Risk and reward

Cutting the time frame for disclosure by issuers and allowing  side-pocketing of bad assets by mutual funds will benefit neither the issuers nor the investors

 The return of foreign portfolio investors beginning second half of the calendar year 2018 pushed up the headline indices into unexplored territory by the end of the third quarter. Their arrival was seen as a response to the bargain prices at which large caps were available as also a confirmation of the recovery of the Indian economy from the disruption caused by the implementation of the goods and services tax a year earlier. Their intervention came at an appropriate time. Mid and small caps were undergoing a brutal correction after domestic funds and investors had propelled their discounting to unrealistic levels at the beginning of the last year. The rally lost steam thereafter, with slightly less than half of the large caps off from their historic milestones giving up over 20%. While the withdrawal symptoms of NBFCs following the collapse of IL&FS has hogged the limelight, what has escaped attention is the role of the regulatory framework in dampening the enthusiasm for mid and small caps. As many as 1,000 small caps have shed half of their values from their annual peaks and are unlikely to regain the position in near future. Despite continuing to command a premium compared with large caps due to large local institutional presence, about 60% of those that have declined from their 52-week highs are down 20% and more .

Ranking by market capitalization and imposing 5% circuit breakers and physical delivery on those identified for increased surveillance have marginalized day traders who are so vital for price discovery. Categorizing the first 100 stocks by market value as large caps and the next 150 as mid-sized erases the arbitrariness and flexibility in their selection by equity schemes. The downside is that fund managers have to reshuffle the holdings every six months to confine to their theme.  Volatility, which is becoming a rule rather than an exception as the market’s reaction is no longer restricted to domestic events, is compounding the problem. As a consequence, the retreat of the small investors from the trading ring will accelerate rather than reverse. The shift has been long in the making and was triggered by the switch to book-building of IPOs. Despite the 35% quota and up to 10% discount to the offer price, retail buyers have little influence on the price band.  Now the requirement for issuers to disclose the financial performance has been compressed to three years. Unwittingly the modification helps institutional actors. They have access to management. It will also provide quicker exit to venture capitalists and private equity. At the same time, the impatience to mop up capital to scale up without notching up profit for five consecutive years does raise doubt about the issuer’s commitment to the long haul. Instead of the dilution of the track record norm encouraging more participants to list, the worry is the market getting saddled with ideas that are half-baked or fads.

The clumsy attempt to ease the doing of business for promoters has been balanced by capping mutual funds' expenses at 2.25% of the corpus and replacing upfront distributor commission with that linked to the stickiness of the investor. Populism seems to have overwhelmed prudence. If not, the regulator would never ever have allowed something as bizarre as side-pocketing of toxic debt. It is yet another instance of how the default by IL&FS in repayment of loans has not only increased risk aversion but distorted the regulatory landscape. The objective of containing a financial crisis from turning into contagion by ring-fencing exposure to institutions in the center of the conflict is attractive but as appalling as the concept of assured gains by market instruments. Rescuers need time to assess the damage and nurse the scarred player back to health or, if the disaster is due to macro-economic headwinds, for the storm to blow over. UTI’s bailout by separating the bad and good portfolio, eventually leading to the extinguishing of the liabilities, is obviously the template. What causes unease is how easily the process allows adventurism by fund managers. The complicity of rating agencies and the sloth of the board are forgiven and forgotten. It will open the floodgates to dubious paper with high yields during boom times.  There will be no compulsion to exercise caution. After all, the investment can be written off. The NAVs will stay pristine for new investors at the cost of the shareholders of the asset management companies. Just as grading of IPOs, which has now been junked, created a false narrative of the market regulator vetting the offer when it merely scrutinized the completeness and accuracy of disclosures, the latest move to level the field creates an illusion of rewards without risks.  

 -Mohan Sule

Scorned and furious

More than setbacks due to economic challenges and changing marketplace, governance missteps damage stocks

If 2018 was remarkable for the sudden change in the bullish sentiment that prevailed for most part of the year to bearish in the last quarter, it also marked a year when the joy of bumper returns provided by many stocks turned into disappointment not so much for their financial performance as for their governance missteps. The rise and fall of IL&FS is the latest addition to a long list of companies that apparently had everything going for them but eventually ended up bust. The business model that investors loved in the first place was also responsible for their betrayal. Niche segment, limited competition, captive market, huge potential and willing lenders dissolved into lax supervision, opaque operations, asset-liability mismatch, unwieldy organizational structure and bumper managerial compensation. More than a downturn in the economic cycle, the market is wary of unexpected company-specific shocks. Changes in market tastes and technological obsolescence are taken in their stride but not window-dressing of accounts. Those attracted to PSU banks for their wide reach felt let down on learning the enormity of bad loans after the Reserve Bank of India carried out special inspections in August-November 2015.Eleven PSUs and one private bank have been restricted from opening new branches, pay dividend and lend. The NSE PSU Bank index has shed nearly 13% in the 21 months since the tightening of the guidelines after their introduction in May 2014 and has lost about 30% from its peak end June 2015.



Irrational exuberance in undertaking growth plans tends to be forgiven but not market manipulation. The headwinds facing Sun Pharmaceutical seem to stem from questionable practices rather than intensifying competition in the US generics market. Allegations of related-party transactions have piled up on top of patent litigation woes. The stock is down 35% in the five months since its recent high. The large cap with the highest weight among its sector constituents in NSE’s Nifty 50 index is not the first giant to be smeared by accusations that are typically the preserve of mid and small caps. Hindustan Lever was indicted for insider trading after purchasing shares of group company Brooke Bond Lipton India from UTI about two weeks prior to a proposed merger between the two in the first quarter of 1996. RIL in 1994 issued non-convertible debentures with convertible warrants to 38 entities to raise Rs 300 crore. The warrants were converted into shares early 2000. Two years later, the company admitted these firms were acting in concert. An investigation by the market regulator found that all of them were dummies with a common address. Sluggish capital appreciation is often brushed aside but not theft of cash. Ramalinga Raju, founder of Satyam Computer Services, used more than 300 shell enterprises to siphon off money to invest in real estate so as to enable the flagship to record healthy profit growth. The Singh brothers were accused of taking out US$78 million out of Fortis Healthcare that they controlled without board approval and at least US$300 million from the lending arm of their financial-services firm.



Cash accumulation evokes mixed feelings of security and lost opportunities but dodgy corporate actions trigger anger. Power trader Reliance Natural Resources wiped out more than a quarter of its market capitalisation after an unfavorable share-swap ratio with group firm Reliance Power. The promoters later excluded themselves from a bonus issue. Reliance Mutual Fund pared by half its exposure to Escorts after the tractor maker undertook a complicated merger that resulted in the transfer of the shares of three group units to a trust floated by the promoters, thereby indirectly consolidating their grip. Investors voted with their feet when Fortis Healthcare bought Singapore-based Fortis Healthcare International, wholly owned by the promoters, at nearly 13 times operating profit. The stock plunged in proportion to the spurt in the valuations of competitor Apollo Hospitals. World's biggest paint maker Akzon Nobel NV annoyed the shareholders when it amalgamated three unlisted in-house outfits to ramp up control in Akzo Nobel India to 67% from 56.4%, because of sketchy disclosures, dubious valuations and disproportionate dilution of public stake. Two mutual funds, together owning 2.39% equity capital, reduced their holdings in the following quarter. Real estate developer Hiranandani Group had to call off plans to combine Hiranandani Development and Hirco, listed on the London Stock Exchange's Alternative Investment Market, owing to opposition from foreign investor Laxey Partners, who fought for a rollback before parting ways.

-Mohan Sule

The year that will be

Pressure on the central bank and companies to change and on the government for tax cuts and freebies

The mean-spirited partisanship that marked 2018 is likely to linger in the New Year. Tensions between various stakeholders are set to get worse before they are resolved. The flash points between the Reserve Bank of India and the finance ministry such as the degree of co-operation among career bankers and outsiders on the board, the extent of autonomy to target inflation, the ratio of appropriate reserves and the quantum of dividend are too contentious to get sorted out in the short term. Lots of blood will be spilled before satisfactory conclusions are reached. For all the noise, one thing is sure. The profile of the arbitrator of the cost and availability of money is likely to change as the wise men at the helm become reactive rather than proactive as more and more of their moves get dictated by the actions of the US Federal Reserve and oil prices. Liquidity challenges due to domestic developments will be managed through money market interventions rather than rate adjustments. With efforts to shape up the slothful public sector lenders proving long-drawn and painful, pressure to relax the recognition of bad loans will intensify as policy makers view them as spigots to kick-start the economy and underwrite populist schemes. Due to restricted powers to control them, private banks will bear the weight of the monetary authority’s attention. Whether it is willing to be pushed back on how much equity promoters should control will determine how serious it is in protecting its turf.

The usefulness of fiscal discipline will find less and less backers in the run-up to general polls, and with plenty of reasons. How corporate and individual tax cuts in the US propelled the economy and the promise to waive farm loans led to a change in government in three states at the end of the year will be cited to eject textbook prescriptions. Rectitude will be rejected in favor of pump-priming.  Higher minimum support prices for agriculture produce will be supplemented by a bump in guaranteed rural employment wages and last-mile electricity connectivity will be complemented by free power. On the one hand, legitimizing of bankruptcy will lead to new owners and release of pending dues of creditors. On the other side, the wave of inter-PSU divestments in the name of consolidation is likely to rise rather than fall to beat volatile markets. What can be safely ruled out is a privatization spree after the sale of one asset that there was consensus on complete government withdrawal from ownership got grounded before take-off. The tightrope walk to appear not selling the family jewels cheap and staunch the bleeding of useless behemoths will be played in the public as well as the private sectors. The dilemma will be how to keep prices of natural resources such as telecom and natural gas low and encourage investment and expand the ambitious air network reach without cutting tax on aviation turbine fuel. The central bank will have its own Hamlet moment: to use the misleading food-laden CPI or core industry-heavy WPI that captures economic activity as a peg to hang its monetary policy because the trajectory of the two does not always run parallel. 

The underlying rivalry to become market leader for better pricing cannot to be wished away in 2019 even if old competitors are replaced by new ones, particularly in the private banking space, where the race is to dive into a small pool of highly rated corporate borrowers. The change in investors’ taste to wholesale credit provider will see bigger NBFCs shift their reliance to bonds from short-term commercial paper, opening up access to varying tenure and quality of debt just as companies will step up buybacks and dividends to shore up valuations following the departure of foreign investors in search of higher yields. Collapse of important institutions, enhanced regulatory surveillance and increased shareholder activism will leave behind a basket of better quality paper as the crises will trigger mergers and acquisitions. It will encompass industries vulnerable to cycles and tight control such as banks, cement, telecom and steel as well as defensives including consumer goods and pharmaceuticals eager to be first off the shelf and for a niche perch. The side-pocketing of bad assets by mutual funds stemming from the IL&FS defaults will not be an isolated event as regulations will improve to address systemic weaknesses. The definition of too-big-to-fail will enlarge to encompass side actors. The rural consumption and infrastructure themes in the election cycle will leave behind a foundation to build on even after the end of campaigning in a manner that unrealistic promises will have the potency for somber realization the day after that there are no shortcuts to prosperity. 

 -Mohan Sule