Striking similarities

Sebi and investment banks have to ensure that the imminent IPO boom does not degenerate into doom as in China

By Mohan Sule
The primary market is a parasite. It survives by feeding on the secondary market. A euphoric Shanghai stock market spun off a share-sale deluge. No sooner did the Chinese controllers stepped in to cap the runaway prices by hiking margins than listed equities began displaying withdrawal symptoms, plunging 30% from the peaks. So much so that financial institutions and brokers had to pledge to step up buying. Issuers were banned from raising capital to shore up the secondary market. China’s secondary market may well hold due to all the public display of affection but will IPOs? India is on the cusp of a primary market recovery. It will be the beneficiary of any disappointment of foreign investors with Shanghai. Yet, China’s experience of boom and projected doom has raised concerns. There are striking parallels. Chinese stocks have run ahead based on the belief that double-digit growth will be the norm. A slowing economy, therefore, can pull down high-flying stocks. Hence, the desperate attempts by the authorities to cool the heated equity market. Indian shares started spurting even before the May 2014 Lok Sabha elections on projections of the rise of Narendra Modi. His stint as the chief minister of Gujarat had established his reformist credentials. Also, the low base of the last two years meant heady growth going ahead. The turn in sentiments propelled the market to cross the 30,000 level. Just like China, India has plenty of room to grow. The potential of both remains untapped due to different reasons.

The deceleration in the grinding of its manufacturing facilities, triggered by the fall in property prices, is slowing China’s growth. The glacial pace of India’s reforms is lagging behind the galloping valuations. A common area of worry is the banking industry. China’s is dogged by dodgy account keeping, hiding the true state of its bad loans. Loose lending has contributed to bubbly stocks. India’s banks, too, are weighed down by non-performing assets, immobilizing their capability to lend to new clients. If the Chinese IPO boom is the beginning of the end of the China’s growth story, is India too destined to burn out before taking off? The composition of investors is a rough indicator to determine the state of a market. Ordinary investors fuelled the Chinese primary market. Indian retail investors are returning to the ring, primarily through mutual funds. On many occasions domestic institutions have bought equities even when foreign investors were selling. The downside is that the small investors responsible for holding up the market through mutual funds might book profit in the secondary market and turn their attention to new offerings. The Securities and Exchange Board of India has shortened the listing period from the close of issue by nearly half to six days. The prospect of bumper profit in a short time span can prompt diversion of funds from listed stocks. No wonder, a frothy primary market is viewed as the last phase of a bull-run. The equity market went bust shortly after the mega offer by Reliance Power in January 2008.

The other danger is the absence of capital appreciation due to high-value offerings. There is at least a probability of gains being recycled into newer offerings. Under-subscription due to richly-priced issues or listing at a discount to the offer price has the malevolent power to destroy the primary market and, in turn, the secondary market. Many issues will be offering exit route to early-stage investors, who would want good returns on their investments. More will be from companies aiming to deleverage. With banks going slow on lending due to money locked up in bad loans or entertaining only those with good credit score, there will be no surprise if those requiring capital will be from risky but promising segments. Small and mid caps will be the most vulnerable to mood swings as money flows in and out of the secondary market, depending on the size and attractiveness of the issue in the primary market. The market regulator has gone out of its way to ensure a smooth ride for small investors by introducing concepts such as retail discounts, anchor investors, market-making and buyback as safety net. With the memory of the roller-coaster ride of Chinese stocks still fresh, Sebi has to nip in the bud any signs of irrational exuberance and become vigilant in vetting the issues. There should be zero tolerance for non-disclosures by becoming visible in cracking down on those who flout rules. Investment banks have to cap the greed of issuers by nudging them to price their shares modestly so that they can be long-term players rather than flashes in the dark.

What to do with banks

Time to junk the concept of universal banking and turn to niche banking to ring-fence risks

By Mohan Sule
One of the stumbling blocks to the revival of the Indian economy is the poor health of public sector banks, which own more than 72% of the assets and 77% of the deposits of the industry. Not surprisingly, the finance minister has to keep reiterating the government's intention to infuse fresh capital into PSU banks. This is to restore confidence in the system, which is apparently to serve the small saver but has been twisted and bent to cater to crony capitalists. The banking industry has been the problem child not only of India but of the global economy, going back to the Great Depression. The Glass-Steagall Act was passed in the US in 1933 to limit commercial banks' securities activities, clearing the way to demarcate savings and lending institutions and investment banks. The idea was to protect the risk-averse depositors from the leveraging associated with dealing in securities. The scope to make big profit from accepting funds at lower rates and lending at higher rates is limited. Expanding physical presence to garner a big share of the market requires huge capital. In contrast, there are bumper gains to be made from advisory services and dabbling in the debt and equity markets on a relatively lower base. The M&A wave in the US in the 1990s saw commercial banks acquiring stake or tying up with securities firm for that much-needed bump to the bottom line. The Gramm-Leach-Bliley Act of 1999 repealed the provisions restricting affiliations between banks and securities firms, sowing the seeds for the blowout of the too-big-to-fail banks in 2007-2008 as exotic derivatives were deployed to top the league tables, ignoring capital adequacy.

The subsequent forced merger by the government of weak and strong financial organizations has resulted in a handful of institutions dominating the US's banking space. Though capital requirement has been enhanced and proprietary trading scrapped, prospects of a systemic failure have increased due to the small numbers. In India, PSU banks replicate efforts, manpower and capital to expand into each other's territory to chase customers. Their bottom lines are influenced by income derived from non-banking activities. Their assets are prone to turn sour because credit sanctions are not always commercial transactions. Mergers can create a few capable banks with scale. The issue is if the alliance should be based on balance sheet strengths and weaknesses or geographical presence to achiever wider reach. Core banking is making brick-and-mortar existence redundant. Interestingly, this leads to two crucial questions. Should banks be viewed as FMCG companies, vying for attention on the basis of brand loyalty acquired through superior service? Or are banks going to become e-commerce entities delivering the basic needs efficiently? FMCG stocks are favored for consistent payouts, while Internet startups are enjoying huge valuations despite making losses because of the potential. Banks combine the best and the worst of both.

Just as the FMCG sector is no longer viewed as evergreen due to dependence on monsoon to drive rural growth as the urban market has flattened out, PSU banks are burdened with the cost of reaching out to the lowest denominator. Like e-retailers who are prone to categorize themselves as tech companies rather than slot themselves with retailers in the real world enjoying poor discounting, banks are embracing technology for the ease of doing business and increased penetration. Unlike cyber malls, however, their valuations factor in the non-performing assets rather than the huge unbanked population as India urbanizes. The second dilemma is if India should go back to the era of institutional lenders confined to corporate clients rather than encourage universal banks. The regulatory framework for banks operating in various niches will differ. Investors will be able to pick stocks in the sector suiting their profile. The discounting due to the thin margins earned by attracting and lending money will be mediocre compared with those for bottom lines supported by trading income. Yet as the business of savings banks will pivot on the credit track record of retail borrowers, they will be viewed stable and safe. Investment banks will focus on maximizing treasury opportunities and big-ticket players will be specialists in devising innovative ways of raising capital, thereby rewarding risk-takers. VC and PE funds are meeting the needs of startups. Microfinance and SME lending institutions can take care of the small borrowers. The proposed Mudra Bank is aimed at the unorganized sector. Thus, clubbing banks as per the markets they cater to, with different capital requirement, will lead to better monitoring and containment of risks.

The 2-minute lessons

What the Maggi fiasco of bans and stock withdrawal reveals about Nestle’s strengths and weaknesses

By Mohan Sule

Every crisis teaches a lesson to the stakeholders, and the Maggi storm is no different. The first is makers of consumer products have to be prepared for a far severe backlash than business-to-business enterprises. Larger the size of the market, more does the echo reverberates. Many top-notch pharmaceutical companies have had their shipments from sub-standard production facilities suspended by the US regulator. Apart from a short-term reaction in the stock market, their domestic image hardly took a knock. Nestle had to face consumers’ as well as shareholders’ ire. This leads to the second lesson. Companies spend a lot on building brands, particularly in markets where entry barriers are low and competition is on the basis of price. Therefore, a breach of trust is hard to bridge: You, too? Investors who had propelled a north-based developer into the largest market cap player in the segment, leading to its inclusion in benchmark indices, felt let down on learning of material non-disclosures in its red herring prospectus. The third lesson is positioning. As long as Maggi remained a convenience food to be cooked quickly, it was looked at indulgently despite the widespread knowledge, at least among adults, that its basic contents contributed nearly nil nutrition. No sooner did it shift the focus to being a healthy alternative for children, it attracted scrutiny, leading to its downfall. Real estate players who forayed into the 2G telecom space have still to recover from the debacle.

Can Maggi win back users’ confidence? Going by the experience of Cadbury, which too faced quality issues, the exercise should not be difficult. A company with an established brand finds it easier to get up after a fall is the fourth lesson. At the same time, there is a danger for a brand operating in a buyer’s market sliding as consumers have other choices. The FMCG sector is a classic example of fierce loyalty to brands and fleeting from one brand to another in many segments of the personal-care category. The fifth lesson is that a track record determines how fast a company can emerge out of a blowout. Nestle has been in India for many years. It has had no run-ins with regulators till the recent episode. The result is that though the Maggi brand has taken a knock, the company has not suffered irreparable damage. The sixth lesson is that even low beta stocks can turn volatile. Nestle lost more than 9% in a single trading session and shed 11% in the fortnight since the snowballing of the content controversy early June. Yet, the stock is more than 25% away from its 52-week low and is still expensive. The market is optimistic of a bounce-back in earnings after a few quarters as the other brands in the basket are holding on. Despite sticking to the basics, the company did not allow any single food item to dominate, which has proved to be a bulwark against the Maggi backlash. Too much reliance on blockbusters can be counterproductive when they face a downturn is the seventh lesson. Core competency can boost as well as drag down bottom lines. Following the 2008 global financial crisis, the tech sector is expanding into Europe. L&T has forayed into the residential segment of the construction market after the slump in the infrastructure space due to the pre-2014 policy paralysis. To de-risk from its bread-and-butter business of cigarettes, ITC is now into food products and hospitality.

The eighth lesson is that tangible assets help a company to fall back during a storm. From small savings, Sahara has diversified into hotels and real estate, which will help its boss to post bail to get out of jail. Nestle has visible presence. There is no danger of the company vanishing like many others after the bust of the IPO boom late 1990s. The reaction of the capital market watchdog was to delist erring companies. Banning a product from the market or a company from the stock exchange should not be a kneejerk reaction is the ninth lesson. Here, the Securities and Exchange Board of India’s insistence on full disclosures by companies raising capital should be the template. Cigarettes are sold with a warning about health hazards. Similarly, consumables should display the ingredients and their nutritional values. Deviation from the stated composition should be the trigger for crackdown. Automobile companies are known to recall models after discovery of faulty mechanism. The return is the reinforcement of consumer bonding. Nestle, too, has recalled Maggi from the shelves. Where it slipped was in its sluggish response. Though the company kept the communication channels with the stock exchanges open, filing regular updates, it was slow in addressing the concerns of the consumers. The tenth lesson is that MNCs, as a rule, are transparent but are not necessarily sensitive to the sensibilities of the local markets in which they operate.