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