The fight over cash

As capital-guzzlers swallow profitable group companies, due diligence will be required of the consolidated entity

By Mohan Sule

It is testing time for minority shareholders. The Securities and Exchange Board of India wants companies to have at least 25% public holding to be eligible for listing. The aim is to increase the free float for better price discovery. The fallout was expected to be enhanced transparency and better corporate governance. Yet two recent instances show that promoters act in a way that benefits them rather than the ordinary shareholders. The furor over the Vedanta-Cairn India merger and the complex restructuring of the Aditya Birla conglomerate once again demonstrate that India Inc merely complies with the norms as a formality. A share-swap ratio that did not compensate the shareholders of the thriving companies being amalgamated with the capital-guzzling ventures was not the only sore point. The concern is that the valuations of the resultant entities will be lower than those of the standalone cash-rich firms. To provide a voice to the small shareholders, the regulator had earlier amended rules for passage of proposals requiring approval by a majority of the ordinary shareholders. Domestic and foreign institutional investors together by and large form the largest non-promoter bloc. Many of them prefer to exit on spotting corporate governance issues. Of late, some have preferred to stay and put up a fight. The promoters justify such exercises for their cost-efficiency. Were they to go the market to raise equity, they would have to offer shares at low discounting due to the capital-intensive and long gestation period of their projects. Dilution of equity is another worry for investors fretting over the leveraged balance sheet.

The owners do have valid arguments. A rejig is usually undertaken for synergies of operations, scale and products. Why should they not use the cushion of a profitable enterprise in their fold to sustain and consolidate a struggling enterprise? After all, they did have the foresight to foray into lucrative sectors for growth after others in their stable had stabilized or become sluggish. The drawback is that the ordinary shareholders might not have anticipated such an eventuality. A small investor buys into a standalone company’s capability and potential. The valuations imparted by the market to a provider of software services might not be the same as those to a hardware maker in the same group. The promoter might want to merge the two to offer a one-stop shop for computer services. The underlying aim might be to use the reserves of the one that is thriving to offer support to the other that burns cash. The margins of the businesses might be different, depending on their market position. The marginal shareholder of the profitable company has two options in this scenario: sell or swallow. The lesson for investors in a momentum stock is to be prepared to share the reward or burden of other subsidiaries. This will require scrutiny not only of the company to which exposure is sought but of other group enterprises as well. Not surprisingly, companies belonging to conglomerates in diversified fields do not enjoy the same discounting as those that stick to their competency.    

 

 Here lies the paradox. The market wants companies to use their cash hoard for better return ratios. With the era of industries across the board surging during a bull run and stagnating during a downturn fading, taking advantage of businesses that are performing comparatively better during a lull in some others makes sense for promoters. Critics of K M Birla’s move to make Grasim a holding company perhaps have not noticed ITC is getting a high discounting because of strategic forays into different markets to flank the cigarette business. Many times disclosures about expansion and diversification are met with mixed reactions even if these are to be financed by internal accruals and nominal debt. The market is worried about the huge cash drain from RIL’s balance sheet to finance the expensive telecom experiment. The disruptive tariff plan means break-even will not be anytime soon as the emphasis seems to be on market share rather on the margins. Some analysts, on the other hand, sense the foray as a foil to the controversial gas venture and the refining legacy because of the emergence of alternate energy sources such as wind, solar and shale and volatility in prices of crude. There are instances of new undertakings outpacing the parent: Bajaj FinServ is getting a huge premium over legacy two-wheeler maker Bajaj Auto. Even different entities of a group in similar niche segments are not immune to different perceptions of the market. The charitable view of ICICI Bank hinges on the expected trigger of listing the insurance subsidiary. In view of no clear trend to rely on, investors need to give the benefit of doubt to the promoters of the Vedanta and Aditya Birla groups.

The cost of liquidity

Rural distress and slowdown of the global economy have ended the era of evergreen sectors

By Mohan Sule

Those who thought the passing of the goods and services tax constitutional amendment bill in both houses of parliament will unleash a secular bull wave have been proved wrong just as those who predicted Britain’s exit from the EU will trigger a prolonged bear phase. Both events are complex and their effects will be felt in driblets over the coming years as new issues get highlighted and old concerns fade.  The euphoric forecasts about the positive impact of GST were reminiscent of those witnessed on the eve of the increase in foreign direct investment in insurance companies to 49%. Similar to GST, the issue had attracted opposite opinions and had got stuck in parliament for a fairly long time. What do the commonalities between these two developments reveal? No doubt, investors’ confidence gets a boost on any reform undertaken to make the economy efficient. Foreign portfolio investors, the movers and shakers of the market, however, act anticipating the outcome of the initiative rather than waiting for the cold numbers capturing the impact at the ground-level. Traders build positions in the run-up to the climax. Ordinary investors see the impatience of big-ticket funds as an opportunity to make capital gains quickly. If the reward is expected to be huge, so also is the risk. The failure of the market to perform to script after the referendum on Britain’s exit from the euro zone trapped many short sellers. The behaviour seems typical rather than exceptional. Increasingly, it is becoming difficult to predict the market’s course by applying historical context.

More than traditional parameters such as economic growth, inflation, debt-to-GDP ratio and current account and fiscal deficits, liquidity is determining the trajectory of the market. As long investors are able to borrow cheaply, arbitrage opportunities will overwhelm decisions taken after painstaking scrutiny. As a result, equities in the US and India are discounting forthcoming events much ahead rather than react at the conclusion. The situation might have been different if the central banks in the developed countries were not making available money aplenty. The negative interest rates by the European Central Bank and the Bank of Japan are emboldening investors to take risks in emerging markets rather than at home and, in the process, skewering the global economy. Global liquidity is posing the biggest challenge to economic stability. Investors in developing economies are increasingly becoming reckless, buoyed by the irrational exuberance of their portfolios. Any stock showing some momentum attracts speculators. The run-up is speedier than the company’s capacity to jumpstart growth. The virtuous cycle attracts more inflow. The rich valuations of equities encourage pricey IPOs that might not be able to sustain going forward. Listing gains fuel a primary market boom. Weeding out companies whose capital expenditure plans are based on genuine demand rather than some fancy projections about the underlying strength of the sector will be the second obstacle that investors have to overcome.

The third puzzle is the concentration of investment ideas instead of even distribution of funds across the spectrum. This is surprising as a growing economy should have the power to lift all the sectors. Fall in unemployment should bolster consumption across the board and not only of cement, coal and two-wheelers. If this is not happening, it is not surprising. Not all industries are catering to the domestic market. Many are pure export plays, depending on the well being of their importing customers. Some others have been deliberately shifting their focus overseas to take advantage of the weak rupee or get around stifling domestic regulations and are unable to fully capture the buoyancy in the local market. Moreover, if the fall in raw materials prices is a boon for intermediates producers and end product manufacturers, it is a blow to producers of these commodities. Airlines and automobiles are predicted to soar on cheap crude. Ironically, the fall in oil prices signify tapering economic activity, indicating a slump in demand for the very services that are supposed to benefit from cheaper fuel.  A cheap currency does not necessarily translate into robust earnings for exporters if their destination markets are not healthy. Even usage of consumer disposables, another set of beneficiaries of dip in input costs, is hit by sluggish off-take. The experience of rural distress of the last two years and global slowdown have demonstrated that, unlike in the past, there is not going to be an evergreen sector that will offer an umbrella  during stormy weather. As a result, the investment horizon is becoming shorter and the basket of investible stocks shrinking. The mid- and small-cap space, in particular, is turning into a Ponzi scheme run by speculators.