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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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