Peering into 2009
Financial Express, 21 December 2008
The year 2008 will be remembered as one of the most bewildering times in the history of Indian finance. On the 1st of January, Nifty was above 6000. When the year ends, it could be at roughly 2500. In addition, the volatility of Nifty in this period has been unprecedented.
Liquidity on many markets collapsed, throughout the world. These included the money market in London, New York and in Bombay. Many stock exchanges, such as Moscow, Jakarta and Karachi, were closed down for short periods of time. OTC trading worldwide got into difficulties owing to non-transparency and counterparty credit risk, and led to massive difficulties for financial firms. In India, the equity market, the centrepiece of Indian finance, held up well. While prices dropped sharply, the market stayed resolutely liquid. The number of trades in the crisis period went up, not down. The market did not falter in its core business of looking at firms and trying to forecast their future profits. This was a welcome contrast when compared with the past, when large price changes were associated with scandals or systemic breakdown.
Resolutely looking at firms and forecasting their outlook is the task of 2009 and 2010. As of today, by and large, the firms of India are in good shape. They have unprecedented profitability, they have cash in hand, and low leverage. But the global economic downturn and the domestic business cycle downturn will affect all companies. Profit rates will drop, and many firms will go into the red.
At the same time, it is important to see that all firms are not alike. Some firms will do much better than others. The challenge for the stock market is to be discriminating, to treat two companies in one industry as unlike each other, and to treat different industries differently. Through the diligent work of stock speculators, very different P/E and P/B ratios will be awarded to different companies. This is a time for careful analysis of the fundamental data about companies, trying to peer into their future and understand how different firms might fare.
Two kinds of firms will be in distress:
- The first is the firm which is over-extended with high leverage. Some firms with a lot of leverage will deleverage by diluting their existing shareholders. Some firms with a lot of leverage will die.
A fascinating twist on leverage that we are seeing this time is borrowing by promoters. Many promoters have borrowed in their personal capacity. In some cases, promoters have shorted put options to institutional investors in their personal capacity, and these options are generally now deep in the money. Some of these CEOs will default on their loans. Their lenders would then sell shares pledged by them on the market, thus reducing promoter shareholding and accelerating India's evolution towards dispersed share ownership.
- The second kind of firm that will be in distress is one which is fundamentally unsound. For the last six years, the rising tide has lifted all boats. Weak companies are a patchwork of products and processes, obsessed with high rates of growth and good valuations, while suffering from shaky foundations of technology, HR, processes and product development. Many companies are focused on putting out press releases and indulging in media hype to drive up their valuation, instead of doggedly working on strengthening their business. These kinds of firms are likely to go under in 2009 and 2010.
Going under does not have to be a messy bankruptcy. The sensible ones will see that the game is up, and sell off factories, brands or the company. The worst trouble will befall the companies who do not have factories or brands that command significant value; where the emperor actually has no clothes.
Some companies who are facing difficulties will resort to unethical practices. Bottom lines in annual reports will be propped up by sale of assets, or not recognising losses on currency derivatives, etc. For investors and analysts, it will become particularly important to use `normalised' accounting data so as to be able to obtain a consistent picture of what is going on in a company, with comparable data across companies and across time. Some CEOs will resort to unethical or illegal activities when placed under acute stress. A few scandals will hit the front pages of newspapers. When this happens, the focus should be on how the institutional framework can be improved to forestall a recurrence of these scandals.
There is a mood in India today that firms are in difficulty for no fault of theirs and thus fairness demands that the government should help them. This is the wrong way of thinking about the downturn. Firms are in distress today for no fault of theirs exactly as they feasted in the buoyant business cycle conditions of 2002-2008 for no fault of theirs. It is times like these which separate the men from the boys. The economy will benefit from the demise of murky business plans, the valuation-obsessed CEO feeding the media with hype, the companies who are more interested in press releases than products. The exit of weak firms will free up capital and labour which will then become available to better firms. In addition, profit rates of their healthy competitors will go up. As an example, many firms in India died in the downturn from 1997 to 2002, but that left the Indian corporate sector in much better shape as a consequence.
The defining theme of 2009 and 2010 is that of financial markets taking a good hard look at the 20,000 largest companies of India, many of whom will experience some difficulties. The challenge before finance is of picking who lives and who dies. For the Indian economy, adjusting well in the downturn is critically about the extent that the financial sector is discriminating, picks the right firms to support, and sees them through the downturn.
Indian banking is ill equipped for this challenge for three reasons:
- Banks are highly leveraged and have little ability to bear risk. If Indian banking suffers a loss of 5% of total assets, we will have a banking crisis on our hands.
- Second, banks in India like to lend to firms with strong historical performance, or firms that have assets as collateral. Banks in India are bad at looking at the prospective cashflow of a company and identifying the companies which have bad accounting performance but have a bright future.
- With PSU banks there is the problem of political interference which distorts their information processing and decision making.
For these three reasons, Indian banking cannot play an important role in the difficult financial activities of 2009 and 2010. The best equipped players for this challenge are in the stock market and the corporate bond market, where price discovery and the financing of firms is done by individuals, FIIs, mutual funds, and private equity funds. These are the participants in Indian finance who have the best incentives -- and the political independence -- to dispassionately analyse companies and discriminate between those which are fundamentally sound as opposed to those who are not.
From an investment perspective, 2009 and 2010 is going to offer remarkable buying opportunities for the long run. Long-term investors will do well by loading up on equities in this period. The corporate bond market will also offer attractive propositions. But in the short term, this will be a daunting time. The greatest benefits will go to the discriminating speculator, who is able to thoroughly study firm fundamentals, make calls on which firms will prosper across the downturn, and choose good entry prices for buying shares or corporate bonds.
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