Do it yourself

Thursday, June 18, 2020

Investors Beware - 3

The financial sector has massively underperformed the broader markets in past three months. A number of experts have called for increasing exposure to this sector in view of this underperformance. They have argued that valuations are now discounting the worst in terms of COVID-19 related delinquencies and the economic activity shall normalize in next 2-3 quarters. The consensus amongst experts is veering towards outperformance of the sector in next 12-15 months. It appears that many non institutional investors are in agreement with the experts' opinion and have increased their exposure to the banks and NBFCs, especially the low priced ones.

I would like these investors take note of the following data points while increasing their exposure to the financial sector in India.

(a) The capacity utilization of Indian enterprises peaked at 83% in 2011 and has ranged between 70-75% since then. It declined to below 70% in 2QFY20, much before the COVID-19 induced lockdown took place. The business sentiment is at multi year low, indicating that businesses do not see any sustainable rise in capacity utilization and need for capacity addition in short term.

Consequently, the project announcement has declined in past five years, from 17% of GDP in 1QFY16 to about 5% of GDP in past 4 quarters. The project completion rate has also declined materially.

This does not augur well for credit growth in the short term. Any growth in credit demand will come from mostly from consumption and working capital requirement. The quality of credit shall therefore remain under pressure, and ALM issues will persist.

(b) Consumer confidence is at lowest since 2013, and the employment outlook has worsened materially. This shall keep the fastest growing credit category (personal loans) under check as the borrowers' credit profile deteriorates.

(c) The liquidity in the system is surplus, and it is likely to remain so in the short term. The call money rates are now closer to reverse repo rate, rendering overnight market competing with RBI.

Besides, the bond yields are now below bank lending rates, even though the benchmark G-Sec yields are well above the policy repo rate. This shall pressurize banks to liquidate some of their excess SLR portfolios and lend aggressively in the market. The pressure on return ratio may increase while the credit quality remains under pressure.

(d) MF as source of corporate funding (especially working capital and promoter equity) has come under pressure due to a spate of defaults in past one year. This could bring some short term financing business back to banks. But the events of moratorium in case of Yes Bank and PMC Bank have left scare in the memories of depositors. They are increasingly veering towards larger banks, especially large PSBs. The cost of funds for smaller private banks may therefore rise in the short term.

(e) The mutual funds and banks are wary of lending to non AAA rated borrowers, especially NBFCs. The cost of funds and availability of growth capital may remain a major constraints for these NBFCs, at a time when the delinquencies are expected to rise once the loan moratorium ends in August.

Personally, I would exercise little extra caution in making fresh investment in any financial stock. For asset allocation discipline, I shall stick to top 4 banks and top 4 NBFCs.

Wednesday, June 17, 2020

Investors Beware - 2

The rise in equity indices in the wake of global pandemic and its long term socio-economic consequences is keeping most experts busy. The central bank bashing is the favorite theme of market participants, like anytime in past 33years, ever since Alan Greenspan took over the Chair of US Federal Chairman and assumed the role of the "champion of stock markets" after 1987 market crash. Since then the markets have been overwhelmingly depending on the central bankers to support any fall in stock prices.

Greenspan is criticized for both creating and causing the burst of dotcom bubble in 2000. It is popularly believed that the easy monetary policy unleashed by him during 1990s to support Clinton's deficit reduction program led to creation of massive dotcom bubble. It is also a popular belief that hiking rates many times by Greenspan in 2000 led to bursting of dotcom bubble. Both the popular beliefs are however contradicted by the empirical evidence. Greenspan was actually a monetarist who religiously followed the Taylor Rule of inflation targeting. In 2000 also, he started raising the rates only after the bubble had already burst. Till the party was on, he neither hiked rates nor tightened the margin requirements. He again supported the markets by a series of cuts post 9/11 incident and was widely blamed for rise in asset prices, especially gold and building of sub-prime crisis.

The detractors of present Fed Chairman are criticizing him for taking the economy for a tiger ride. They fear that the ride could end only in one way, i.e., the tiger jumps off the cliff taking the economy into the deep abyss with it.

(Strangely, back home RBI is being criticized for not emulating the central bankers like US Federal Reserve, European Central Bank and Bank of Japan etc.)

As an investor, I am carefully watching the global monetary policy actions and taking note of the following:

(a) The printing of new money by Fed, ECB and BoJ may not be too much of a problem as yet, as presently the money velocity is at lowest in recorded history, and any new dollar printed does not augments the money supply in any measure. So one should be watching money velocity more closely rather than the amount of new dollar/EUR/JPY printed.

(b) As per the Bank of International Settlement recent data, the current total international debt securities outstanding is over USD25trn. Out of this about 50% debt is denominated in USD terms, and about USD2trn of this USD denominated debt is maturing in next 12 months. Despite the unprecedented amount of load on the printing presses, there may not be sufficient USD available in the world to discharge these liabilities.

One should be watching this space closely to see how this debt is discharged or rolled over and at what price. Shortage of USD in international markets for discharging these liabilities could result in temporary spike in USD exchange rates. The borrowers who are not fully hedged against their USD liabilities could face serious solvency issues. Also the effort to develop an alternate reserve currency, preferably a neutral currency, shall also accelerate putting pressure on USD. This game of push & pill might lead to heightened volatility in currency market raising the cost of hedging. The impact on exporters' earnings needs to be observed closely.

(c) More than USD11trn worth of bonds are presently yielding a negative return. This means the low rates are here to stay for longer; and the central bank shall continue to pump in cash in the system to grease the wheels of economy. The COVID-19 led deeper recession shall require even more new money to fill the larger fiscal gaps. For next couple of years this should not be too much of a worry for asset owners. But one needs to be prepared for the eventual collapse of the fragile mountain of debt.

....to continue tomorrow

Tuesday, June 16, 2020

Investors beware

The public sector capital goods bellwether company Bharat Heavy Electricals Limited (BHEL), reported its earnings for the fourth quarter and financial year ended on 31 March 2020. The numbers were poor and quite off the mark from what the equity research analysts had forecasted. For the quarter 4QFY20, the company reported total revenue of Rs50.5bn (vs Rs103.7 yoy); and for the full year FY20 the company reported revenue of Rs210.9bn (vs Rs304.41bn yoy). The revenue for the quarter was down ~51% yoy; and for the full year it was down ~29% yoy.

The research updates on BHEL by various brokerages raised three points in mind, which I find are critical for investors (especially the smaller one like me) to assimilate. I would like to share these points with the readers as follows:

(a) In the notes to account, BHEL reported that in 9 days of lockdown (23rd March to 31 March) Rs40bn of revenue was lost. This is appx 39% of the 4QFY19 revenue and 13% of the full year FY19 revenue.

A large number of companies which have declared results so far have reported similar loss of revenue. (Please note I am talking about revenue here not profit). To me this sounds disproportionate for most of the companies.

I have spoken some senior chartered accountants to understand this phenomenon. Most of them informed that it is a regular practice amongst Indian corporates to manipulate the revenue of the month of March. In some cases the revenue of March month is shifted to next financial year (April); and in the other cases the revenue earned in April is accounted for in the month of March. In the last week of the year, some auto and FMCG companies dump inventory to their dealers to book revenue which is not actually earned. Conversely, in cases where the companies want to show lower revenue and/or profit, they book "sales returns" in the month of March and "resale" in the subsequent months.

In case of project oriented companies (real estate, project construction etc), which follows percentage of completion method the practice of manipulating the revenue for month of March could be even more widespread.

Please note that lower revenue booked in the Month of March by most companies is certainly not due to accounting issues, for they get full 3 months to complete the accounts for the financial year and month of March.

(b) The consensus estimates of various equity analysts for BHEL 4QFY20 revenue was Rs87bn. It reported revenue of Rs50.5bn instead. There have been wide divergences in the analysts' estimates and actual reported number, even when adjusted for no recurring and exceptional items. In past five year, I have noticed, the one year forward Nifty EPS estimates consistently diverging 12-18% from the actual numbers.

This must raise serious questions about the efficacy and utility of the forecasting portion of the equity research function. There is enough evidence that the forecasting by research analysts has been off the mark; still a large number of non institutional investors place material reliance of such forecasts. SEBI must consider making it mandatory for the research analysts to adequately explain the divergence in their forecasts and the actual adjusted numbers; else the analysts may be restrained from making forecasts.

(c) BHEL is a navratna company. For past one decade it's been racing fast downhill to join the junk yard with MTNL, Air India et al. Quarter after quarter its balance sheet is deteriorating; and revenue & profit growth is declining. No one in the government however appears concerned. Its hard to fathom, why BHEL was not privatized a decade ago, and why it is not being done even today!