: capital expenditure (91 per cent) and dividends (9 per cent). Both have remained stagnant over the past six years, resulting in stagnant capital allocation. Meanwhile, working capital has increasingly strained the company’s cash flow over the past four years.
We have observed many negatives so far in our analysis. Among them are the past decade’s volatile stock price and earnings, superior though declining gross profit margins, capital-intensive business, stagnant capital expenditures and dividends, increasing debt servicing cost (interest expenses), and increasing working capital strain on cash flow.
With so many unfavourable factors, why are we discussing the stock in the first place?
Two factors piqued my interest in the stock: the cheap valuation and superior gross profit margins (though declining). But there are other favourable factors too. The firm has generated a minuscule free cash flow over the past five years due to higher earnings and lower operating investment.
Another favourable factor is a positive quarterly trend in profit margins. However, unfavourable factors such as the poor quarterly revenue growth, profit growth, and declining return on capital far outweigh the positive trend in profit margins.
Long-term investment success depends on investing in stocks with strong fundamentals and positive earnings momentum at a reasonable valuation. Earnings momentum will likely face occasional and temporary reversals in the form of earnings slowdown or earnings decline. The negative impact of such reversals will be limited if the stock has strong fundamentals and a reasonable valuation. In other words, strong fundamentals and reasonable valuation provide a backstop to a stock’s price during earnings upsets.
We don’t invest in stocks with mediocre fundamentals at a cheap valuation. You might have observed a few such stocks deliver superior returns under normal times; several might during exciting times. But don’t get misled by a small sample of such incidents. The strategy has highly unfavourable odds on a larger sample of cases. Most stocks valued cheaply by the markets are valued so for a valid reason.
M M Forgings seems to be a cheaply valued, mediocre stock. Though superior, the declining gross profit margin is the most disturbing aspect of the stock, according to me. Regarding a stock’s investment prospect, it is not whether its gross margins are superior, average, or poor that matters; rather, it is the margin’s trend – whether expanding or decreasing. M M Forgings’ gross profit margins have declined consistently for the past five years.
When I think about declining gross profit margins and their impact on a stock’s investment performance, the case of Control Print comes to mind. I considered (and still do) Control Print to have strong fundamentals. I was optimistic about the stock’s investment prospects in early 2023 when it was trading at less than ₹500 per share.
The stock rose towards ₹1,000 per share by the start of 2024, aided by positive earnings momentum. However, I soon became pessimistic about its prospects as an earnings slowdown became evident in early 2024. Looking back, it seems like a good judgment. The stock has lost 35 per cent since then; today, more than a year later, it trades at ₹650 per share.
Stocks are expected to underperform during an earnings slowdown. However, in Control Print’s case, the extent of underperformance confounded me. The stock declined by 35 per cent, while the decline in earnings was much less, at 10 per cent. I expected more resilience from a fundamentally strong stock.
After some contemplation, I surmised that Control Print’s declining gross profit margin could be a likely reason behind its stock’s excessive underperformance since early 2024. At more than 60 per cent, Control Print has superior gross profit margins. However, the margins have declined for the past five years, from 65 per cent in FY19 to 60 per cent in FY24. A declining gross profit margin indicates a weakening of competitive position, which is detrimental to a stock’s long-term prospects.
M M Forgings’ gross profit margins are in a downtrend, which doesn’t augur well for its investment prospects. We could have downplayed it if the stock had a favourable cash flow or capital allocation. Unfortunately, M M forgings doesn’t. Thereby, sidelining M M Forgings from our investment options seems wise now.
Disclosure
This post is not a piece of investment advice to buy or sell stocks. We are neither registered investment advisors nor research analysts. This analysis is prepared for our internal investment decision-making. The purpose of sharing it is purely informational.
Investment in the stock market is subject to various risks and can result in capital losses. It is advisable to do your own research and/or consult your investment advisor before making your investment decisions.
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