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Vishal Koul

My Best Pick 2015

Where are you, George?
Asset values are way out of whack but nobody is stepping forward to point out that the emperor has no clothes

Chaitanya Dalmia

Ever since I can remember, free market theorists have been advocating ‘pure and perfect competition’ (PPC). This ideal state, that is, PPC hinges on the over-simplifying assumption of a large number of buyers and sellers (incapable of distorting prices individually), any number of firms entering/exiting the market without any imposed restrictions or transaction costs and every market participant knowing everything at all times. The end objective, of course, is to provide goods and services to maximum number of people at minimum cost. While this is the best outcome for consumer markets, it would kill the ‘animal spirits’ in the producer markets, thereby curtailing supply and pushing up prices for consumers, thereby destroying the very crux of PPC.

Hence, in reality, we have all kinds of market distortions in the form of natural or artificial barriers. We have tariff as an international trade barrier, capital as a barrier in many heavy industries, brands and distribution as barriers in certain consumer industries, cartels in commodity markets, immobility and immigration laws in labour markets, traders who hoard produce etc. This is what keeps the animal spirits alive and the supply going. In essence, the term ‘animal spirits’ has an inherent dichotomy wherein it needs to be kept alive, while not being allowed to run amok. Curiously, ‘animal spirits’ are best flamed by cheap money and in the past decade, central banks have more than played their part.

Lender of first resort

The helping hand extended by most major central banks globally post-2008 seems to have created severe distortions in the capital market. An unprecedented, almost unquantifiable stash of liquidity has been unleashed as if money can actually create oil, minerals, alluvial soil, clean air and water etc. The fact is that money can only buy these things, not create. (It’s a different matter that money can’t even buy love, honesty, health, etc – but that’s for another day). It seems that so much liquidity has been artificially created that virtually everything on this planet can be bought, and still some surplus liquidity will be left over. And this should really imply inflation on a massive scale. Inflation rate very simply is more money chasing less goods and services. Clearly, money supply has increased without any increase in real demand (though artificial demand has been ‘manufactured’) but inflation, as traditionally measured is still under wraps. 

On a related note, central banks are supposed to balance growth and inflation. The best case is benign inflation that lays the ground for healthy growth. However, a balance needs to be maintained even between benign inflation and deflation. While hyper inflation can lead to a crippling impact on growth, income and wealth, deflation can send animal spirits into prolonged hibernation. Most global central banks have been guilty of letting capitalism rule the roost, for longer than they should have, so long as it produced winners. However, they have taken every pre-emptive action that they possibly could to prevent the losers from losing; all this in the garb of trying to prevent deflation. However, my sense is that with debt/GDP beyond 100% and with anaemic growth of 1-2%, it’s hard to see a way out of this money-printing except by debasing the value of money. So even though the intent of the central banks is to prevent deflation, the longer they continue with their free-money policy, they might actually be strengthening the foundation of a hyper-inflationary world.

Capital (mis)allocation 

This liquidity glut induced me to think about the impact it is having on traditional parameters of valuation. One such parameter is Ebitda. It has its own utility for lenders and bondholders. It also has some utility for equity holders. Ebitda can be the sole yardstick only for equity holders who invest in capital-light businesses, whose cost of borrowing is close to nil, and who invest through tax havens making their tax liability nil. But in recent times, its use has been over-extended and applied to places even where it does not appeal as much as some other parameters should. It has gained overwhelming prominence amongst equity holders which is distorting asset-markets, perhaps irrevocably. 

Equity holders comprise of businessmen (promoters) and financial investors (private equity investors, institutional investors – FIIs or mutual funds or insurance companies – or even the public). Strangely, intoxicated by unsurpassed liquidity and fuelled by M&A brokers, financial investors have managed to seemingly convince many businessmen to keep investing in assets, without caring too much, about whether the assets churn-out cash flows. Total return for a financial investor is dividends plus capital gains arising from the increase in the value of the financial instrument but the returns for the promoter should really be “Profits after Tax”. However, we have this deluge of capex undertaken in the past many years by several businessmen which is being justified by the increase in the created asset’s replacement cost (and hence value) over time, than by an increase in operating profits. Even legislators/accountants are facilitating such dubious activity through what is termed as “fair value accounting”; whatever happened to the “conservatism principle” taught to a class XI student of accountancy. 

 

A few billion here and a few billion there soon adds up to a trillion

The cumulative balance sheets of central banks has doubled with China leading the way

Consequently, these days it’s almost a matter of pride to have “goodwill” and “revaluation reserve” in balance sheets. It’s a self-fulfilling, albeit fallacious (and I dare say, malicious) prophecy wherein you raise debt, invest in an asset, gold-plate it and thereby contribute to asset inflation, and then claim its value has increased more than proportionately citing the very same inflation which you caused in the first place. In other words, even businessmen have turned into investors by virtue of this liquidity glut. So, most debt-ridden companies are ‘coincidentally’ blessed with surplus trophy assets which can be ‘easily’ sold off at the flick of a button to service their debts. Taxes on supposed gains accruing through such mysterious fantasy sales are also conveniently ignored; well, at least they have Modigliani & Miller on their side! And even though they can supposedly sell assets any time at their desired price, they don’t. They want to keep waiting indefinitely for the ‘greater fool’ who would buy the asset at the desired price, while forgetting that the interest clock is ticking and eating away the already meagre operating cash that the core business is generating. Maybe, that ‘greater fool’ has perhaps wisened a little, with the result that the businessman cannot sell the asset as opposed to his whim of not wanting to sell.

It’s funny that lenders are justifying their lending on the basis of assets that the borrower has; and the borrower is also justifying his ability to service the debt by claiming he has assets. Traditionally, lenders looked at operating income of borrowers as a source of repayment of the loans. But now it appears we are in the age of “Ponzi borrowing” as described by the late economist Hyman Minsky. Rating agencies are also playing their role by being perennially behind the curve and giving their nod of approval. Incidentally, the rating business is the coolest racket on earth where you make a 60% margin by deploying negligible capital and all you have to do is nod, and the icing on the cake: rating is mandated by statute! And if something goes wrong, just say it’s a black-box model and that we are just expressing an opinion without any recourse to be held liable (more on that some other time). But nobody is asking the vital question of what the value of an asset which is not producing anything should be, and whose value is just a whim of just about anyone. 

Dog that didn’t bark

Due to such benevolence, there aren’t many losers. Is making money, then, become that straight-forward? If it has, there are two possibilities. Either wealth is being created, or it’s a zero-sum game. If wealth is being created, incomes should accrue before/while wealth is created. If people are still making money without incomes accruing, then it’s akin to a khoi bag at a children’s birthday party where the central bank is showering relentlessly and investors are scrambling to gather as much of the loot as they can. 

The two baffling data points that come to light in this regard are as follows: The first is on heavily indebted Indian companies which don’t seem to be earning enough to service their debt. I used Debt/Ebitda as the parameter to assess the same. The top 100 such companies had an average D/E of 2.7x, average interest coverage ratio of 80% and average Debt/Ebitda of 10.5x. 63 companies are making losses, and among them, have a total debt of ₹680,000 crore. If we increase this number of companies to top 200, the average D/E improves to 2.1x, average interest coverage ratio improves to 122% and average debt/ebitda comes down to 7.2x. 89 of these companies are making losses, and they have piled-up amongst them a total debt of ₹1,270,000 crore. All this data is based on FY14 consolidated results. Unfortunately, nothing much has changed in H1FY15. Implicitly, banks have made provisions and shall continue to take larger haircuts, but it’s hard to imagine who would plug the rest of the gaping hole?

The second data point is a list of 70-odd Indian listed companies where between 50-85% of the free float is captured by foreign and local institutions (ex-insurance companies). And since the incentives of people at the helm of such institutions are heavily loaded on the long side, they would do anything to keep the NAV and AUM up. So we have companies trading at 50x and 60x and 70x and even more than 100x P/E; and this despite the underlying corporate earnings not really justifying such valuations. The P/E (trailing twelve months) of Colgate has gone up from 34x in April 2014 to currently 48x. Similarly, Nestle from 42x to 53x, HUL from 33x to 44x, Dabur from 36x to 43x, Marico from 28x to 38x, etc. This is despite sales growth being slowest in the last many quarters for some of these companies (in some cases, up to eight quarters!). Similarly the P/E of some pharma companies have gone from mid-20x in April 2014 to mid-30x currently. The two other sectors which are captured by these institutions (partly overlapping with the two mentioned above) are MNCs and scarce/unique ideas. So, any MNC with a 75% parent holding is supposed to be a delisting candidate that justifies a ‘mu-maangi kimat’ for the tenderer (Blue Dart > 115x, 3M 90x, Kennametal 90x, Glaxo Pharma 60x, Bosch 60x). Scarce concepts in the listed space also command mind-boggling valuations (Just Dial 80x, Info Edge 80x, Jubilant Foodworks 75x, Page Industries 70x, Eicher Motors 60x etc.). The valuation of concept stocks in the unlisted space are truly what Warren Buffett calls Alice in Wonderland (upto 1000x sales!). Finally, we have some random stocks from not-so-fancied sectors such as retail, textiles, ancillaries, construction/realty and capital goods etc. which also find a place in this list; clearly a case of the fund manager trying to buy as much floating stock as he can, so as not to let his NAV drop and pre-empt a premature end to his career.

Flowing from my tirade, this is the inference:

  • We have global central banks creating credit as if that can make people spend on anything and everything round the clock.
  • We have asset prices going through the roof in most parts of the world. 
  • Very meagre operating profits to show for a host of businesses.
  • Massive amounts of funding chasing ideas which are sub-par.
  • We have lenders taking majority of the haircut on under-productive assets that they have financed.
  • Promoters are going virtually scot-free even if they haven’t distinguished well between taking a calculated risk and gambling. 
  • Financial intermediaries are merrily sprucing their NAV by queuing-up on only one side of the trade (thereby pocketing their bonuses and also increasing their assets under management).

It doesn’t add up

To sum up, two parallel things are happening here. First, local banks are lending not on the back of earning capacity or the book value of assets, but on the basis of a notional value of the pledge of the underlying asset. Second, institutional investors are playing football with one another in a race to the supposed top. In both cases, there is a shortage of sellers of either the underlying assets of borrowers or of financial assets. There is no revival either of underlying demand which would show-up directly or indirectly in income accruing to some component of the economy. And it’s the merciful central banks that are playing God here and blessing the casino. 

 

Give me all you got and then give me some more

Bailing out those 'too big to fail' has filled the Fed's treasure chest with all kinds of paper

Something’s got to give. Either we should have inflation in its most destructive form or asset prices must crash and the invisible hand of the markets must force many players out of business. Or bafflingly, we have entered a new phase in the global economy where the fundamentals of hard work and law of demand and capital structure and traditional parameters of measuring risk and valuation have been dusted away and it’s a free for all. 

The trouble is, unlike the markets for goods and services, the price in the financial markets are set by the marginal demand as opposed to aggregate demand-supply factors. And since the financial sector is contributing a much larger chunk of the GDP than in the past, it’s turning out to be the case of the tail wagging the dog. This was most starkly visible when the price of crude refused to crash (due to long positions in the derivatives market) despite years of slowing demand before it finally gave in during the last few months (it should never have gone that high up in the first place since the underlying demand merely grew from 75 million barrels per day to 90 million barrels per day over the last 15 years but the price, thanks to the sheer power of money, gyrated wildly between $20 to $140 and is now around $70 per barrel). This is leading to a massive misallocation of resources, misdirected lending, mispricing of assets and perhaps misallocation of animal spirits too.

The central banks (mostly developed countries) are focused on creating demand out of thin air without realising that the majority cannot possibly be made to eat half a dozen meals a day, or buy new clothes every week, or buy a new gizmo every month, or buy a new car every quarter or buy a new house every year. Even if they manage to do that, it would entail an unforgivable damage to the environment and misallocation of resources which are always assumed to be scarce and limited. Moreover, just merely creating credit is not having the desired impact on domestic demand on their economies since a lot of the capital is finding its way overseas into emerging markets. In short, liquidity on its own is not enough for creating resources or jobs or even growing GDP; it’s an enabler like the internet, and the internet can’t satiate hunger. Given that global central banks cannot get over their obsession with GDP growth and are pumping even more toxins, we cannot bank on them to withdraw this liquidity and deflate this bubble painlessly.

Finally, it is a supreme irony that to address a crisis born out of excess liquidity, the problem was used as a remedy. It was a solvency crisis, and such crisis requires erring players to go belly-up to get the poison out of the system. Instead, it was treated as a liquidity crisis alone, and the can was kicked down the road. It’s hard for anyone to have the guts, wherewithal and sheer weight of money to take on this central bank-sponsored mad rush. We had only one George Soros to take on the might of Bank of England in the early 1990s. With liquidity having multiplied manifold since then and the scope of money having spread to virtually every aspect of the global economy, it would many a Soros to get some sanity in the marketplace or maybe a global revolution far bigger than Occupy Wall Street and Arab Spring. Let’s see what happens first: a Soros-equivalent appearing from the janta bearing the brunt of the financial mayhem, or a new Soros emerging in the financial markets. 

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