The year that never was

Fake outrage, rotten governance and volatile markets left investors none the better in 2018

The plight of investors landing with a thud after riding high on indices touching their lifetime peaks neatly captured the frothiness of the year that was. Assets turned into ashes, solid business models seized up and the liquidity tap turned into a trickle. Sought-after retail lenders became outcasts and the virtues of low-cost deposits overshadowed the convenience of short-term borrowings. Near the end of its run, governance missteps, frauds and boorish behavior clouded the sunny optimism at the beginning of 2018. The stench of rotten practices enveloped the private as well the public sector, companies with dispersed shareholding and family-control. Cooking the books was not restricted to the promoters. Professional managers turned Ponzi operators. If the accomplishments of historical and mythical figures were sought to be equated with the height of their statues, the stature of the guardians of constitutional institutions, social icons and swashbuckling pioneers shrank as they tried to protect their fiefdoms in the wake of demands to share their cash-chest, snuff out misuse and adopt high standards of conduct. Auditors and independent directors shed their reticence and opted to depart than face the increasingly active shareholders. The eyeball-to-eyeball face-off between nations was not over geographical influence but to pacify the home base. The weapon in use was tariffs instead of bombs. Monetary authorities became the favorite target to take pot-shots as they grappled with the existential dilemma of being dampeners or drivers of growth.         

End of the year resembled end 2017, with Whatsapp continuing to remain the medium of message. If circulation of leaked financial results raised a storm then, the platform was preferred to air insinuations of dodgy dealings in boardrooms. Along with suspect news, fake outrage dominated the discourse. Frequent disclosures of breach of personal data mysteriously vanished from the public domain no sooner did the apex court restrict the usage of the unique identity number to subsidies and tax returns. The irony surely was not lost that these rebels searching for a cause did not balk from using social networks that tracked the user’s habit relentlessly to enlist warriors to their column. Amid the dire warnings of a contagion in the financial services sector crippling the economy, a housing financier merrily raised more than Rs 1700 crore. The distinction between dissent and deception blurred. Raids stemming from economic offences such as using shell companies and manipulating penny stocks to launder money were painted with ominous undertones of assault on freedom of expression. Easing of farmers’ distress due to output glut was linked to blanket waiver of loans without addressing the root cause: shift in India’s economic activity to manufacturing and services from agriculture. A suggested revision to compute GDP growth was welcomed as long it suited the narrative of higher historical expansion but was accused of being contaminated with bias when the method incorporating internationally accepted standards pulled down the past trajectory.     

 

There were plenty of reasons for investors to come out of the year that was dazed and puzzled. Their wealth as measured by the broad market had hardly moved. It was as if crude oil had never crossed US$80 a barrel, the rupee had not plunged to 74 a dollar and bond yields had not pierced 8%.  The Federal Reserve had not caused havoc by being hawkish and dovish. There never ever was disruption due to a new indirect tax. Neither was the country without a full-fledged finance minister for more than a month and central bank governor for a day. Yet, there were some reminders of the tumultuous times. A jeweler fled after depleting a bank’s treasury by Rs 11400 crore. A showcase of public-private partnership came down crashing under the weight of Rs 91000-crore debt. The mere five percentage point difference in tax on equity holdings for less than and more than a year turned the premise of investing for the long term upside down. Four new-age banks were set for a New Year with fresh hands on the top deck. Imminent share offerings from another four presented a striking picture in contrast: the eagerness of nationalized lenders to make provisions to clean up the balance sheet as against the private bankers masking bad assets and staying in the game without following the rules on ownership. While a state-owned airline’s disposal was grounded before takeoff, the frenetic search for a capable pilot to steer a private flyer looked likely to descend into a bumpy landing. The fastest-growing economy’s silhouette lighted up as last-mile power connectivity turned into a reality, cost of data went off the cliff and inclusive healthcare coverage became the world’s envy.

-Mohan Sule

Winds of change

As stakeholders put pressure to reform or lose their companies, promoters are shedding their reluctance to let go control

A tsunami is battering the boardrooms of Indian companies. Ends can no longer justify the means.  Regulators are cracking down hard. Big and small companies are facing the ire of scorned investors. The central bank has denied extension to the bosses of two private banks for hiding bad assets. Another was forced to go on leave for favoring a borrower. One new-age banker’s method of reducing his holding got a stern rebuke and two small finance banks were reprimanded for not sticking to the timeline for dilution of stake. Lenders told a jeweler to service the debt instead of using the reserves to buy back shares.  Auditors of a food processor and an IT services retailer quit mid way through the finalization of the annual results, citing inadequate disclosures. A large-cap chemicals producer was dumped due to the inability of the promoters to explain the restructuring within the group. Costly acquisitions by a leading tech solutions exporter eventually saw the departure of the first CEO who was not the promoter. The legendary money manager of a home mortgage provider escaped narrowly from getting ejected by foreign investors for being on the boards of too many companies. The reappointment of the managing director of a tyre maker on a salary that was nearly 7% of the net profit that had declined by a third over the year was nipped by angry shareholders. A former chief of the market monitor had to quit shortly after his appointment as a director to rescue a cash-strapped financier and developer of infrastructure after pressure from institutional investors for his association with a bankrupt airline. The top brass of India’s leading trading platform was bundled out after a whistle blower complained of servers on the premises of some brokers allowing them to jump the queue.  A former bureaucrat charged with conspiracy in facilitating a shady telecom deal had to make a hasty departure from his top post at a private bank on the insistence of stock exchanges.

   

The war on bloated, sluggish and extravagant bosses is just one side of the story. The other important part is the shedding of reluctance by the owners to be the sole occupants in the cockpit. Technological disruption, leverage, change in market tastes and competition from deep-pocket players are shaping the decision. The Tatas and a German steel maker are now equal partners in their European venture and KM Birla, too, has joint custody with a UK group of the Indian cellular business. The Tantis manage Suzlon Energy with Sun Pharmaceutical Industries’ Dilip Sanghvi. The offer of the Essel group, in possession of nearly 40% of the total promoter holding, to offload half of the shares in Zee Entertainment Enterprises to a foreign investor is the latest wave of change that is shaking up family-run enterprises in India. After the upheaval in the media space as it transited from print to digital and cable to satellite, streaming services are posing a new delivery challenge. At home, Mukesh Ambani has created an insatiable beast for engaging fare and last-mile connectivity. It took a couple of months of tough negotiations for Zee to get back on to Jio’s menu. In the meanwhile, RIL snapped up two listed multi-system operators, putting pressure on the group’s direct-to-home broadcaster Dish TV and cable distributor Siti Networks, whose consolidated June 2018 quarter net loss widened 31% over a year ago.

Enlarging capital hurts return ratios. Leave aside hefty valuations, the market response to even modestly price offering from a struggling enterprise is uncertain. The Subhash Chandra group’s likely gradual withdrawal from the general entertainment segment follows Old Economy media mogul Rupert Murdoch’s divestment of his film and TV portfolio in a US$ 70-billion cash-and-stock deal to another conglomerate, Disney, while retaining the bouquet of news channels just as Zee Media Network will remain  within the fold. Fears of the National Company Law Board auctioning assets to recover bank dues have led to the scramble to sacrifice capital-guzzlers and peripheral revenue-earners. BK Birla of Century Textiles and Industries transferred the non-core business of cement to pare debt and embark on capital expenditure. Usha Martin sold its steel division to the Tatas to lighten the balance sheet and focus on the wire rope business. DLF put up 40% equity of its rental arm on the block to flank the real estate flagship. Naresh Goyal ceding major or complete control of ailing Jet Airways to the Tatas or to strategic investor Etihad Airways will be a logical move in the post Insolvency and Bankruptcy Code era. The honorable option for promoters is to live another day rather than be labelled as defaulters and get shut out of the capital markets. 

-Mohan Sule

Stranger things

NBFCs are out and corporate lenders in, world is no longer flat and central banks causing turmoil rather than stability

A decade after the global economy suffered withdrawal pangs, the Indian financial markets are experiencing a relapse. It took a series of defaults beginning July by infrastructure financier and developer IL&FS to put the spotlight on the practice of non-banking financial services providers raising short-term funds to lend over a longer period to buyers of automobiles, consumer goods and homes. The US Federal Reserve began buying bonds within a month after credit dried up following the collapse of Lehman Brothers in September 2008. In contrast, the Reserve Bank of India is fretting if the finance ministry’s pressure to part with a portion of its bulging reserves is yet another blow to its autonomy. The earlier flare-ups were over creating a separate regulator for payments bank, initiating bankruptcy proceedings against defaulting power producers and allowing banks under preventive corrective action to resume normal operations to meet the needs of a growing economy. While the issue of taking away supervisory power over digital couriers of funds remains in abeyance, the Supreme Court permitting pass-through of fuel costs to distribution companies has extinguished the other irritant for the time being. The standoff between the monetary authority and elected policy makers is not new.  Former finance minister P Chidambaram was vocal about his frustration with the RBI’s reluctance to embrace a softer regime. US President Donald Trump has berated the Federal Reserve for making access to funds dearer. Foreign investors fled Turkey when its president warned the central bank against raising interest rates. What the controversy has done is to expose the lack of accountability of those regulating the banking system. Most follow rigid textbook prescription of tightening the flow of money to stick to the mandate of targeting inflation. To deal with the excesses of easy money, the Fed adopted a contrarian strategy. It took six years of expansion of the balance sheet from US$ 900 billion to US$ 4.5 trillion and seven years of near-zero interest rates to revive the US economy.

If the RBI’s resistance to respond to the market’s need for liquidity is strange, NBFCs going out fashion is even stranger. Till recently the flavor of the market due to the boom in rural consumption, concerns over their asset-liability mismatch triggered by the IL&FS episode is producing a tilt towards big-ticket lenders. Government spending on infrastructure is filling the order books of construction services providers and capital goods makers. Housing-for-all and a normal monsoon over most parts of the country have pushed up demand for items of mass consumption. Many producers are undertaking modernization and capacity enhancement. What has also spurred lending to companies is the resolution process for bad assets. Borrowers can no longer keep on refinancing their debt. To become eligible to take over Essar Steel, Arcelor Mittal had to clear SBI’s dues owed by Uttam Galva Steels, a company it had co-promoted before being sold to the other promoters for Re1. Pay or perish is the new slogan that is helping to clean up the balance sheets of banks. Even the original owners of insolvent entities are now ready to service their entire leverage. Instead of reacting with horror to the stepped up provisioning for bad loans, the exercise is now greeted enthusiastically as a fresh beginning.

Stranger than the changing contours in the lending space is the reshaping of the world. It is no longer flat and has turned nations into islands that suffer the adverse effects of someone else’s prosperity. Largely due to trade wars and surging crude oil prices, the impact of a strong dollar is not booming exports but weak domestic currencies.  If the IMF’s belt-tightening prescription for indigestion from reckless consumption caused social unrest, the outcome of central banks intervening to cap imported inflation is not likely to be much different. The puzzle is if supply not keeping pace with demand, that is triggered by easy availability of credit, is the cause of rise in prices, how is increasing the cost of money going to achieve the aim of matching output with usage. The recent correction in US equities captures the paradox perfectly. The preoccupation of investors seems to be with how low unemployment is consolidating the resolve of Fed to continue with hiking the policy rate rather than drawing up strategies to capture the opportunity presented by the buoyancy in jobs. Building up capacity to gain a bigger market share comes at a price. Dilution of equity even at exorbitant valuations calls for servicing obligation. Too much debt spoils the gearing ratio. Strangely, companies that have undertaken expensive expansion during a bullish phase spend the downturn in disposing of the assets at bargain prices to pay the creditors from whom they had acquired financing at a higher cost.     

-Mohan Sule

 

The home run

The growing presence of mutual funds in the trading ring is making equities vulnerable to domestic turmoil

The increasing influence of mutual funds on stock movements is a welcome counter to the dominance of foreign investors. At the same time, it has given rise to a peculiar set of problems for Indian equities. Domestic funds have to reckon with around Rs 10000 crore of inflows every month. There is urgency for quick results as the difference in the tax rates on long and short-term gains is now just 5 percentage points. The regulatory cap on exposure to stocks implies constant search for new investment themes. The beneficiaries have included companies low on performance but with plenty of hints of great potential. Discoveries have a cascading effect as other investors copy the cues. It took the Securities and Exchange Board of India to dismantle the Ponzi scheme. Increased surveillance and regrouping of stocks as per their market cap rankings triggered a shake-up of portfolios. More than 1,500 small caps lost over half their value and over 100 mid caps between 20% and 50% from their 52-week highs by late October. The bounce-back of these stocks will depend on several factors. Bumper festive-season buying on the back of normal monsoon and fading of the GST roll-out pain will be the short-term signal. The satisfactory completion of the election cycle by end May 2019 will be the medium-term trigger. The second effect of the vote of confidence in mutual funds to create wealth is the lack of panic among retail investors to economic headwinds. A weak rupee is trapping an import-intensive India into a high interest-rate regime. The climbing up of fuel prices has hurt consumption but not the savings habit. The consumer price index has remained nearly flat in the three months to September 2018 though Brent prices rose over 17% to US$ 82.72 a barrel in the two-and-a-half months to end September 2018. The gross savings to GDP ratio has remained constant at around 29% in the last two years to the June 2018 quarter. The surge in SIPs shows no sign of slowing: they grew 52% in September 2018 from a year ago and 13% from April 2018.  The IL&FS crisis has been shrugged off after the government takeover. The smooth transition of Satyam and UTI to normalcy has put to rest for now fears of a blowout.

The third worry is the inability of mutual funds to sway large caps. Most of their expensive discounting stems from the inclusion in various widely-tracked indices, making them indispensable to foreign institutional investors. The pace of their appreciation or decline depends on the volumes of dollars chasing or exiting from them due to issues that affect liquidity rather than any company-related event. After languishing for the first six months of 2018, when mid and small caps were hitting new peaks, the headline indices raced to hit their lifetime highs in August after overseas portfolio managers turned net buyers. The fourth outcome is the comeback of local news in shaping the market. NBFCs were dumped on concerns of asset-liability mismatch despite healthy operational performance of all the front-line players. Their net profit improved 31% and the return on assets 0.3 percentage points to 1.9% in FY 2018. The chatter of how these lenders had occupied the retail loans space untended by PSU banks went silent. In a diametrically opposite strategy, big investors have voted for private banks despite corporate governance issues at most of them.  The Reserve Bank of India has denied extension to bosses of two private banks for hiding bad assets and pulled up two for not diluting their stake.

The fifth fallout of mutual funds being bestowed with the responsibility of outperforming the market all the time is the increasing trend of turning over portfolios to squeeze out maximum value by ejecting slowing stocks and spotting growth opportunities. The 24x7 news cycle that is constantly spewing information has only accelerated the trend. On an average, equity schemes churned 94% of their stocks in September 2018, up from 76% in January 2018. The frequent shuffling of the pack means higher trading charges and diminishing returns. If the growing demand resulted in heightened scrutiny of mid and small caps, the spurt in interest is triggering a close examination of the way mutual funds operate. The crackdown on floating of similar schemes will result in rapid rotation of stock allocation and volatility. Sponsors of asset management companies will be left with little choice but to shift focus to high-frequency portfolio management schemes, whose fees are linked to performance, or encourage passive investing. After equal preference, with Rs 8000-crore subscriptions each in June 2018, it will be interesting if the marked tilt towards active funds in September 2018, after the benchmarks touched their lifetime highs end August 2018, persists after the market's plunge since then.

-Mohan Sule

Passing the buck

The fall of IL&FS is a story of enlisting the private sector to facilitate ease of living without ensuring ease of paying the bill

The mimicking of the Satyam Computer Services model to take over IL&FS is intended to assure the market that the crisis will be contained swiftly. The tech services exporter was sold within four months after the Union government bundled out the discredited board. A finance ministry official has put the bailout timeline for the cash-strapped financier and developer of infrastructure at six to nine months. The improbable feat seems to have succeeded for now. Save for one mutual fund, there was no mass-scale dumping of debt, belying fears of a contagion. Though similarities are sought to be drawn, the two cases are different. The promoter-driven software solutions provider’s problem was not with liquidity but its deployment. The fallout of the collapse was restricted to its stakeholders as was in the case of a non-performing airline and some steel makers. Accountability could be fixed. In contrast, no single institution controlled the resources-hungry showcase of public-private partnership that absolved the government from raising funds for execution and maintenance of bare-bones projects. Lenders include financial institutions, banks, NBFCs and mutual funds. Operations span across geography and involve numerous participants. Despite maintaining an arm’s length, the government is an indirect shareholder. Satyam dressed up earnings to retain a slot among the top three players in the sector. IL&FS’s illiquidity stemmed from pending receivables, resulting in defaults. While the desperation to scale up contributed to Satyam’s demise, the obstacles for IL&FS were not bagging orders but implementation and payment delays.  Handpicked directors being ignored by a founder cooking the books is understandable. What is not is the passive role of two foreign big-ticket investors, a poster-boy for transparency and state-owned entities even as professional managers without skin in the game recklessly piled up short-term debt. The ejected nominees represented government-controlled entities as well as the private sector. The plumbers replacing them are drawn from bureaucracy and deal makers.  

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 If the chief of a mortgage pioneer was penciled to find another home for Satyam, a new-age banker has been entrusted to staunch the bleeding of the IL&FS group, excise the infections and wrap it up in an attractive package. Despite a record of wealth-creation, it will not be out of place to wonder how much time an owner, who is in the midst of reducing his stake by the December 2018 deadline to comply with regulations, can devote to his flagship from an honorific job. Not only that, the issue is of enlisting someone who has been pulled up by the monetary watchdog, for trying to bypass the dilution of his holding by issuing preference shares, to rescue a sinking ship whose corporate governance practices are responsible for the mess it is in. Instead of one enterprise, he will have to reckon with over 300 listed and unlisted subsidiaries, associates and joint ventures with a web of cross-holdings. A company doing generic back-office work is bought for its client roster to expand market share. In contrast, the challenge for the new buyers of assets, floated mostly by special purpose vehicles, is to make them revenue-accretive. Rather than trying to plug the leakage, what is required is disentangling and slicing and dicing of the IL&FS group so that it can be disposed of piecemeal.

More than survival, the preoccupation of the fire-fighters will be to open lines of credit to extinguish the likely redemption pressure. The issue in Satyam was not of de-leverage but of restoring confidence. The Rs 91000-crore liability of IL&FS is a collateral damage of a hybrid monster, created by the government to snag private capital for local body projects, gone out of control. In turn, the policy makers could conveniently shrug off the responsibility to boost tax revenues to support the demand for world-class facilities and, at the same time, not muster courage to make users pay for them. Retail finance companies get assured monthly returns on their assets. Apart from collection of toll over a fixed tenure, other essential but capital-intensive projects such as water treatment do not generate annuity. The one-time payout hinges on release of funds from the sponsor, often municipalities and Central and state undertakings hobbled by the need to provide subsidies and free services. Now that the experiment has backfired, the government has two options. It can take the exposure on its book by subscribing to the NBFC’s bonds. The alternative it to disallow the beneficiaries of the services a free run. Not all the woes of IL&FS are of its making. Its misfortune is being present in a sector that promises ease of living but does not assure ease of paying the bill.       

-Mohan Sule

Against conventions

Investments tracking economic expansion and mimicking institutional investors have to reckon with higher costs

It takes a crisis for investors to realize the uselessness of conventional theories. A track record of expanding revenues and profit, a sound dividend policy, transparency in operations, prompt disclosures, shunning discrimination against the small shareholders, standing out in comparison with peers, good liquidity and presence of institutional investors are high on the checklist. It is rare to find a stock that has all these qualities. Gain in market share is often at the expense of the margins. A low base can push up profit in a year but becomes difficult to sustain going ahead unless debt is taken to grow organically or through acquisition. Cash accumulation creates unease about the longevity of the niche position in the event of technological disruption going ahead. Instead of imparting a sense of security, deployment of cash becomes a concern. Promoter control offers solace about continuity as well as discomfort over sudden change of direction. If foreign and local fund holdings are tracked to validate the correctness of the investment decision, their contradictory behavior during the recent market turmoil has caused confusion rather than resolve the issue of using these big-ticket investors as the guiding pole. Overseas portfolio investors have exited while mutual funds stayed put in stocks. The question is whose actions should be considered a reliable indicator of the outlook for a company.  Investors mimicking the footsteps of institutional investors have to prepare to churn their portfolios along with these leaders. Trading expenses and taxes can eat into the gains.

History is rife with the futility of policy makers trying to shape the movement of liquidity to maintain the growth momentum and at the same time exercise fiscal rectitude. During the Great Depression of the 1930s, the US limited credit and cut down expenditure. It took a decade for the global economy to recover from the risk-aversion. The controls imposed on the surging fund inflows into the Asian Tigers to tame prices of assets triggered the first currency crisis in 1998 after the formation of the WTO to facilitate seamless trade. In contrast, the dot-com boom and bust at the turn of the century resulted in loose monetary policy by the Federal Reserve, clearing the way for the global financial meltdown in 2008. Ironically, the seeds of the present turmoil in the foreign exchange market can be traced to the US central bank embarking on an opposite path of money-tightening. The more the Fed raises rates, the more is the intensity of the flight of funds back to the US, weakening the emerging economies and disheartening those betting on a strong US economy boosting exports and inward investment. The effort of India to discourage imports of non-essential items by raising tariffs is a classic throwback to a bygone era but has the capacity to make indigenous manufacturers attractive. The contrasting step of easing foreign investors’ access to corporate debt is an out-of-the-box move to meet the resources need of a growing economy and at the same time check the fall of the rupee. What it means is that henceforth the problem-solving playbook will be a mixture of traditional and innovative solutions, throwing into disarray the usual preference for companies with FDI over external debt. 

A sprinting economy is known to light the fire of inflation as supply lags demand. Those taking positions to capitalize on the consumption story have to keep in mind the heavy-handedness of the central bank. The obsession of the Reserve Bank of India with heating prices was taken to a new level by former governor Raghuram Rajan. He kept the lending rate at 8% throughout 2014 even though the new peg to benchmark the policy rates, consumer inflation, composed mainly of food items, halved from 8.1% in the year. The Wholesale Price Index, with predominance of the core and manufacturing sectors, was negative in 2015. The repo rate was 7.5%, when the headline CPI was 5.3%, in March 2015. By the time he left a year later, the headline WPI was 1% and CPI 5.2%. Yet, the base rate remained at 6.25%. In the process, growth slumped from 8.8% in the September 2014 quarter to 7.6% two years later. The downside of tracking the GDP to get ready to invest is confronting stocks preparing to sprint being weighed down by higher operating costs. Recent events have also demolished the strategies of buying at dips and picking stocks with tailwinds. Cheap forward valuations have proved illusionary as promising stocks crash-landed not because of sudden transformation in the marketplace but on unexpected corporate governance issues. Attractive trailing discounting becomes deceptive when the company’s problem is not cyclical but arises from misjudging the market.     

Mohan Sule

Trigger-happy

Interest rates, movement of oil and rupee, corporate results, divestment and state polls will influence equities

 After furiously accumulating 6,300 points in the five months to end August 2018 as against 16 months taken to travel the same distance earlier, the equity benchmark seems to be losing stamina. It shed more than 4% in over a fortnight since reaching its life-time high. The US-China impasse on trade tariffs continues. Following Turkey, Venezuela became the second emerging economy to see flight of foreign capital. The fear is of the contagion spreading to more countries. Oil prices rebounded to US$ 79 a barrel and the rupee slipped below 72 a dollar.  Bond yields have crossed 8%, indicating the central bank might have to increase interest rates for the third time after four years in its October policy meet. After the euphoria, there is a sobering realization that the 8.2% expansion in the GDP in the June 2018 quarter over a year ago might not sustain as the spurt was on a low base of 5.7% increase in the June 2017 quarter. Floods in Kerala in August, too, are likely to dent the GDP numbers of Q2 of the fiscal year ending March 2019.  What is striking, though, is the side-way movements of the market. After declining for a number of consecutive trading days, equities bounce back over the next few days, fully or partially erasing the previous losses. There are alternate bouts of selling and buying by both foreign and institutional investors. Those who prefer to sit out during the surge enter on dips. The message from the market is clear: though expensive relative to their trailing earnings, the future of Indian companies is bright. To move up to the next level, there is need for fresh triggers.   

 

 A significant cooling of crude might come after the IPO of oil producer Saudi Aramco, slated anywhere between this year and 2020, is out of the way. Saudi Arabia is pushing for a price beyond US$80 a barrel to get a good discounting for the offering in spite of the Organization of Petroleum Exporting Countries meeting the objective of draining out excess inventories after agreeing to cut output end 2016 for a year and then extending it to end 2018. A barrel had crossed US$ 140 in July 2008. A few months later many US banks collapsed. After falling in reaction to the credit crunch, crude recovered to US$ 100 in 2011 as pump-priming by the US monetary authority opened up the credit pipeline. As many smaller European countries struggled with debt default, prices started slipping in 2013 and plunged by half a year later. Hopefully, the Gulf nations would not want such a situation to repeat as the current level of cutback in output is sufficient to put their economies back on track. Alternatively, a government-induced slowdown in the world’s second-largest economy, China, can soften commodity prices and lift import-intensive economies such as India. Easing of the current account deficit will follow. The second trigger will come from the Federal Reserve if it stays put for the rest of the year, citing contradictory signals from the US economy. Consumer confidence is high but uncertainty arising from tit-for-tat trade barriers has muddied the outlook for American exports. Compensating exporters with subsidies will expand the widening fiscal deficit and derail the booming domestic economy.       

 

Stability in US interest rates will give the Reserve Bank of India flexibility to pause from its money-tightening exercise. Soft consumer prices have enabled it to let the rupee beyond 70 so as to remain competitive. Despite dipping into the reserves, there seems to be no urgency to prop it up to above 65 prevailing at the beginning of the fiscal year. The existing disparity between the interest rates in India and US is quite attractive for dollar inflow into the local capital markets. The Make-in-India campaign is an acknowledgement of the limits of relying on exports to shore up foreign exchange. Instead of higher external borrowing limit for Indian companies, opening up aviation, insurance and multi-brand retail to controlling foreign ownership will prove a powerful magnet for overseas funds. In the short term, the Q2 and Q3 performance will reveal if the resilience of Corporate India in overcoming the disruption of demonetization and implementation of GST extends to circumventing the effects of expensive inputs. Release of more dearness allowance to Central government employees and enhancing the overdraft facility to Rs 10000 for Jan Dhan account-holders should spur urban-shopping just as a normal monsoon and higher farm support prices have provoked rural-buying. Many companies’ volume-push due to reduction in GST is slated to translate into higher margins on pass-through of costs after the cooling period and improved capacity utilization. In between, the beginning of bidding for bankrupt power assets and divestment in PSU cash-guzzlers will boost investor confidence. Later, results of elections to five states will provide clues on the mood of the market.

-Mohan Sule

Strange things

Rupee weakening despite return of foreign investors, growth without discipline and promoters unwilling to let go

The snap decision of electric vehicle pioneer Elon Musk to take Telsa private and then reverse it after a few days is not the only strange thing that has happened of late. The comeback of foreign portfolio investors since July after being net sellers in four of the first six months of the current calendar year to lift the local equity market to lifetime highs is equally jolting. The BSE benchmark took half the time to amass over 2,800 points that it had accumulated in the three months to end June, gaining 27% in the next two months. Their return was despite trade tensions running high and Brent crude quoting above US$77 a barrel, triggering fears of inflation spiraling and current account deficit widening. The Federal Reserve was sending hawkish clues. The Reserve Bank of India and the Bank of England were yet to meet. The hike in their policy rates coincided with the US central bank pausing from its ramp-up cycle beginning August after raising them for seven times in three years from end 2015. The tariff agreement between US and European Union was still to be reached and signs of thaw between the world’s two largest economies to agree to talk were not visible. The buying by overseas investors continued even as there was a flight of capital from fragile Turkey after the US slapped import duty on steel exports. Not that the Indian market was cheap, with the Sensex quoting at a P/E of around 22 end June. Mid and small caps were tumbling on tighter surveillance by the market regulator. The resumption of foreign fund inflow did not offer any support to the rupee. The Indian currency continued to weaken, breaching the 71 mark, along as with those of emerging markets in reaction to the 17% plunge of the Turkish lira in a day mid August.  

More than being satisfied that India is capable of expanding in double digits, as shown by the revised GDP numbers of the UPA years, the question that investors want to ask is why 2006-07 was an exception, with growth plummeting to 6% over the next five years. Adding to the confusion if the figure of over 10% increase in output in the third year of the then regime should be taken at face value is the admission of the official compilers that there was no reliable data. Assumptions have been made. The trajectory was accompanied by 6% average CPI inflation in 2006 from 4.5% in 2005. The combined Center-states fiscal deficit had deteriorated to 23% of GDP from 15% in 2003-04, when the UPA government took office. The spending spree included 43% higher allocation to eight flagship programs over 2005-06. The target for farm credit was enhanced 15%. Importantly, cheap money from the US and Japan was sloshing around. The accelerating net external flows into India’s capital markets nearly tripled to US$20 billion in 2007-08 from the previous year. The inability to sustain the momentum thereafter is a testimony to the transitory nature in the absence of structural reforms. The asset bubbles burst in the second half of 2008. FIIs pulled out US$ 15 billion in 2008-09. In contrast, the first two years of the NDA government were marked by drought. Disruptions due to recall of high-value notes and the roll-out of the goods and services tax followed.

If the exhilarating thought of what India could have been is enough to depress investors so have certain corporate actions. Though the long-serving former boss of HDFC escaped from being ejected from the board by a whisker, the direction by foreign proxy advisors to vote for his ouster should result in introspection. No doubt even international intermediaries participating directly or indirectly in the domestic capital markets should follow standard operating procedures. Yet the firepower against them appears an attempt to divert attention from the crucial issue if the shareholders’ representatives are performing as per expectation. The scarcity of wise men to offer guidance is not a secret. What is not widely known is the number of boards they grace, raising concern of their capacity to pay full attention to the companies they are counselling. Fixed-term tenures and a gap before re-induction are ideas worth exploring. Two of the long-serving directors took the hint and quit. Hopefully, Deepak Parekh, too, will so as not to tarnish his legacy of being a role model for transparency by making way for professionals to run the mortgage lender. That owners are reluctant to let go off is not something new. What dismays is how those who preach corporate governance fall short. It took the Reserve Bank of India to nip Uday Kotak’s bypassing the spirit of reducing his stake in the private sector bank he founded by issuing preference shares instead of ordinary shares. When it comes to Indian promoters, time and again it has been demonstrated that it is selfishness rather than the interest of the small investors that guides their actions.           

-Mohan Sule

Spoilt for choice

On offer are small caps with governance issues, mid caps taking debt to grow and large caps prone to missteps in using cash  

Investors are in an enviable position. There is an array of old economy sectors to explore: The dependable FMCG companies, private banks, NBFCs, automobile assemblers and pharmaceuticals producers. The fading of the disruption due to the recall of high-value notes and roll-out of the goods and services tax and the turning of the commodity cycle riding on the recovery of global economy have put into play oil and gas explorers, refiners, metal miners, capital goods and cement manufacturers, construction companies and providers of housing-related products. PSU banks are getting capital infusion and being empowered to drag defaulters to insolvency. The basket of emerging industries, too, is expanding, with the addition of small lenders, asset management companies and life and non-life insurers. Large-cap laggards are waiting to be picked. Mid and small caps beckon after many shed 30% and more flab. The market regulator has turned hawkish in monitoring stock movements. Policy makers are pump-priming the economy by a series of steps to provoke consumption, particularly in rural areas. GST has widened the tax base as the beauty of input tax credits motivates every tax payer to ensure that his supplier is compliant with the new regime. The arbitrage of price advantage to gain market share is disappearing.    

At the same time, investors today are a pitiable lot. Only about one-third of the more than 3,000- listed stocks trade regularly. Small caps celebrated for spotting niches are also susceptible to headwinds of macro-economic trend reversals, revision of policies and changes in market tastes. The other side of a booming economy that lifts airlines is surging prices of inputs.  The tight grip of the promoters that gives flexibility to change directions without much outside interference can be misused. An e-governance facilitator is now being probed for buying shares of a jeweller. Disclosures can be sketchy. A promising packer of fruit pulp went into a free fall on allegations of divergence of its plan on paper and on ground.  Corporate actions such as bonus shares and stock-splits can be deceptive as there is no outflow of cash. More information is available about mid caps. Their outlook is enticing but can become outdated quickly. An air-conditioner maker unexpectedly skidded in the June 2018 quarter after a `bad summer’. If the upside is survival bias in once-emerging sectors, the downside is sluggish growth. Presence of domestic and foreign institutional investors does offer comfort about their numbers and practices. The concern is the constant need for capital to achieve scale. A builder of airports, a sunrise opportunity, has a debt-to-equity ratio of 46. Ironically, the revenue visibility coincides with the economy heating up and the cost of raw material and money beginning to rise.

Large caps have the strength to withstand economic instability. Yet they are not immune to company-specific issues. Overseas buy of a domestic steel giant that seemed like a masterstroke turned a cash guzzler after the global meltdown. The boards of those that have dispersed ownership are prone to dither over resolving issues that can affect stock prices. In contrast are promoters who do not want to let go and make a mockery of price discovery. The price-to-earnings of a discount retailer with just 20% float is above 100. Opaque acquisitions, bumper compensation packages and accusations of conflict of interest have tarred brands in the private banking and technology services spaces. Usage of reserves becomes a lightning rod. Buybacks to shore up prices result in limiting liquidity and loss of interest among institutional investors. Unrelated diversifications are typical gestures to flank the core activity. The market is unsure if the primary business of tobacco should get more weight or the unevenly performing portfolio of hotels, foods and paper. A petrochemicals conglomerate has been re-rated not because of the cash that its refinery is producing but because of the promise of capital gains from telecom services. A personal-care MNC dependent on rural income is darting from indigenous solutions to frozen desserts to stay attractive. An infrastructure player’s subsidiaries providing financial services and software solutions are getting more interest. The shareholders of a quality private bank are figuring out the next move of the smart founder to dilute stake without causing destruction of wealth: offload shares, enhance the capital or undertake an expensive merger. Those who bought into a legacy LCV and M&HCV owner’s bet on top-of- the-line luxury passenger vehicles to capture China’s growth story are stumped as the local market is showing more potential. When it comes to side-stepping risks, investors do not seem to be spoilt for choice.        

-Mohan Sule

Liquidity injection

Capital infusion into PSU banks, hike in MSP for kharif crops and cut in GST rates lift large caps

A striking feature of the recent rally in large caps that took the benchmarks to lifetime highs is the role of domestic institutional investors. Foreign portfolio investors are reducing their exposure to equities since August 2017. More stocks were liquidated by them than bought in the first six months of the current calendar year after being net buyers in the previous three years. In contrast, mutual funds’ net equity investment was up 30% between January and June over the same period a year ago. As the US and China respond with tit-for-tat import duties, countries are going to look inward. The trend of subsidizing home producers even as import barriers are being pulled up is pushing out overseas investors, who will prefer to operate within their boundaries rather than risk taking money outside. Countries will be left no choice but to manipulate their currencies to achieve growth. How they do so will depend on their orientation. China intends to loosen money supply to depreciate the yuan to make exports attractive even in the face of higher duties. India wants to prop up the rupee to slow down the flight of capital to pay the import bill. The US Federal Reserve has taken a pause from hiking interest rates. A strong dollar will push American exports out of competition.

Mutual funds do not seem unduly perturbed by the macro-economic headwinds. Equity scheme folios have increased 30% and those of exchange traded funds ex-gold 60% over the June 2017 quarter.  Cash has to be deployed. Many large caps had yet to participate in the rally and looked moderately priced compared with their smaller peers. The first wave of June 2018 quarter results underlined their capabilities and outlook. The reorganization of market-cap groupings, as per the Securities and Exchange Board of India mandate, has resulted in the downsizing of several stocks. Schemes whose selection is based on the criterion of market value had to shuffle their portfolios. With the shrinking of availability, the search has intensified for value buys by large-cap funds that had become lighter after many of their picks became mid caps. Big-sized companies are ready to run after spending most of the last year ensuring that their distributors and suppliers become GST-compliant to claim input tax credit. The capital market regulator’s increased surveillance has put off investors from small caps. A portion of the profit booked by exiting from these counters is making its way into large caps. A massive fiscal stimulus has been pumped into the economy. The minimum procurement price of crops that will be sown in April-September will be 50% more than the cost of production. Karnataka is the latest state to waive farm loans, writing off Rs 34000 crore. The depletion of the treasury of states can be expected to be made good by the buoyancy in tax revenues as the rural economy embarks on a spending spree.

With the worry about recovery vanishing, banks will have to make lower provisions and will have more funds to lend. Alongside, the clean-up of books by tightening the bad loan recognition norm, shepherding defaulters to the insolvency process, initiating corrective action against worst-case-scenario banks and infusion of capital by the Union government are shaping up PSU lenders to meet the increased demand for credit. Creating a favorable atmosphere for consumption is the latest round of reduction in the indirect tax rates. In a year since implementation, cement, air-conditioners and large screen televisions are the only mass-based items in the highest slab of 28%. Trends suggest the economy has not only recovered but is picking up momentum, too. The services sector recorded a 21-month high growth in July. The thrust on infrastructure and housing segments has spurred demand for steel (output up nearly 3% end June 2018 over a year ago) and cement (12% increase). Monthly electricity generation is the highest ever. Sales of passenger cars rose 8% to an all-time high of 3.3 million and two-wheelers 16% to cross 20 million. The good response to recent IPOs suggest availability of funds for investing. The tailwinds of the festive season are around the corner. The US-EU accord on tariffs has bolstered hopes of cooling down of the trade-war rhetoric. Oil prices look unlikely to climb up any further, having lost over 5% in July. The downside to the upbeat mood are corporate governance issues that might crop up, surging valuations of large caps and intensification of the panic selling of mid and small caps by retail investors, hurt by the recent brutal correction.

-Mohan Sule

A hug and a wink

The market finally embraces large caps with a nod to efficiency, leadership and transparency  

Large-cap indices are touching lifetime highs even as mid- and small-cap indices have slipped more than 20% from their peaks. The pace of gains of the benchmarks has been slow as against the rapid climb of their peers in other categories. Only a few components in the S&P BSE Sensex and the NSE Nifty 50 are driving the rally in contrast to the all-round surge in the discounting of the constituents of the tier 2 and 3 indices. Beyond the obvious, the stock movements are sending subtle signals about the state of the market. Those that have taken debt to grow, are in sectors that are subject to cycles, are facing increased competitive pressure and are confronted with changes in the market place due to scaling up of technology have been left behind. The leaders and laggards include promoter-driven as well as professionally run companies. Hopefully, the latest outcome should set to rest the fruitless debate on the effect of promoter holding in attracting investors. What matters are transparency, vision and leadership position. Missteps and corporate governance issues are not unique to any particular type of organization. Companies within Old Economy and emerging areas have scored differently. The market has recognized the foolishness in rushing to re- or de-rate a sector because of the stunning performance or misdeeds of one or two peers. Examples of resilience can be found even in the face of an epidemic such as economic slowdown or ballooning bad loans. Product innovations and efforts to reach the last customer can overwhelm even a crowded field. Prudent use of cash for diversification can unleash a sluggish stock. Conflict of interest can de-rail a promising counter.

An inescapable inference is that the benefits of the policy thrust on rural economy and infrastructure-building have yet to percolate to companies slated to be the recipients of the largesse. The lack of enthusiasm for these stocks is due to two factors. One, most of the spending is by the government with its downside of delay in approvals and payments. Second, many winners are lowest bidders: the top line gets a boost but not the margins. Despite their dominant market share, the demand for large companies in core sectors is lukewarm. The firepower of automobiles, usually in the forefront of any rally, seems to have been consumed to remain competitive amid rising input costs, fuel-efficiency norms and the coming transformative challenge of electric vehicles. The surge in the side counters hinged on the cost of money staying low to facilitate growth plans. The limits of efficiency in giving a bump to the financials have been exposed, with producers unable to take price hikes to stay in the game. Volumes had to compensate for healthy operating profit. Also souring the mood was the flurry of resignations by auditors, raising doubts about the numbers in the public domain.

Some stocks with a track record and brand recall escaped from the stampede. Clearly, the market concluded that, though expensive, these counters deserved the premium. Left unsaid is the inadequate supply of quality stocks. It also points to another problem: the subscription flood into mutual funds during a bullish period. Schemes have exposure ceiling.  Not many want to let the cash remain idle. The result is a hunt for counters that have a semblance of operations and an enticing spreadsheet of consumption projections in the hope they shape up and justify the trust.  A few companies abandoned by investors due to tighter regulatory surveillance are now buying back shares to support prices. The problem is there is hardly any headroom for most mid and small caps to maintain the 25% minimum public shareholding due to hefty promoter holding. Many owners dilute stake just so to stay listed. Price discovery is the casualty. Significantly, the Securities and Exchange Board of India recently relaxed the norms for delisting. Instead of a consensus price, a range will be offered to the investors. Despite the unease, there are three satisfying conclusions from the recent partial meltdown of the market. Companies in the services sector are majorly creating wealth for the investors. India is leaping into being a services economy, unlike China, due to near 35% millennial population, according to Morgan Stanley. Many services sectors are yet to get recognition in the headline indices. Retail, logistics, hospitality and healthcare have poor representation. Their eventual inclusion will be a powerful booster dose for the benchmarks. Second, those that have invested in brands are enjoying an edge. Third, the divergence in trends in gains and decline within and outside the sector- and  market-value-based grouping points to selectiveness that will cushion future shocks so typical of mid and small caps.       

-Mohan Sule

What investors want

Setbacks to growth plans are more likely to be forgiven than opacity and fudging of numbers

The initial reaction to a long-overdue correction dissolved into panic as the slide of mid and small caps that began early May continued over two months. Of late, even large caps seemed to be losing their stamina in their climb to catch up. An across-the-board secular direction irrespective of performance, usually indicating over- or under-valuation, troubles investors. They are braced up for alternate cycles of boom and bust as they know that policy makers will tighten liquidity to prevent bubbles and loosen money supply to borrow and spend. What investors are not prepared for is disturbing of established agreements. The flooding or starving the market of lubricants essential for smooth operations such as oil by oil producing and exporting countries unnerves them. They detest uncertainty. There seems to be no clarity as to how the US and China trade war is going to conclude. Nasty shocks throw them off-balance. The overhang of social obligations and political considerations in taking business decisions had not diminished investors’ enthusiasm for public sector bank stocks, considered the best vehicle to ride India’s growth trajectory. The magnitude of the investment risk became evident after the Reserve Bank of India narrowed the time-frame for recognition of bad loans from six months to 90 days, restricting operations of banks under prompt corrective action. Investors are prepared to live through turmoil if they know the outcome. Selective picking of mid and small caps by the market regulator for tighter surveillance to nip price manipulation appears right. What they are not sure of is the objective. The selection signifies corporate governance deficit and thereby a warning to keep away or an intervention to cool prices and therefore afford an opportunity to enter at a lower level.

Investors love road maps. Monetary authorities give indications of their approach on policy rates during the course of the year. The inclination is not to cause unnecessary volatility in the equity and debt markets. No wonder many governors of central banks assume rock-star status. Investors are attracted by policies creating higher consumer spending. What they are not reconciled to is to companies growing their sales because of limiting competition. Leadership position due to being first-mover is embraced but not monopoly status that does not encourage cost-efficiency. Long-term capital gains tax on equity is just when the principle is that all income must be taxed in a fair manner. The move is unjust when the revenues are spent on short-term measures such as loan waivers and hiking support prices for farm produce. Investors do display patience while promoters rehabilitate their company following errors of judgment. Inexcusable are issuing bonus shares and announcing grand expansion plans to divert attention from the shoddy performance and reckless raising of capital.

Missteps by companies in spending capital on expansion or downturns in an industry due to change in consumer tastes and technology are eventually forgiven. What are not are siphoning off funds, related-party transactions and window-dressing. The spate of resignations of auditors has spurred questions about the authenticity of numbers of even earlier years. The new accountants of a company that was hammered because the predecessor made an issue of inadequate disclosure of material information have found no evidence to substantiate the claim.  The result is confusion rather than transparency. The problem is while figures can be validated, the quality of governance becomes a victim of subjective assessment.  The failure of a bank chief to disclose conflict of interest while being part of consortium that granted loan to a company that had invested in a family member’s business can be viewed as an oversight as well as lapse of judgment. The market does not seem to have a uniform rule to weigh on such ambiguous matters. In contrast, shares of a jeweler whose co-promoter gifted some shares to a related party was beaten and so also of a tech company for investing in the ornament maker. What follows in an indictment of the entire group that share common characteristics with those found wanting of their fiduciary responsibility. No wonder investors feel irritated due to opportunity missed if the blacklisted category resumes its strides after a time gap. Like fast food, quick judgments, investors have now reckoned, are injurious to health. The valuations at which a public sector player will take exposure to an ailing private bank will leave ample space for capital appreciation compared with if it were to buy into a profitable venture. The long tenure of redemption of policies puts the insurer in a unique position to pluck such low-hanging fruits.

-Mohan Sule

Survival strategies

Companies respond to opportunities and threats in a manner that might seem contradictory but relevant to their predicament

To understand how Indian companies are strategizing to stay in the game as banks become selective, equity investors impatient and the debt market expensive, there can be no better instructive exercise than observing the Ambani brothers. When the RIL group was divided in early 2005, the younger sibling’s portfolio had a combination of new economy and traditional but emerging businesses. Refinery and petrochemical complexes and the nascent retail outlets were assigned to the elder brother. More than a decade later, Anil is divesting stakes. The huge power plants put up to benefit from the deficit are slow in showing results.  Reliance Energy has been sold and Reliance Jio is taking over Reliance Communications. Foreign investors have been offered substantial shareholding in the financial services, asset management and insurance companies. Mukesh, in contrast, is facing a different predicament: how to deploy the reserves accumulated through old economy operations to keep the shareholders happy. Believing wireless services to be as essential as oil, voice calling was offered for free and data at bargain tariffs to create a big bang. The contradictory styles of the two capture the current preoccupation of Indian promoters to survive and grow. Heavily-leveraged companies are shrinking their balance sheets to concentrate on their competency. Those on the leadership perch are darting back and forth to become a one-stop shop or diversify to boost the return ratios.

The important lesson is that companies’ cash utilization and leakage-stemming policies are responses to the evolving situation. ADAG slipped not solely because of misjudgment. Rather external factors such as the Supreme Court’s crackdown on irregular issuance of telecom licences and the subsequent chaotic regulations skewed calculations. At the same time, Tata Motors’ determination to pull off its Jaguar-Land Rover buy appears to be paying: Main market China is stabilizing and the euro region is recovering. The second outcome is if unbridled ambition can hurt a company so also too much cash. RIL has quelled investors’ revolt over the mediocre capital appreciation by its aggressive RJio posturing, possible only because of its liquidity chest. In contrast, tech companies are distributing bonus shares and resorting to buybacks as they navigate an uneasy transition to digital offerings from back-office support. The third take-away is that the idea of growth differs for different companies. A high-entry barrier requires huge capital and patience. These are the strengths of large groups who were prominent in bidding for spectrum and circles. For a mid-sized sanitary-ware maker, extending the presence in the kitchen to ride on the housing boom is less risky than integrating backwards to secure supply of inputs. The fourth draw-down is that if commoditization of brands poses a danger to some, it presents an opportunity to the others. Consumer durables and FMCG are turning into generics. On the other hand, the expiry of patents is a window to the developed world for copy-cat pharmaceutical producers.

The fifth inference is that regulated industries that attract due to the fat margins can also become graveyards. Some ambitious entrepreneurs want to be present across the commodity spectrum for pricing power though these sectors are susceptible to policy whims and are cyclical. The distressed core sector assets are a testimony of how aping the current fashion can lead to destruction. At the same time the fact that the interested parties are seeking consolidation rather than trophies indicate careful homework of the outlook. Many first-generation entrepreneurs have become millionaires by servicing the needs of the recession-proof healthcare sector that is, however, subject to intense scrutiny. Mines can be shut due to local agitation. Price caps are imposed on scarce and essential requirements. The sixth conclusion is, despite the captive audience, B2B players yearn for B2C presence to shield the core cyclical operations and gain a direct entry into homes. Retail lending, asset management and insurance are the flavor though most conglomerates have not been able to replicate the success achieved by their flagships. The seventh observation is that if the upside of India’s consumer markets is the rapid urbanization, the downside is intense competition. The churn in the mobile handset segment has not deterred new entrants. The eighth lesson is the nature of tie-ups is changing from expanding the market to preserving the existing share. Pooling of equity or know-how-access ventures between Indian and foreign peers are giving way to collaboration with competitors. Joint custody of assets and sharing of resources by rivals indicate the trend is likely to turn into a tide. The bottom line is that one size does not fit all when adapting to the changing environment. The key is to be ruthless in letting go and careful while spending.

-Mohan Sule

The riddle

Do institutional investors and auditors have different standards of due diligence?

Well-meaning investment advisers recommend ticking a long checklist before venturing to trade. A basic requirement is consistent growth in revenues and profit. Corporate actions such as dividends, bonus and stock-splits come next. Growth plans and capital expenditure, too, are important. Presence of foreign investors and mutual funds offer comfort. Valuations tell a story, either of sluggish earnings growth not keeping pace with price gains or yet not reflecting the potential. At the tail-end is corporate governance. Unable to pin a definition, the explanation ranges from timely release of quarterly results and holding AGMs to having independent directors on board as per regulations. With the exercise done with, the attention shifts to stock-picking. The preference is for high-growth mid and small caps due to the messaging that large caps are reliable but slow in appreciating. Amid the unrealistic discounting of the mid-cap and small-cap indices, some stocks stand out. Trading at an attractive P/E of 20 based on trailing 12-month ended December 2017 earnings compared with the hefty valuations of the BSE Mid-cap index, this particular scrip reported CAGR of 24% in sales and 28% in profit after tax in the five years till FY 2017. The dividends in the range of 7% and 10%, with FY 2017 seeing no payout, no doubt disappoint but are in line with a company undertaking expansion to grow: Rs 100 crore are being tapped from internal accruals for Rs 600-crore expansion to add a fifth plant. Importantly, finicky foreign institutional investors held a huge 39% stake. Mutual funds owned a reassuring 12% equity end March 2018.

External factors, too, are favorable. A scorching summer is set to be followed by a normal monsoon, thereby boosting the prospects of consumption-based sectors such as FMCG in which the company operates. Despite the alluring factors, there is a hitch. The auditor has refused to sign the accounts for FY 2018. In fact, the firm has quit, citing lack of access to material information. The dilemma for investors is if the halving of the stock price from its September 2017 peak following a 1:1 bonus issue opens a window to take a bite of the lucrative business of mango-flavored drinks or a warning to stay away due to a corporate governance issues.  Manpasand Beverages smashes all conventional theories of investing. Since debuting in the primary market, the reliance of the net debt-free company considering cash in hand is on equity for capital expenditure, indicating the confidence of the promoters in servicing the enhanced base. Yet, there were warning signs. Retail participation in the 40% over-subscription of the IPO was marginal.The shares listed nearly 11% below the offer price. Operating profit more than doubled in the year after listing but could expand only about 20% in the next year.  After mopping up Rs 422 crore in the run-up to listing in July 2015, a slightly higher amount was collected from institutional investors a couple of years later to set up bottling plants at two existing locations and another in a new geography.

As the outcome of the examination of the books by a new auditor is awaited, the episode triggers memory of another case of breach of trust. Welspun India, the largest supplier to the US and the second largest producer of towels and bed sheets in the world, has lost 60% of its market value since its high end March 2015 after a prominent US retailer, among the top five customers, terminated its relationship, accusing the company in August 2016 of wrongly selling Egyptian cotton bed sheets. Target refunded all customers who bought these sheets over two years. Walmart followed, though it did not cut off ties. Others such as Bed Bath & Beyond and JC Penney, too, launched probes. Two class-action suits have been filed. The bath and bed linen maker exports nearly all its produce, with the US comprising a major chunk, followed by Europe. Operating profit that had doubled in the previous three years rose about 12% in FY 2017. The 80% jump in other income seemed to have restricted the fall in the bottom line to half. Dividend plunged from 100% to a measly 3%. Though net profit crashed more than 40% in Q3 of FY 2018, institutional investors have not given up. FIIs controlled about 9% and mutual funds 6% stake end March 2018. The trailing 12-month negative return has disappeared since the past month. The consultancy firm hired to examine the issue is yet to submit its report. In the meantime investors are left to speculate if the market’s impatience to seek growth year after year prompts companies to seek shortcuts. Besides, the divergence in the due diligence between institutional investors and the auditors is a puzzle that needs to be solved.    

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Add to cart

Not all purchases are value accretive as the market differentiates between a good buy and a bad bargain

If any doubts lingered about the decisive turning of the economic cycle, the feverish shopping spree by companies should scotch them. Tata Steel offered nearly double that of its nearest bidder to snap up an ailing peer. Buyers have lined up for four more distressed steel assets. Close after agreeing to take over Century Textiles’s cement division, UltraTech Cement’s Rs 8000-crore interest for Binani Cement is likely to be successful. With the sector veering towards a duopoly, more mid-tier players will come into play as they struggle to match the firepower of the Aditya Birla group and Lafarge. Besides scale to pare cost of production, proximity to raw materials and market provides a crucial edge to both cement and steel producers. A spree of sell-outs and buy-outs have left three large services providers in the wireless business, with one of them the product of merger. Service providers are opting for an asset-light model by divesting their tower businesses. Since the introduction of the Real Estate Regulation and Development Act, 2016, the trend of weak players transferring their unsold inventory to those with staying power has accelerated. The problem of bad loans has triggered speculation of mergers among PSUs and between private banks. If pessimists tend to view every company on the block as a sign of a slump, optimists note the rush to grab as an indication of a bright outlook. 

The market does not have a thumb rule to judge takeovers and amalgamations despite the fact that the process leads to better bargaining power for the acquirer and provides an exit for the shareholders of the struggling player. Instead of applauding for getting a foot inside the world’s hottest market, investors of Walmart panicked after it scooped up Flipkart for a hefty price. For those critical of companies not doing enough to deploy cash to improve returns, the plunge in the US discount retailer’s market cap must be confounding. In contrast, Torrent Pharmaceuticals has appreciated more than 300% since it mopped up the formulation brands of Elder Pharmaceuticals end 2013 for Rs 2000 crore, that is, nearly 60% of its sales in the fiscal year ended March 2013. Sun Pharmaceutical Industries gained 150% in the three years to September 2010 that it took to wrest control of Israel’s Taro despite the US$37-million tag in anticipation of access to the lucrative US and Canada markets. The share price doubled in a year after merging Ranbaxy with itself in an all-stock deal in April 2014. In contrast, buying 23% stake by the promoter in Suzlon early 2015 did nothing for the debt-heavy renewable energy producer, who has shed half of the value since then. Hiving off Taj Boston in July 2013 has not helped Indian Hotels because the transaction value was just a fraction of the Rs 4000-crore loans in the book. Tata Steel went up nearly 10% in the four months after announcing an equal joint venture of its European property Corus with Germany’s Thyssenkrupp. The counter is back to the pre-September 2017 level on fears of cash drain: After collecting Rs 12800 crore through a rights issue, Rs 17000 crore will have to be raised to finance the Rs 45000-crore Bhushan Steel purchase. 

Ultra Tech spurted for a fortnight or so after agreeing to take over Rs 16000-crore debt of Jaiprakash Associates’s cement business but is down 5% over the 10 months that have passed on worries of the debt-to-operating profit ratio of 1.85, though down from a high of 2.4, worsening in the quest for consolidation.  Infosys is still smarting from three recent additions, with a whistle-blower claiming Israeli automation firm Panaya served an inflated bill. One was merged at low valuations and the other is yet to make a difference to the top line. The jury is still out on Tata Motors’ US$ 2.3-billion JLR adventure at the peak of the global bull-run. In the ensuing credit crunch, it took a decade for the scrip to double after losing 75% of its value in a year. Hindalco’s US $6-billion (compared with sales of US$ 4.5 million in FY 2007) conquest of Novelis makes sense now as aluminium prices are bouncing back. The shareholders, however, suffered in the two years since February 2007, seeing 60% erosion in wealth. Airtel’s operations in 15 African countries, picked from Kuwait’s Zain Telecom for nearly US$11 billion in 2010, started making money in the September 2017 quarter. The leverage of US$ 13 billion is pitted against the latest fiscal year’s annualized revenues of US$3.1 billion. The chairman recently admitted funds could have been better utilized to strengthen position in the domestic market. The two important lessons are the market distinguishes between a good buy and a disastrous bargain. Calculations can go haywire if the environment turns hostile.

-Mohan Sule

Oh, not again!

India’s e-commerce pioneer’s ownership change underlines Indian enterprises’ struggle to achieve scale

 The churn of big-bracket investors at India’s first digital marketplace continues. The price tag for 77% stake by the new buyer puts a valuation of over US$ 21 billion, making it more expensive than decades-old Old Economy companies such as Tata Motors and Coal India. In the absence of listing, the transaction size becomes a function of the buyers’ capacity for risk and projection of outlook for the business on one hand and the sellers’ doggedness to get the desired price or impatience to exit to cut losses on the other. After all at the turn of the century internet properties were assigned discounting based on eyeballs rather than cash flow. Foreign direct investment in multi-brand retail is not high on the current government’s agenda. At the same time, the fastest-growing economy in the world is too important to ignore by global companies in search of growth. Offline retailer D-Mart in fact is supposed to have mimicked the low-cost model of US peer Walmart, the new buyer of Flipkart, with great success. Despite keeping prices low, the net profit margins are near about 4%, highest for any discount retailer in the world, and are projected to increase 1% point and  the return on equity by nearly half in another three years. The sparkling performance is in stark contrast to the cash-guzzling and loss-making e-commerce pioneer. Interestingly, there was no panic selling in Avenue Supermarkets, indicating that competition from cyber space is not expected to affect D-Mart in the immediate term.

What the transaction instead does is trigger a tinge of regret that India is yet to produce a Jack Ma in the e-commerce space. Alibaba’s US$ 21-billion IPO four years ago is the largest capital-raising exercise so far. Hint of further capital infusion is as an acknowledgement of the Indian consumption story as much to the difficulty in cracking the market. Walmart is known to get is calls wrong. It had to wind up physical presence in Germany due to inability to understand local tastes. Its online investments in the US and China are more of counter-strategies to stave off Amazon and Alibaba. The coexistence of brick-and-mortar retailers with e-tailers highlights a strange paradox of post liberalization India: a nation ready to embrace innovations and at the same time conservative in accepting change. If the two-wheeler segment demonstrates the ability of local companies to beat foreign brands, the consumer durables space is a tale of meek surrender: regulations reduced domestic labels to assemblers of knocked-down kits. The typical reaction of an entrenched Indian enterprise that prospered on patronage to any threat to market share is to scurry into unrelated areas such as telecom, aviation and oil and gas.   

The many bright sparks in the non-digital space are mostly first-generation entrepreneurs. Their horizon is not restricted to the Indian borders. Naturally, they are from sunrise areas. Some degree of success has been achieved by generics makers exporting to the US. The old and new coexist in healthcare, but the money-spinning diagnostic centers have the stamp of start-ups. The personal-care segment is a testimony to the innovative spirit of Indian entrepreneurs so much so that even multinationals are looking at home-based remedies. Similarly, the food business is seeing a replay of David taking on Goliath, with a tilt in preference for Indian savories of regional brands over foreign labels. Though reminiscent of the crowded 2G spectrum era about a decade ago, the money-transfer business looks set to become the next big theme after private banks. More often, an unexpected success sees re-rating of the entire sector. The over 100% subscription and listing returns of Avenue Supermarts brought into fashion Shoppers Stop, V Mart and Future Retail. French giant Lafarge’s entry through ACC and Ambuja Cements prompted a relook at a mature market. The lining up of suitors for distressed steel assets is taken as a sign of recovery. Unfortunately, not all missions have had a happy ending. Many have succumbed under the weight of their ambitions as well as due to the hostile environment post the global liquidity crunch. Suzlon sold itself to Sun Pharmaceuticals, another new-age venture. The wireless business has proved to be a graveyard across generations of would-be telecom czars. Airlines remain work in progress as promoters without baggage of experience struggle with regulations and a brutal marketplace. Yet, the notable take-away from the Flipkart trade, representing 5% of the total assets of mutual funds end March 2018, is that deals in India are going to get bigger. Money is waiting. The question is if Indian promoters are ready to loosen their grip to let in big-ticket investors to achieve scale. Ma owns only 7% equity shares in Alibaba.   

-- Mohan Sule

The run-up

Despite lousy macros, the market’s near-quarter gain in slightly over a year to the last general elections was on hopes of a Modi win

The market returned more than 25% from mid April 2013 till the Lok Sabha poll results were announced. As the world’s most populous democracy begins the countdown to elect the next government, the question is how equities will move in the run-up. If history repeats, the benchmark will be near the 40,000 mark five months into next year. Stocks had surged despite the infamous policy paralysis that turned UPA 2 into a lame-duck government for the last two years of its term after a spate of scandals. The Supreme Court early 2012 cancelled the 122 licences for 2G spectrum issued in 2008. Over the first part of the year, CBI investigated if coal blocks allotted between 2004 and 2009 were by bidding. These scams came on top of the discovery of financial irregularities in the 2010 Commonwealth Games and that apartments in the Adarsh housing society in a prime south Mumbai location were given to politicians and bureaucrats instead of war widows and army personnel. There were allegations of a surreptitious environment tax to pass capital-intensive projects. Macro factors, too, had had turned hostile. The 10-year government paper yielded 7.75% and home loans were being disbursed at above 9.70%.  Oil had crossed US$ 100 a barrel. The fiscal deficit in the March 2013 quarter was 3.14% of the GDP (totaling to nearly 5% for the entire year). The current deficit was at 3.58%. The gloom did not restrict equities from scaling new highs. By the time the calendar year ended, the Sensex had crossed the 21,000 level, last seen before the global financial meltdown of September 2008.

A contributor to the rally was the US Federal Reserve finally initiating the anticipated roll-back of the liquidity injection that was introduced to prevent the US from sliding into recession due to the credit crunch as too-big-to-fail banks collapsed. Foreign investors were pleased with the victory of the BJP in Rajasthan, Madhya Pradesh and Chhattisgarh assembly elections, hoping that Narendra Modi as prime minister would pencil broad reforms to boost the economy. There are many similarities with the period five years ago. SBI’s base rate is about 8.7% and yields on government bonds are slightly below even though consumer inflation is at a five-month low of 4.28%. Brent crude is hovering above US$ 70 and looks set to rise further due to slide in output even as the global economy gathers strength. The stark differences include weakening of the rupee to the 66.40 level from 53.5 at end April 2013. The fiscal deficit is projected to decline to 3.3% in the year ended March 2018 from 3.5% in the previous year. Still off the original target of 3%, it is lower than 4% in FY 2015 and 1.5% points down from the penultimate year of the Manmohan Singh-P Chidamabaram regime. The current account deficit was 2% of GDP in Q3 and is expected to be 1.5% in FY 2018 from a low of 1.3% in FY 2015 but much more comfortable than what it was in FY 2013. After hitting a lifetime high of above 36,000 early 20018, the stock market corrected over 10% on higher bond yields in the US and India.   

Another striking dissonance is that small and mid caps have been at the forefront of the current rally. In 2013, investors preferred large caps. Implementation of the long-term capital gains tax on equity instruments and dividend distribution tax on equity mutual funds is a downside. Yet, mutual funds are replacing overseas funds in propping up stocks: their investment in equities was double that of foreigners in 2016 and 2017. Since the start of 2018, domestic institutions’ debt exposure has outstripped that of their non-local peers, who have been exiting from both equities and debt. The Sensex’s jaunty ride in 2016 and 2017 was as much due to global liquidity finding its way to high returns emerging markets as to the cleansing of the real estate sector, roll-out of GST and shepherding defaulters to insolvency by shortening the outstanding loan recovery process. Later reforms such as opening up coal mining and putting Air India on the block as well as forecast of good monsoon have not energized on concerns of what farmers’ loan waivers and guaranteeing minimum support price 1.5 times the cost of food-grain production will do to the fiscal health. High-growth stocks are expensive even after correcting more than 10% from their peak. As such the triggers for the market are more likely to come from the US (pause in the scheduled three rate hikes by the Fed) and China (maintaining the manufacturing momentum). Overriding economics will be politics. The tailwinds of the BJP passing the test in Karnataka can only get stronger if Modi wins the three-state sweep-stake at the end of the year.

-Mohan Sule

A new threat

Apart from the rocky transition to a rule-based economy,

Indian companies have to brace for smear campaigns

Besides facing headwinds of cyclical demand, out-dating of technology, regulatory changes and shift in consumption pattern, companies have now to brace for another kind of storm: allegations of impropriety. The battle between promoters and activists over compensation packages of top managers is a cause of much grief to the small investors. Crimping on the quality of processes and products is another source of wealth destruction. Giving unsecured loans and favorable terms of trading to related parties is not uncommon. These corporate governance issues can occur without warning unlike industry-specific rumblings that can be heard before they hit the boardrooms. Investors get a whiff of the dodgy practices only from auditor’s qualifications or stock exchange filings. Of late, whistle blowers are playing an important role in shining a light on how companies are run. The problem is ascertaining their motive. Many might be risking going to the authorities due to genuine concern about the effect of the toxic environment at the headquarters on the health of the company. Some might be acting out of spite for some perceived wrong. Another worry is if the informant has fully comprehended the systems and procedures that are causing distress. At the receiving end of undue attention recently has been ICICI Bank. The directors do not feel the CEO and Managing Director acted improperly by clearing a loan as part of a consortium of banks to the Videocon group, whose promoters had invested in her husband’s company.

Whether it was a knowing abuse of power or there was ignorance of what constitutes a conflict of interest will eventually be established. Or it might not as the case winds up through various layers of investigation. The important issue is what happens in the meantime. The erosion in market value in most cases is halted if the protagonist steps down till conclusions are established. Yet there is a loss reputation (of the boss) and opportunity (for the company) as much of the energy and time of the successor is expended in putting the embattled enterprise back on track. The dilemma for those caught in such a rotten situation is whether to make symbolic sacrifices or fight it out.  Credibility of a brand is not based on following established procedures to the letter. Perception of trustworthiness is a combination of tangible (financial performance) and intangible (treatment of various stakeholders) acts over the years. The crux is how quickly it takes for those at the centre of the storm to acknowledge the problem, initiate steps to make amends, and establish communication with the shareholders to shape the narrative. Many times there is diffusion between transgression of moral boundaries and violation of law, making taking a stand difficult. There might be temptation to find scapegoats as impatient institutional investors build pressure on the company to adopt an arm’s-length distance from the controversy to cap any more slide in the share price. Though ICICI Bank is off from its March high and has under-performed the private bank index, the underside has been limited. The message from the market is that the damage is not irreparable.

What the unspooling of the episode tells is that a new type of threat has emerged: smears. The shocking decision of a global technology investor’s founder to bypass his heir-apparent, it is now understood, was influenced by a campaign launched to tarnish the contender’s image. For companies, the danger of theft of intellectual property seems to have been taken over by insidious attempts to spread misinformation in the market place. In the pre-social media days, scorned analysts would rip companies by knitting together pieces of information to paint a portrait of rapacious promoters.  A few years ago, a new-age real estate group with interest in financial services filed a criminal complaint against an overseas research firm for depicting a vivid picture of window-dressing.  Handles, anonymous and known, have to post a few ambiguous tweets to raise doubts about a stock to spur investors to exit till a clarification is forthcoming. In a way, companies have to take some of the blame for increasingly becoming susceptible to accusations of cover-ups in the smug belief that their attempt to trapeze between what is acceptable and what is not will remain private. If the digital era has made conducting business easier, it has also enforced transparency and heightened scrutiny. The recall of high-value notes in November 2016, the roll-out of the goods and services tax from July 2017 and the implementation of the bankruptcy law are steps to a rule-based economy. Those who fail to adapt to the transition will end up losing investors’ confidence.      

Mohan Sule