Stress Ahead, Distress Priced-in?

BizNotes_April_20

Private Equity and Public markets are far-cry from each other when it comes to marking down valuation. For PE industry, protective masks in the form of “marked-to-myth” come handy during pandemic outbreaks. Without the access to that mythical protection, public market funds, where valuations are marked second to second, start dancing to the sound of every sneeze and wheeze. If one is marked-to-myth, the other is marked-to-madness. This note is not about myth versus madness, but to discuss more about the myth behind the ongoing mayhem.

No one can argue about the stress that is ahead for the economy on account of lock-downs across the globe. The stock prices need to adjust for the impending recessions across developed markets. Whether the recession will be shallow or deep is difficult to say at this point of time. The debate is not on whether the stock prices need to adjust, but on how orderly or disorderly it can be. No assets in financial markets adjust orderly for the new information or the new situation, be it equities, currencies or commodities. The nature of the beast is such that every adjustment, upwards or downwards, are brutally dis-orderly. It is no different this time. But the new fancy features of the beast, such as, algo trading, passive ETF bubble (more in US) etc. are adding fuel to the fire of familiar old time suspects like margin-calls, speculative unwinding etc., This fancy combo has conspired with other panic sellers to wreck a brutal bloodbath in markets, that too in a very short cycle time of few weeks, which would have normally happened over few months in the past crises. In such dis-orderly adjustments, deep under-shooting is inevitable. Though screen may look scary, investors shouldn’t resort to selling during under-shooting as it will make the pandemic losses (notional) permanent.

Going beyond the technical context for the correction, what about immediate fundamentals? Easy to see that there will be a washout for earnings in this and the next quarter for many businesses. In our view, no business will be spared because of second and third order impacts across the economy. For many businesses, it will be a survival issue, esp. if they carry any balance sheet related risks. Debt can become a great de-railer for many companies. Across the spectrum (large to mid to small caps), companies with higher gearing (high debt to equity) may face survival risks. On the flip side, companies with low debt and high cash surplus may come out stronger from this crisis as they equip themselves to gain market share from weaker ones that will battle for survival. This will be the case across the spectrum including quality small-caps.  Portfolios built on conservative approach with stocks with low debt will have much less to worry.

But what about medium term?

Right now, market is in the mode of scoot and run. First sell and then think later. In such mayhem, it is easy to lose sight of anything that is not in the immediate vicinity. But when the dust settles, market may start looking at some of the India specific opportunities (listed below) that are arising out of this crisis.

  • The Covid crisis is now expected to accelerate the china-hedging process that has already begun post US-China trade war in many of the global corporates. Reducing china dependency is no longer a cock-tail discussion for many companies worldwide. It is a serious issue facing many boards today. When it is translated into action, India is likely to be one of the potential beneficiaries, esp. in industries where India is globally competitive. This is likely to incrementally boost growth in the medium to long-term, esp. with the new concessionary corporate tax regime of 15% for the new investments in manufacturing.
  • Amid the rising fears of global slowdown and recession, it is important to remember that the following factors that are likely to alleviate the impact on India.

 

  1. India is coming off from a deep deleveraging cycle and a decade low growth. Since impact from global recession is mainly fed thro’ credit crisis, given the deleveraging that has already happened in many of the balance sheets, impact from global recession is likely to be limited (on relative scale) on this aspect, though there will be a collateral damage.
  2. Being domestic and that too consumption driven economy, India will be relatively insulated. Since it is coming off from a low base, any incremental growth that can potentially come from low oil prices and from china hedging, will make it look respectable for global investors, esp. if the Indian Govt. contains the covid crisis successfully (initial signs do give hope on this). In such a scenario, out-performance of Indian markets (after the dust settles) can’t be ruled out, esp. when India has more headroom in both fiscal and monetary policies in comparison with global peers. Recent RBI bazooka is a case in point (75bps cut in repo and other large liquidity measures).

At the moment, the consensus view is to wait for clarity. But, as past cycles show, one has to pay a heavy price for clarity. When cloud clears, prices will be already up. For those who are already well invested, it is not the time to panic, but to add to the portfolio by taking advantage of the pandemic prices. For those lucky few who are sitting on high cash, no better time to start deploying than now.

Happy Value Investing!!!

 

 

Scared of small-cap investing? Here’s how one can avoid landmines in small-caps

FinExpress_Mar20

There are two ways to look at small-cap investing. One, take a very conventional view that it is a highly risky space and avoid it all-together. Goes with that, is all the potential reward as well, as one says no to the alpha generation (higher returns that come from small-cap space). The other is to take a more contrarian, but an objective approach. That is, take the pain to understand the various risks in that space and build a process to mitigate those risks. This is more demanding, but rewarding in the long-run, as the whole game in small-caps investing is all about weeding out bad apples. This piece is an attempt to cover the critical steps (below) that are required in the stock selection process to mitigate the risks in the small-cap space.

Nature of risks in small-caps:

Small-cap is not a sexy space, notwithstanding the seduction of spicy returns it promises to lay investors. It is a space which is infested with lot of risks. They are many, but the prominent ones are,

  • Sub-scale and unproven business model
  • Poor governance
  • Key man and succession risks
  • Leverage and balance sheet risks
  • Management depth
  • Client concentration risks

These are mighty risks and the process to mitigate them may seem herculean at the first look. But the good news is, it can be distilled with few basic hygiene filters which, surprisingly, can surmount much of the risks in this murky space. Though these filters are simple, sticking to them in a disciplined manner when spirits run high (bullish time), is not easy. That is what makes this process fascinating.

Let us look some of the most crucial ones.

Debt: The great derailer:

There is a twin side to the debt story. The same debt that is greeted with cheers in bull market, turns into a dreaded one in the bear market. While it can spruce up returns in the upturn, it has the lethal power to turn a liquidity issue into a solvency crisis in the down-turn. In that sense, it is a dangerous beast. This much is well understood. But, what is not that understood and appreciated is the extra-ordinary influence the debt has on the overall governance standard. One thing that constantly pops out from our extensive experience in small-cap investing is this – if the business doesn’t need debt to grow, there is less likelihood of mis-governance in that business.  At the first sight, this co-relation may seem odd, but every down-cycle has shown that the real catalyst for corporate mis-governance is rooted in debt. When debt puts additional pressure on the management in a down-cycle when the business is already under duress, there is extra-ordinary incentive for the management to pursue the sub-standard governance practices. In this case, the debt pushes the otherwise okay management into below-board practices (Zee Entertainment is a classic example – group debt in the promoter entities). What about managements/promoters who are inherently unclean and with bad motive. For such managements, debt is a convenient alibi for siphoning money out. Hence one will find such managements loading up debt more than what the business might need as debts are taken with the intent of not repaying. In both the cases, debt is a very accurate indicator of potential governance issues that may be lurking under the radar. It leads to a surprising simple filter, that is, avoid excessive debt to avoid much of the risks in small-caps. To put it differently, look for businesses that hardly require debt to grow or more ambitiously, look for those that has the ability to throw free cash-flow after funding its growth capital.

Long operating history:

This is another critical metric to weed out the bad ones. Longer operating history essentially means that the business model is tested under many down-cycles and hence more robust. If it has survived down-cycles without facing liquidity issues, it also reflects stronger long-term financial position.

Sticking to Knitting (Focus):

In this era of mega expansion and diversification, talking about focus may seem odd. But, hardly anyone can over-estimate its importance, esp. when it comes to its impact on both quality of business and also on quality of management. As we have seen from our extensive research, sticking-to-knitting in a given segment over long period of time leads to solid specialization which in turn builds a durable moat in the underlying business. Focused management has less need to expand empire. With that comes less risk of unrelated diversification, either thro’ promoter pledging  or thro’ diluting balance sheets (loading up with debt). Both such actions have always led to deteriorating governance standards in addition to solvency risks as many examples have shown in the current down-cycle (many reputed groups like Eveready, Zee, Emami etc come to mind).

Conclusion:

The list of filters can go on. But what is explained above covers most part of the requirement. If one adds the other hygiene factors such as, management compensation, related party transaction, capital allocation track record, capital efficiency (high return metrics like ROCE/ROE) and skin in the game etc. along-with bit of scuttle-butt work on management’s quality/track record (channel checks in analyst’s parlance), one pretty much gets to size the overall management and business risks. Small-cap investing is much like “road-less travelled” poem by Robert Lee Frost – “Two roads diverged in a wood, and I – I took the one less travelled by, And that has made all the difference”.

Happy Value Investing!!

(as appeared in the online edition of Financial Express dt. 24th Mar’20)

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Luck Has Still Not Run Out For Bears?

Mailer_Mar_2020

No hiding from the fact that we are going through an extraordinarily difficult time for the market. Precisely when we thought that the luck has run out for bears in the broader space, market has been hit by a double whammy of COVID and Oil price war. This is after a glimpse of hope (from the first signs of momentum in small and midcaps in Jan-Feb) that things may be turning after a long and painful bear phase in the broader markets. The light at the end of tunnel turned out to be that of a speeding train. It does test the tenacity of last few standing value investors. Outbreak is not limited only to COVID in this social-media-driven frenzied world. Everything is an outbreak, but with a short shelf-life in such a wacky world. After this final (hopefully), but a painful lap of capitulation, as one may call it, with more or less everyone throwing in the towel, is there a hope for the few who are left.

In the short-run, what would happen is anyone’s guess. On one side, COVID news-flow will keep the markets edgy while on the other side, the talk of stimulus from Govts and the hope of co-ordinated actions from central banks will keep the market’s hope alive.  Push and pull forces from these opposing news-flows are expected to keep the markets extremely volatile in the short-term.

But what about medium term?

Right now, market is in the mode of scoot and run. First sell and then think later. In such a mayhem, it is easy to lose sight of anything that is not in the immediate vicinity. But when the dust settles, market may start looking at some of the India specific opportunities (listed below) that are arising out of this double whammy crisis i.e. boiling corona amid plunging oil.

  • Oil price, if it is sustained at this or around the current level, will give a huge headroom for both fiscal and monetary stimulus. RBI, constrained currently by inflationary challenges, will have more elbow room to cut rates. Similarly, with reduced oil price, govt. will get the additional leeway to hike spending or pass on the benefits in oil price to stimulate consumption.
  • Covid crisis is now expected to accelerate the china-hedging process that has already begun post US-China trade war in many of the global corporates. Reducing china dependency is no longer a cock-tail discussion for many companies worldwide. It is a serious issue facing many boards today. When it is translated into action, India is likely to be one of the potential beneficiaries, esp. in industries where India is globally competitive. This is likely to incrementally boost growth in the medium to long-term, esp. with the new concessionary corporate tax regime of 15% for the new investments in manufacturing.
  • Amid the rising fears of global slowdown and recession, it is important to remember that the following factors that are likely to alleviate the impact on India.
      • India is coming off from a deep deleveraging cycle and a decade low growth. Since impact from global recession is mainly fed thro’ credit crisis, given the deleveraging that has already happened in many of the balance sheets, impact from global recession is likely to be limited on this aspect.
      • Being domestic and that too consumption driven economy, India will be relatively insulated. Since it is coming off from a low base, any incremental growth that can potentially come from low oil prices and from china hedging, will look respectable for global investors. In such a scenario, out-performance of Indian markets can’t be ruled out, esp. when India has more headroom in both fiscal and monetary policies in comparison with global peers.

It may sound cliché if we conclude this communique by saying that the darkest hour is just before the dawn. Many false dawns have come and gone, as we all know. But, is it not a mystery that the darkest hour in the night is not “mid-night” as anyone would intuitively think? The jury is still out there on why it is darkest just before the dawn. Is it a known-unknown?

Happy Value Investing!!

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Value Investing: Back to the Future?

BizNotes_Mar20_Rev1

In 1985 Hollywood flick “Back to the Future”, the protagonist needed the time machine to travel back in time. Value investors rarely use such sophisticated machines to back-test in time. Simple travel back in time in memory would do. It was year 2013. Going back there was like travelling to the future of 2020.  It was like setting the clock back to the future. Scanning the headlines in financial dailies back then, it exactly feels like 2019 and 20. What is fashionable now, was fashionable then too. Take for example the headlines that screamed – The Death of Value Investing; Is Bubble Building in Quality? Flight to Safe Haven Stocks etc. – they equally reverberate now in financial and business headlines. But what is interesting is, in the interim between 2014 and 2017, this fashionable theme quietly lost its fancy when small-cap story rose from ashes like a phoenix to dominate the narrative for three successive years.

How does one take the current headlines that are flashing in the financial dailies? As one headline goes, the well-known veteran value investor has succumbed to his self-doubt and become a neo-convert who has fallen for his new found love for quality. Of course, in the social media, there is a huge chatter that yells ills about value investing. That begs the question whether value investing is dead for the second time or forever?

Fundamentally, value investing doesn’t stand in isolation. If it is only value for value sake, it deserves to be deserted. But, if growth is embedded in value, then, that value investing is very much valuable and it will continue to vault, though with hiccups here and there. Similarly, “quality” is not the exclusive possessions of some coveted coffee-can-clubs or the neo-converts or privilege of much fancied large caps. It is equally relevant in small-caps. Nothing to beat the value that comes from trying to buy “quality-cum-growth” at a discount, be it large-cap or small-cap. Of course, in small-caps, such spicy opportunities spurt more often, because the space is under-researched and under-covered (also more volatile).

To borrow a phrase from one of the seasoned stock pickers, value investors are like a group of beasts now that is being hunted to extinction. Why? It is not difficult to fathom the reasons. Value as a strategy has been under-performing for an extended period of time since early 2018, because of flight to safety and polarized market dynamics. Even the last man standing out is being tested for his tenacity. Should the last few standing be worried? No. If one sets the clock back and look at the past 2 decades, one would find that neither this narrative (that value investing is dead) is new nor the crowded trade in quality is new. There has been only one thing that has been constant across cycles. That is, every strategy has a day under the sun and only thing that has always worked all the time is “reversion to mean”. It is a question of time before market takes its fancy to value, though it is difficult to predict the time of the turn.

Seasoned investors understand that every strategy has its time of out-performance and has its time of under-performance. The key is to stick to a strategy and not to flirt around with the flavor of seasons. Stay the course to smell the roses, however hard one is being hounded.

Happy Value Investing!!!

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