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VISHAL KOUL/ LOCATION: INDIA GATE, NEW DELHI

My Best Pick 2016

Ranting of a value investor
Economic growth is in limbo but asset prices continue to be valued abstractly

Chaitanya Dalmia

Robert Cialdini’s theory of influence lists ‘authority’ and ‘scarcity’ among the six principles of persuasion. And there are plenty of examples of both in the consumer market. Celebrity endorsements are an example of the former, while inaugural or exclusive offers, limited-edition etc. are examples of the latter. In fact, even airlines egg you to push the trigger by reminding you, ‘3 seats left’. Authority and scarcity are extensively used by peddlers to maximise the perceived value of a product/service regardless of its real value. More so when things which don’t have an overt physical utility (except inviting envy) like art, gold or luxury goods are in play. Art is perhaps where the value truly lies in the eyes of the beholder. Its value is randomly determined by prices quoted by different pairs of eyes in an art-auction. The price of gold also has gyrated in the last 15 years with the highest price being 6x its lowest price. 

In the financial markets, even funnier things happen. After the end of the barter system and abandonment of the Gold Standard, money’s most important use is as a medium of exchange. And when central banks endlessly open their spigots, it opens a Pandora’s Box where intermediaries with ‘authority’ start unduly influencing the price in real product markets. This phenomenon mostly explains what happened to commodity prices in the past decade, which moved far north than they would have if determined purely by the forces of demand and supply.

In the stock market, too, at any given instant, those who don’t care about intrinsic value far outweigh those who do. They operate in the realm of the abstract and so we see stocks quoting mostly far above or below their intrinsic value. This aberration is even more pronounced with one-of-a-kind businesses in the unlisted space. They command a premium over a business which has many listed options, even though the robustness, longevity and financials of the two may be similar. 

Just to illustrate how arbitrary a basis of valuation could be, at one point, dotcoms were valued on the basis of eyeballs. Then came a phase when they were valued on the basis of ‘cash burn’ (the quicker you spent, the higher the value). Later, a saner basis of valuation emerged, i.e., sales growth, even if it was a profitless one. We seem to be coming full-circle with the latest fashionable phrase being ‘disruptive digital’. Many net/app-based businesses are being valued on the basis of trading turnover (rechristened as Gross Merchandise Value), or number of listings or potential customers which/who would eventually (with generous dollops of hope) contribute to making some money. 

This is the beauty of virtually zero cost of money which magically and instantly travels several seas and equates an amount earned today to the same absolute amount earned a decade later. This creates an anomaly by valuing similarly unique businesses that shall keep earning handsomely till eternity, and businesses which are on the disruptive digital bandwagon shall hopefully earn something by eternity. This becomes possible by virtue of the latter type of businesses being abstract, which can command a valuation which can be as amok as the picture one can paint to support the same.

To add to this bohemian rhapsody, stocks with uncertainty of any kind (demand/supply, margins, growth, competition, regulation, etc.) are beaten down mercilessly by investors. For abstract to turn into reality, it must pass through grave uncertainty. Both businesses, one based on an abstract concept and another with on-the-ground long-serving business hinge on varying degrees of uncertainty. However, ‘disruptive digital’ which has much greater uncertainty is valued far more exorbitantly than the latter going through some relative moderate uncertainty. The following example will drive home this point. The current valuation of Flipkart is similar to Indian Oil Corporation (IOC) while the reported FY15 consolidated sales of the former is only slightly higher than the trailing-twelve-months net profit of the latter. Investors are implicitly more enamoured by the abstract future of Flipkart’s tripling sales (and with it, losses in the same proportion), than the massive and hard-to-replicate assets that IOC owns simply because these assets are on the ground and not abstract at all! To the naked eye, it’s easier to imagine IOC churning out money by utilising its assets on the ground than when and how much money will Flipkart make, whose sales are linked to the amount of discounts and losses that it gives/makes; which might itself diminish if the discounts are eventually withdrawn with a view to earn money.

 Fuzzy logic

This makes me wonder why such a humungous anomaly exists (or I just cannot fathom what’s going on – which is more than equally probable!). Looking at the whole process in terms of the ‘value-chain’ of a company from inception till its flotation, it starts with a few rounds of ‘angel’ funding, with the value increasing dramatically with each round. After a few rounds, venture capitalists (VC) enter the scene and here again a similar story is repeated. Right before the climax (i.e. IPO), private equity (PE) investors join the party. All-told, there might be anywhere between half a dozen and a dozen ‘investors’ who would have minted money at the speed of thought! In the end, in most cases (there are exceptions where all set of investors and the public have made a reasonable return), the public is left to hold the baby. (Disclosure: I have not been able to gather enough data on various deals to support my thought process, but I don’t remember reading about many lost deals. I request the informed reader to help me correct my view.)

A reading of the prospectus of IPOs defines the purpose of raising money as either to repay debt or for working capital (which can also be easily and readily financed by debt) or for general corporate purpose (operating expenditure). This is besides using the proceeds for IPO expenses. In some cases, a certain percentage of the IPO money is earmarked for capital expenditure. A preliminary student of finance would tell you that the cost of equity is higher than the cost of debt. In fact, a layman can tell you that if he is taking a risk with his money, he must be compensated more than the rate offered by a Fixed Deposit. So to raise equity money (higher cost) to repay debt (lower cost) is as absurd as it can get. (This could somewhat be palatable though if the capital structure is inappropriate and needs to be corrected with some equity capital infusion via an IPO.) 

 Give me the money

However, the cause for indigestion is that a significant amount of money raised these days is in the form of Offer-for-Sale which is really about giving an exit to an existing investor rather than raising money for the purpose of growing the business. With the scrapping of Controller of Capital Issues, the increasing influence of VC/PE funds in the private/pre-IPO market space, and the bulging size of IPOs and the burgeoning merchant banker fee linked to the amount raised, the public is increasingly being fooled into buying virtually anything at any price. Here, the sellers are a collusion of promoters, private investors and merchant bankers, and the uninformed and gullible public is the ultimate buyer at a price solely suited to and determined by the collusion of sellers. This is reflected by the fact that of all IPOs since 2007, 58% are underwater in absolute terms (without accounting for opportunity cost). Also, in aggregate, the total amount of money raised by 230-odd companies was₹163,000 crore, and its current market value is₹153,000 crore. That’s a loss of₹10,000 crore. If we add the opportunity cost @ 8% p.a., then this capital erosion climbs to more than₹100,000 crore. If we split the IPOs between PSU and non-PSU, then the performance of the PSU pack is better than that of non-PSUs. The issue related expenses (only for 210-odd companies, since data for the rest is not available) is a mind-boggling₹2,500 crore. 

Even more astonishing are businesses which actually generate free-cash and don’t really need any fresh capital but still come out with an IPO. These are mostly for either promoters or private investors or both to pocket some money at the cost of the public. The usual spiel in such cases is that they want to share the spoils with the public and help them generate/create wealth. How very charitable indeed! The latest high-profile IPO takes absurdity to the sky. It is not a capital light or a very capital efficient business, and the promoters cleaned up the balance sheet as well as the bank balance before raising fresh money. It is aerodynamically crafted to suggest that they don’t need the money though they require it. And here the dual-entity concept is binned; they is used interchangeably between promoters and the company. It’s an epitome of an oxymoron. 

Surely, the ability to influence key decisions governing a company deserves a premium. This is illustrated in most acquisitions of listed companies which occur at a premium to the prevailing quote on the stock exchange. Even in private deals between two corporates, there is a control premium built-into the pricing of the deal. However, when a company is IPO-ed, the buyer (in absence of investor activism) has no ability to influence any decisions taken by the promoter-management of the company. This ability is lost (by exiting private investors) or not gained (by incoming public investors) when a company transits from a private domain to the public market. However, during this process, there is no discount applied by the intermediaries (termed merchant bankers in this case) in the pricing for this loss of control; though the intermediaries (this time called stockbrokers, who are mostly born of the same mother) always apply a discount while valuing an listed company for cash or some cross-holding investments or some other valuable asset embedded in the company.

The way some sections of the equity market seem to be functioning is based on big funds and banks with not much to lose (most money managers keep their own money in their safe pockets), creating a saleable ‘story’ via a spin-doctored media who influence the public into buying the fairy tale. But of course, there can be no sellers if there are no buyers. So, equal blame must be attributed to the ‘retail investor’. Gordon Gekko famously remarked, “A fool and his money are lucky enough to get together in the first place.” Not just the infamous Gekko, even the venerated Benjamin Graham in his classic The Intelligent Investor in his closing remarks on new issues (IPOs) wrote: “It will be difficult to impose worthwhile changes in the field of new offerings, because the abuses are so largely of the public’s own headlessness and greed. But the matter deserves long and careful consideration.” This was written more than six decades ago. Since then, neither the regulators, nor the public has paid much heed. Instead, perhaps sensing this opportunity a new breed (angel investors, VCs and PE investors) has joined the party hosted by the promoters. 

 Don’t roll that dice

With the tenets of investing based on fundamentals, ingrained in me, what is happening in the private and public markets seem unjustifiable. To make me change my mind, I want to know what these angel, VCs and PE investors are seeing through their crystal ball. I want to know how their view might change if some of the ‘helicopter’ money is sucked out. I want to know how realistic are their time-frame assumptions about these investments making any worthwhile money? I would happily concede my prognosis to be wrong when these businesses start to make money adjusted for the highest premium for taking equity risk. Under all other circumstances, it’s wise to treat these rumblings as the goings-on of a casino without any moral stigma attached. 

However, readers who can’t bear the agony of their friendly neighbour doubling and tripling his money in such deals, they would do well (only for bragging rights) to jump right in with a tiny allocation to an angel/VC/PE fund so that even if the end is disastrous financially, it doesn’t disturb your mental wellbeing. And even if all goes well, don’t expect a miracle since the intermediaries will cut a fat fee and the taxman will take his fair share before you can ease into that hand-painted Mulsanne. The probability of discovering the next Facebook is infinitely worse than even the most favourable odds offered by any casino, even though the payoffs could be far superior to playing all-night roulette.

For those who have the discipline to stick to their tried and tested approach, they should look for opportunities in the public market. There are two ways to go about it, directly for the informed investor and through mutual funds for the novice. (Unfortunately or may be fortunately, high yield bond and private debt are out of bounds for both category of investors.) However, the trouble with mutual funds is that due to their large size and the current reality of low growth and not-so-cheap valuation, they are mostly positioned for safety (the institutional imperative). Safety of course is important, but safety of capital and not which comes through collective herding in blue-chips or flavour-of-the-season sectors. And safety of capital that is not only nominally measured but inflation and opportunity-cost adjusted. 

As far as I can see, it is very much possible that India’s GDP grows but that growth could come with stagnant profitability. This is because GDP is sales, and profit is what remains after filtering finance costs. But corporate balance sheets and the return profile of many businesses is such that not much profit remains even while top-line grows. And the equity market is about profit and not simply top-line growth. Also, whichever sectors have visibility are priced to perfection. However, across sectors there are many bottom-up ideas which merit attention. But even if they find a place in an equity fund, they have a negligible weight incapable of tilting the needle. Therefore the only way to play that is by digging a lot yourself and for that you need a lot of time and patience besides at least an intermediate knowledge of the art of investing. And if you can’t do that, it’s good to follow the words of wise men. To quote French philosopher Blaise Pascal, “All men’s miseries derive from not being able to sit in a quiet room alone.” Consciously deciding to do nothing (parking your investible surplus in a Fixed Deposit) is wiser than getting influenced by supposed authoritative people who are masters at creating scarcity and succumbing to your headless greed in  pursuit of the abstract. 

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