Market Outlook- June 2020

Contributed By : Navneet Munot, CFA, CIO- SBI Funds Management Pvt Ltd and Chairman- CFA Society India

Market Outlook

Elon Musk’s SpaceX created history by launching astronauts into the space for the first time ever from a commercially made spacecraft. This at a time when the world is still struggling with the virus lends out some hope, that we should not write off human ingenuity. It also underscores the importance of innovation and technology as key drivers for success in today’s era when some are seeing the crisis as an opportunity while most others fall by the wayside. It is no surprise then that big tech and biotech continue to drive the US stocks rally. Yet a continuation of the rally should not be taken for granted given the rising civil unrest in the US, the growing global clamour for protectionism and perhaps a potential second wave of the virus. And nor should be the dominance of big tech.

The deflationary environment of the past decade marked by low growth, low inflation and low rates has driven polarization of the stock market into select few winners globally. A structural break into a reflationary environment can reverse this. With a rapidly rising unemployed population and an ever-increasing number of zombie companies, this is all but vital. A regulatory backlash cannot be ruled out to correct this. More simply, aggressive fiscal measures complemented with accommodative monetary policy can help revive inflation globally, provided economies reopen enough to allow multipliers to work. That however is contingent on the progress of the pandemic with further waves of the virus staying the key risk.

The deflationary pulse has also led to continued underperformance of emerging markets, in line with the trend of the past decade. In a crisis, the challenges get aggravated as EMs cannot afford the same fiscal profligacy as their developed peers nor can their central banks explicitly monetize the fiscal deficits. Run on the currency and hyperinflation often result from deficits and direct monetizations perceived as incredible and unsustainable. History is full of such instances. EM performance bottoming out too will depend on return of reflationary forces with dollar weakness and commodities strength being the two key trends to watch out for. The recent rally in EM equities has indeed been fuelled by a pullback in the US dollar even as the sustainability of this pullback remains to be seen.

Indian market had been an under-performer within the EM complex in this crisis. Even though an environment of dollar strength and commodity weakness is usually associated with its relative outperformance given low dollar debt, high FX reserves and net imports of commodities. Yet, the still rising number of Covid cases, concerns on financial sector and lesser fiscal support all contributed to this weak performance. This, when we were already in a prolonged slowdown as underscored by the recent GDP print. The technical aspect of high weightage of Financials in the index also weighed on relative performance. However, recent signs of the economy opening up have led to a sharp rally for Indian equities helping reverse some of the underperformance.

The government announced a slew of stimulus and reform measures in a bid to seize the crisis as an opportunity and fight for a position of strength in the changed world order. Overall, it prioritized structural supply side reform over near-term demand boost. Reforms in the farm sector were encouraging and should help address the two key challenges of price discovery and value addition. Also encouraging was the intent for reforms around factors of production- land, labour, capital, and enterprise.However much more needs to be done on this front, especially on the last one – enterprise.

Corporate profits as a proportion of GDP have been dwindling for almost a decade now. Large profit pools are necessary to fund investments leading to employment and income generation. At a time when innovation and technology are key differentiators, these profit pools are critical to fund R&D. Aspiration to play a prominent role in the global supply chain requires pro-business policies that incentivise creating organizations of size and scale that can compete in the global marketplace.

The PM also talked about the government’s focus on laws. Judicial, administrative, and regulatory reforms are needed to align the machinery to this growth aspiration; accountability and efficiency must go hand in hand without compromising one for the other. We must leverage data and technology to accelerate our transformation. The thrust on uplifting the masses must continue as strong social capital is vital to fulfil our aspirations as a nation. The current migrant crisis needs to be carefully handled. Rehabilitating them is important, and so is keeping the rural economy insulated from Covid, as it has remained amongst the only bright spots so far.

Another thrust of the stimulus announcement was to revive the credit engine through credit guarantee support to MSMEs and to some extent NBFCs. This should help better transmission and allow money multiplier to kick in. Similarly, the focus on NREGA is welcome given its high multiplier impact. We believe this is one of the most productive ways of boosting aggregate demand and should be significantly scaled up. In the same vein, allowing additional borrowing by states with conditionality attached on reforms is in the spirit of cooperative federalism and makes immense sense given the higher multiplier of state spends.

Yet the gravity of the slowdown may force the government to spend more to revive demand. If additional borrowings are accompanied by a credible medium-term plan to revive growth, emphasis on structural supply side reforms, and a roadmap on fiscal consolidation, it may not be taken negatively by rating agencies. On the other hand, lack of growth will anyway deteriorate the debt profile through sheer interest burden. The recent downgrade by Moody’s is a quick reminder of this very dynamic. In any case, capital flows into India historically have been driven by growth prospects rather than ratings.

The RBI will need to undertake calibrated monetization of additional borrowings. On its part, it has been aggressive on rates, liquidity, and transmission. Yet the current yield curve is one of the steepest in India’s history. Given the sharp jump in quantum of bond supply (both G-sec and SDL), the market would be keenly watching the actions of central bank in creating additional demand avenues including OMOs. Additionally, further relaxations may be needed for greater flexibility to lenders on one-time restructuring. Hasten to add, while this is the crying need of the hour, we must keep an eye on hard-earned gains on the credit culture across all segments. It is our collective responsibility.

We have been maintaining a relatively high duration in fixed income funds. While structural view remains unchanged, we will take advantage of tactical opportunities as we expect bond market to be in a consolidation mode for the time being. Credit spreads are elevated, but they also reflect the economic uncertainty and constraints in the financial system and therefore we stay selective.

On equities, we are anxiously excited as we scout for winners amidst this chaos. With a deadly mix of issues ranging from a pandemic, country-wide migrant crisis, locust attacks, cyclones, earthquakes, border tensions with neighbours, a ratings downgrade, all coming together, India’s resolve is being tested. Adding to the macro issues, disruption is becoming a norm be it around consumer behaviour, technology, policy, geopolitics, supply chains, and so on. The response can be either to hope for normalcy to return or to seek opportunity in this apparent chaos. Firms that take the latter approach are likely to survive and thrive.

Winners will be the firms that stand ready to rethink and reimagine their business processes. Agility and nimbleness will matter more than size. Innovation and R&D will create lasting competitive advantage, and not the scale of physical assets. Planning will help, but more important will be creating strong feedback loops to prepare for unknown-unknowns. Risk management should evolve to account for black swans and also newer risk areas such as cyber security. Scouting for talent will be important, as will be re-skilling and holistic well-being of employees amidst the new Work regime. Treating all stakeholders fairly amidst the crisis will be vital in building trust, that in turn will help create long-term value.

As we navigate this period of heightened uncertainty, market gyrations will likely continue. Investors who identify these winners and have the patience to stay invested should end up reaping rewards in the medium term.

Is India’s equity market responding to the threat of climate change?

Contributed By : Labanya Prakash Jena, CFA

The financial sector is exposed to climate change risk

Climate change is threatening economic growth, food production, livelihood, and the financial system. In the “Report on Trend and Progress of Banking in India,” Reserve Bank of India (RBI) acknowledged that climate change risks could adversely affect the stability of the financial system. As climate change risk is recognized as a systemic risk to financial stability and potentially affect the performance of the portfolio exposed significantly to carbon emitting and polluting sectors, there is an urgent need to change portfolio allocation.

Interrelationships between the financial sector, real sector, and climate change

Source: Author’s Analysis

Climate change risk is going to adversely affect more to long term institutional investors like insurance companies and pension funds compared to short/medium term investors since both liability duration of these investors and realization of climate change are long. Climate change risk is more problematic for the insurance company since their liability is linked to the adverse impact of climate change. An increase in the frequency of natural disasters such as floods and storms increases the insurance claims and, consequently,growing liability for insurance companies. For example, total global losses due to weather catastrophes were $340 bn in 2017 due to weather catastrophes, out of which $138 bn were insured losses[1].Indian banks and investors have an exposure of $1.4 tn[2] to sectors that are prone to climate change risk – both physical and transition risks. In this scenario, the Government is expected to come out with policy regulation favorable to carbon mitigating economic activities and penalizing carbon-emitting businesses. Hence, the expected change in policy and regulation warrants the rebalancing of the banks and institutional investors’ portfolios and calls for a shift in their asset allocation in favor of green businesses.

Does India’s stock market react to climate change risk?

Source: BSE Database
Note: The S&P BSE Greenex is designed to measure the performance of the top 25 “green” companies in terms of greenhouse gas (GHG) emissions, market cap, and liquidity.

The above chart suggests that the “green” index has underperformed that the market index (BSE Sensex) over 2010-2019. The “green” index lagged the market, particularly after 2017, when India has come out with several measures to decarbonize the economy and made a commitment at the Paris Agreement to reduce carbon emission intensity of GDP by 33%-35%. Logically, the green companies should have performed better than the market since the Government is expected to deploy policy and regulatory measures to incentivize “green” companies and penalize the carbon-emitting companies. However, the above chart indicates that the Indian stock market has not captured environmental risks yet. The market efficiency theory suggests that market participants incorporate all the information in capital allocation, which reflected in the market price. However, sometimes market participants don’t have enough useful information to decide or do not know how to interpret available information. In the long term, the market will be more efficient as the companies start disclosing more information on climate risk and opportunity (either forced by regulator or investors or other stakeholders). Besides, market participants will be paying more attention as the impact of climate change become more visible and learn ways to interpret this material, climate change risk and opportunity, information.

Our primary research with institutional investors indicates that Insurance, pension, and mutual funds not focused on environmental risk. The financial market regulators such as PFRDA, IRDA, and SEBI have not paid attention yet on climate change risk in their regulatory guidelines. PFRDA and IRDA can make climate change risk assessment of portfolio as a fiduciary responsibility of fund managers, which can force them to incorporate this imminent risk in their investment decision making. SEBI can recognize climate change risk and opportunity as material information, and make regulation on compulsory disclosure of climate change risk disclosure of listed companies, which can help investors in making an informed decision on securities and sector selection. It is noteworthy here that oversight of climate change risk exposes the financial sector to systemic climate change risk.

The way forward for: Need to allocate capital to mitigate climate change risk

Since the carbon-intensive sectors are currently facing both physical and transition risk, consequently eroding the profitability of these sectors and companies who are exposed to these risks. Hence, the investors should identify companies who are proactive in taking the right steps in mitigating these risks. Besides, the investors should look at investment opportunities in the sectors, which are climate-friendly, such as clean energy, energy-efficient, and clean transportation,to mitigate climate change risk.

Sources:

[1] https://www.munichre.com/content/dam/assets/munichre/content-pieces/documents/pdf/302-09092_en.pdf

[2] http://www.emergingmarketsdialogue.org/wp-content/uploads/2018/04/Study-Natural-Capital-Risk-Exposure-of-the-Financial-Sector-in-India.pdf

About the Author:

Labanya is currently working as a Manager – Climate Finance in Climate Policy Initiative’s (CPI) Delhi office; CPI is an international development and policy consulting company in climate finance. At CPI, he is engaged in research and consulting activities related to policy, regulation, and investment aspects of green financing, including renewable energy. Besides, he is also engaged in designing and analysis of new financial and business ideas at CPI’s Green Finance Lab, aiming to drive capital into the climate sector.Before CPI, he has worked with Copal Amba Research (A Moody’s Subsidiary), Emanation Partners, Skylar Capital, and Mandrill Capital Management in various capacities.

Labanya is a management graduate and holds a Master’s in Economics. He is also a CFA Charterholder and currently a Doctoral Scholar at XLRI, Jamshedpur.

Covid-19 & EM: From Panic to Possibility

Contributed By : Rajnish Kumar

The COVID-19 pandemic represents serious economic, social and psychological impact globally and Emerging Market (EM) in particular due to lack of health care infrastructure as well as poor living conditions. The full impact of the pandemic is yet to be seen but initial impact on financial market suggests that the COVID-19 has affected EM regions differently. This presents a very unique opportunity for institutional investors to buy undervalued countries and diversify across different EM regions.

On March 11, 2020, World Bank declared COVID-19 as pandemic after there were 118,000 confirmed cases in 114 countries. However, it was detected first in Wuhan, China on December 31, 2019. Since then there has been exponential increase in confirmed cases across EM regions. Chart 1 presents the number of confirmed cases across EM regions (countries part of JP Morgan EMBI Global Diversified, grouped in different regions). Asia has highest number confirmed COVID-19 cases followed by Europe EM countries. The number of confirmed cases of COVID-19 in Africa is insignificant as compared to other EM regions. It would be interesting to examine if the impact of COVID-19 on EM debt market is related to number of confirmed cases in the region or are there any factors at play which are impacting the debt market.

To examine the impact of COVID-19 on EM debt market, we consider three different types of EM indices, namely: JP Morgan EMBI Global Diversified (hard currency sovereign index, EMBIGD), JP Morgan CEMBI Broad Diversified (hard currency corporate index, CEMBIBD) and JP Morgan GBI-EM Global Diversified (local currency sovereign index, GBI-EMGD). For past several years, EM debt market has garnered lots of interest from institutional investors globally. The incremental interest in sovereign local currency is greater as compared to hard currency (sovereign as well as corporate). As seen in Chart 2 below, since the inception of local currency debt, the market capitalization has increased drastically over time as compared to hard currency debt.

The issuance of variety of EM bonds provides good diversification benefits to institutional investors during the risk-on period. However, during risk-off period (COVID-19), it would be interesting to see how different EM regions are getting affected due to the pandemic.

The factors which impact the performance of EM debt market differs between sovereign local currency and hard currency sovereign and corporate debt. Therefore, even though, COVID-19 is a pandemic and has created a risk-off period, resulting in flight to safety, all three types of index market is going to be negatively impacted but considering that EM countries are at different stages of socio-economic development, there is differentiated impact across indexes as well as across EM regions in the respective indexes.

As on April 17, 2020, GBI-EMGD consists of 19 countries with maximum weight of 10% to Brazil, Indonesia, Mexico and Thailand. EMBIGD has 73 countries; however, it has only 32 countries with weight of more than 1%. China has the maximum weight of 4.63%. CEMBID consists of 57 countries but less than half of the countries make up for more than 90% of total weights, with China occupying the top spot with 8.15% followed by Brazil (5.42%). With respect to number of constituents/ countries, EMBIGD is more diversified as compared to other two indices.Considering that three indexes represent different asset classes and each index include quite a few countries, they provide a good source of diversification benefits to institutional investors and at this stage of COVID-19 pandemic, a tactical allocation across countries and assets can enhance risk-return of the portfolio.

To examine the impact of COVID-19 across EM debt markets’ performance, we plot the cumulative returns of each indexes, grouped under different regions along with the respective indexes performance. Chart 3 to Chart 5 presents the daily cumulative returns charts for GBI-EM GD, EMBI GD and CEMBI BD respectively from January 16, 2020 to April 16, 2020.

Since the advent of COVID-19 on December 31, 2019 and before WHO’s declaration of COVID-19 as pandemic on March 11, 2020,we see a differentiated impact across the Emerging Market regions as well as indexes, however, the pattern of impact is similar across different indexes. There are two distinct impacts of COVID-19 on EM indexes. The first one starts around February end and for a brief recovery within a week, the indexes return goes into tailspin beginning March 2020. Further, the drawdown is more for local currency sovereign indexes followed by hard currency sovereign and hard currency corporate.

Comparing between regions across indexes, Africa is the worst hit with biggest drawdown across all three indexes followed by Latin America and Middle East.

The cumulative performance chart clearly dictates different perception/ expectations of institutional investors regarding future growth path and recovery from COVID-19 across EM regions. This differentiating impact across EM regions can provide institutional investors to take advantage of future possibilities. One of the reasons that can be a contributing factor in differentiating impact on EM debt market can be health care expenditure by EM countries.

Chart 6 presents the average current health expenditure by EM countries, grouped into different regions. Asia and European EM countries are spending more as compared to other EM regions, which is a lot less as compared to any developed countries. Africa has the lowest health care expenditure per capita and as per the charts above, even though the number of confirmed cases is a lot less as compared to other EM regions, the drawdown is more for Africa regions is more as compared to any other regions. This dispersion of health care infrastructure across EM regions is going to greatly impact the recovery of EM countries from COVID-19 pandemic and institutional investors can incorporate this information in their portfolio construction.

The revival of EM countries will depend on economic stimulus by government and central banks which in turn will depend on capacity in monetary and fiscal space of the respective countries, political will and social consciousness. Country selection is going to be a key variable during this time and institutional investors can gain by incorporating the differentiating factor in their portfolio construction.

About Rajnish Kumar, PhD

Rajnish Kumar has over 8 years of experience in factor research across equity and fixed income. His area of interest includes ESG, smart beta, portfolio construction and risk-return attribution analysis across different asset classes. He has publications in top tier journals. He holds PhD in Economics from Indira Gandhi Institute of Development Research, Mumbai.

“My experience in the Covid-19 War-Room” by Rishi Doshi, CFA

The world came to a pause, but for some, it was not just busier than ever, but riskier than ever. Yes, while the unprecedented COVID-19 pandemic relentlessly marched across the globe, there were some individuals who relentlessly walked the extra mile to battle this crisis. From the global bodies to the central and state governments to the frontline warriors, their unparalleled efforts to combat the situation were highly commendable.

Day by day, the COVID-19 pandemic conquered more and more countries with such momentum that it left me in anxiety as to what is happening to the world. As a millennial, I have never experienced such a grave situation in my entire lifetime.  It was agonizing to learn that every day the death rates were increasing at an incremental rate and members of the families, in some cases even bread winners, were left disbanded.

At that moment it dawned upon me how dreadful the situation was and how grateful we were to be equipped with all the facilities in the comfort of our homes. I wished I could provide my support in some manner to manage this crisis. I imagined, had I been a medical professional I could have contributed in some way or the other. Hailing from finance domain, little to no scope existed for me to help on the frontline, and hence, like the majority of us – volunteering was another wishful thought.

By sheer serendipity, while browsing across social networking websites, I noticed a tweet from Mr. Uddhav Thackeray (#CovidYoddha) inviting volunteers to assist the Maharashtra government in their efforts to manage public health. I clicked on the application form and as expected, I saw the requirements were primarily for medical professionals, communication specialists, tech experts and public health administration professionals. Apart from this, there was a category for ‘Other’ volunteers.

I spent a few minutes introspecting how can I help and then realized that my extensive experience (7 years in Big Four consulting) of project management, data management, working at top speed under high-pressure situations and qualitative reporting can help them in these pressing times and added it in my application.

After a few days, they reached out to me saying that the local ward government administrative office needs my help for data management and reporting. At that moment, I was in a dilemma regarding the ingenuity of the call and was unable to decide whether this was an opportunity to make a difference or was this just another scam call? Occupational hazard, I must say, of being a Fraud Investigator.

Well, after analyzing and conducting some checks, I realized that it was a genuine call and immediately joined the War-Room team at Brihanmumbai Municipal Corporation (RS Ward). I was very overwhelmed to have received this opportunity and my excitement level to do my bit had reached the zenith. The war-room team comprised of our frontline commandos in this pandemic that were Doctors, Nurses, Senior public health administration staff, travel and logistics support members, and other members of the BMC staff.

The War-room team was responsible for appropriate management of Covid-19 positive cases, contact tracing, containment and quarantine, running large scale screening tests in suspected areas, quarantine center capacity and facility management, test kits requisitions among others.

On day one, I was introduced to the work I would be doing and was asked to confirm if I would be available for a few days to ensure continuity of resources and plan the further course of action. At that moment, I was unequivocal about my answer and immediately said a ‘Yes’. This was my opportunity to give back to the community in some form. Without further ado, I applied for personal leave from my employer to give my full support to this initiative.

In a couple of days, I was hooked and working on massive data of patients, contact tracing, capacity utilization of quarantine centers and others. My key responsibility was to put together unstructured data that we received from various places in a format that we could put to use and report the numbers to the BMC HQ on a daily basis.

It was stressful but fulfilling and an enriching experience. I was fully aware what was at stake, any gaps in my work would lead to a possibility of a patient not being tested or detected at the right time or may lead to inadequate capacity utilization at quarantine centers.

The silver lining in the toil was when the personnel heading the war-room was appreciated by the CM’s office for the quality and speed of information put through by the ward. Now, the responsibility of timely and accurate information reporting was on my shoulders and it was a job well done as other wards started reaching out to learn and seek information on best practices for data management followed by us.

Amidst this chaos, I conversed with a lot of members of the war-room and realized how empathetic they  were of the people’s problems. Some of the staff were Civil or Electrical engineers but were working in public health support – Crisis makes us adapt, learn and grow!

Most of the war room team members for safety reasons wanted to go back to their respective hometowns or families of the staff members were apprehensive about them going to work every day but these ‘Warriors’ (in the true form) did not budge and were at it relentlessly and tirelessly. To add to this, the government ordered a freeze on Dearness Allowance (DA) for its staff – DA is an allowance paid to government staff to mitigate impact of inflation.

With all these on their minds, I will never forget a statement by a war-room member – “Hum nahi karenge toh kaun karega” (Translated – If we don’t do it, then who else will?)

Fighting all of these adverse situations, these people took up the challenge head-on. A sincere gratitude and appreciation for the people working for our well-being and safety. In a true sense this crisis has brought the whole world together to effectively become one and fight against a common enemy ‘Covid-19’.

 Thank you and stay safe.

 “I cannot do all the good that the world needs. But the world needs all the good that I can do.”

About Rishi Doshi, CFA

Rishi works with KPMG’s Risk Consulting Practice with an expertise in financial fraud investigations. A CA and CFA charterholder by qualification, he has 8+ years of work experience and is a passionate consumer rights activist. Apart from a penchant for societal reforms, Rishi loves to travel, dance, swim, play badminton and cook.

Session on “Practitioners’ Insights: Valuing IPOs” by Mr. Nitin Bhasin

Speaker: Nitin Bhasin -Head of Research, Ambit Capital

Moderator: Shreenivas Kunte, CFA, CIPM – Director of Continuing Education and Advocacy, CFA Institute

Contributed By: Srividhya Venkatesan, CFA, Public Awareness Committee of CFA Society India

India has witnessed several domestic companies getting listed on the bourses and growing to become strong global brands today. Some of these companies like Infosys, TCS, HDFC Bank, etc. have become long time return generators and wealth creators for its shareholders.

Through this webinar, the speaker has covered certain important aspects of how to evaluate an issuer company and valuing its IPO so that investors can make an informed investment decision.

Indian IPO Market Overview

“An IPO is like a negotiated transaction – the seller chooses when to come to public – and it’s unlikely to be a time that’s favorable to you” – Warren Buffett

Traditionally,the bull market witnesses a lot of IPOs hitting the market. In India too, the period of rising market (e.g. FY 03-08 and FY 14-18) saw a significant rise in the number of IPOs hitting the market and they dropped drastically during the bearish period (e.g. FY 09-13).

The chart below reflects the IPOs journey in India (timeline series of IPOs from FY 2003 to FY 2019)

In FY 03-08, the number of IPOs along with the markets was booming, and large caps (at that time ~INR 10,000 Cr market capitalization) dominated the IPO market. This was followed by a dull period (FY 12-16) and by FY 18 there was a spike in IPOs again, as the market bounced back but with much larger sized IPOs. As can be seen from the above chart, IPOs also go through market cycles.

Unlike the US, India doesn’t have many loss-making IPOs or tech IPOs getting listed. Most of the companies getting listed in India, have assets on their balance sheet and a historical track record of earnings, which makes its IPO valuation much easier.

Performance of Issuer Companies – IPO Returns

Everywhere in the world, the IPO returns possibly look very similar.

As can be seen in the chart above;the average returns generated are positive only on the listing day. Over time, returns from the IPOs decrease, indicating a significant overpricing of these IPOs.There have been several IPOs that have given supernormal gains on listing, but these are few and far between.

Hence, the quality of IPOs that comes for listing, plays a very important role in generating a long time stock returns and wealth creation.

Quality of IPO

• RoCE of companies, in the year of IPO listing, is one of the best metric to evaluate the quality of the Issuer Company
• As can be seen in the pie chart, closer to 55-60% of the Issuer Companies, had a RoCE of more than 15% (32%+26%)
• This means some very good quality IPOs were launched in the Indian stock market unlike the other parts of the world like the US or China
• The second metric for evaluating an Issuer Company, is its growth prospect
• Many of these Issuer Companies project to grow larger over 10-15 years
• If we check the vintage of the Nifty Index, we would notice that almost 2/3rd of the constituents were listed more than 15 years ago
• Indicating that it typically takes a long time for a company to grow large enough to become part of the Nifty Index
• When investing in an IPO, this growth aspect should be evaluated properly

IPO Returns – Examples

(a) Examples of IPO that generated returns

Generated Investor Wealth

Page Industries: Initially listed as a textile company. It started getting valued as an innerwear brand almost 7 yrs post listing. Even after correction, around Sept’18, the 12 yr CAGR (till Mar’19) was 41%

Avenue Supermarket:Generated very high returns and has been a consistent performer

Long Term Investments

TCS :Took time for leadership to be appreciated. Has been a consistent performer in the last 10 years (2009-19)

(b) Example of IPOs that eroded value

Looking at the IPO returns chart and the above examples of some of the recent IPOs, it brings us to the key question of how an Individual Investor should diligence an Issuer Company and check its IPO pricing.

How should an Issuer Company be evaluated?

• Diligently read the draft prospectus, its corporate website, management interviews and any published financials
• Assess attractiveness or lack thereof vis-à-vis industry peers
• Assess KMP (Key Managerial Personnel), team and promoter family – understanding people running the business
• Use financials of industry/peer, to make a judgment call and estimate how the company would evolve since forward-looking estimates are not publicly available
• Valuing company using DCF for the next 10 years and pricing the near-term valuation using relative valuation

Some Important factors to keep in mind while reading a Draft Prospectus

• DRHP is a very informative document that offers a lot of details about the company
• Key aspects to be checked include risk factors (both imaginable and non-imaginable), legal issues about the company-KMP (Key Managerial Personnel) -Board, related party transactions, business performance over last 3 years, industry analysis and relative peers, the reason for going public and use of proceeds, any further dilution proposed (further Offer-for-sale), etc.
• These points act as filters while evaluating the Issuer company 

Key Filters for evaluating the company 

(a) Accounting and Corporate Governance

• Access the key accounting ratios used in the industry – with a focus on cash flows and funding for expansion
• Assess corporate governance – managerial remuneration, auditor quality, capital allocation through cycles, board composition (over the last couple of years), disclosures and simplicity/complexity of group structure

(b) Company and Management

• Understanding genesis of company and evolution
• Family and professional management team involved, employee retention policies and ESOPs

(c) Primary Data Checks

• Search for information on company and management on the internet – networks like LinkedIn, product surveys, etc.
• Face-to-face channel meetings, ex-employees, industry conferences, suppliers, customers and competitors
• We should be aware of bias and look at a reasonable sample size

(d) Assess competitive advantages and the sustainability thereof

• Use John Kay’s Innovation, Brand, Architecture and Strategic Assets (IBAS) framework to analyze the firm’s competitive advantage
• Innovation is the most tenuous source of a competitive advantage
• Brand or reputation gets built over decades and hence is a very powerful source of competitive advantage and can become a strategic asset
• Architecture involves understanding a firm’s distinctive style, ethos, and relationships with suppliers and distributors
• Strategic assets include natural monopolies, intellectual property, licenses, etc.

 Valuation and Pricing of an IPO

Business Valuation and IPO Pricing are not the same

(a) Valuation of the Business:

• Estimate operating cash flows, growth rates and risks
• Can the company use its competitive advantage to lengthen its competitive advantage period or enter adjacencies?
• Don’t lose track of reinvestment rates to grow an asset, working capital or intangible needs can impact free cash flow and RoCE
• Equity-raise and de-leveraging from IPO to be incorporated in valuations

(b) IPO Pricing

• Mostly done on a relative basis by establishing similarities/dissimilarities around scale, market leadership, opportunity, management and near-term earnings growth
• Frequently used multiples are P/E, P/B and EV/EBITDA; these need to be adjusted for idiosyncrasies
• Comparable from same industry may be missing domestically; the global universe and companies similar on business characteristics available domestically

Key Takeaways

When making an investment decision, the quality of the management and the business is very important.

Investment in an IPO should not be purely based on the backing of a Private Equity investor, large and long anchor list or high over-subscription (specifically on the last day). When investing in IPOs, it’s very important to do proper diligence on the Issuer Company and its management from sources like Draft Prospectus, management interviews, internet coverage, etc. Pricing should be checked and compared with peers based on similarities/dissimilarities and accordingly an informed investment decision should be made.

Watch webinar at : https://cfainstitute.org/research/multimedia/2019/practitioners-insights-valuing-ipos

 

 

Session on “CEO’s insights: Client communication in times of crisis” by Ms. Radhika Gupta

Speaker: Radhika Gupta, CEO, Edelweiss AMC

Moderator: Rajendra Kalur, CFA , Director- CFA Society India

Contributed by: CA Nishit Vyas

In these times, communication can be a strength (we can be champion at it) or a weakness (which may lead to a crisis of communication). No training or corporate boardroom can train an individual to communicate in times like these. For example just imagine a beach…

Under normal times, we would have imagined a beach to have a beautiful sunset (A), or a beach hut (B) or a sand castle (C), but today we imagine it to be a colour painting by a kid (D) because that is the closest we can get to beach while we are under lockdown. In an example as simple as this we get four different interpretations and that summarises why we need to communicate clearly. Thus, it is imperative for leaders to help their teams and clients envision the same beach that he or she is envisioning and not four different beaches.

For a client who has been suffering from all of this, communication must remain sensitive and empathetic towards him/her.  Statements like “ Valuations are cheap and it is time to buy or my fund has fallen significantly less than others or you would have made 90% return in 1 year after Global Financial Crisis (GFC)” appear too ‘Sales-sy’ and must be avoided.

Therefore good communication must be:

• Quick, ie: Put out a note (on the same day) in response to the impact of a RBI move or a rumour in the market
• Simple and not cheesy marketing gimmicks
• Bold
• Consistent, ie: the CEO and the salesman in a remote location must communicate the same version of the beach (remember!!!) to avoid vague interpretations for the client
• Not sound desperate but be empathetic and honest.

How do we communicate when we can’t go to work?

• Bad messages are better delivered through face (video conferencing like zoom etc) and not voice (phone calls).
• Avoid watsapp as a tool of formal communication.
• Social media is a big-big friend: intelligent blogs and clarifications in response to a crisis can be hosted on social media platforms to communicate to a wider audience including the media.
• People watch and listen more than they read: 2 min video garners more eyeballs than a 2 page note.
• Written records of oral communications is a must to avoid legal implications later.

A real story:

• Mr David Kabiller is the head of sales at AQR Capital.
• In August 2007, AQR funds lost ~3Bn $ overnight when the bond crisis happened and David was vacationing in Bermuda then.
• But David was a master of client communication, he called each client and told them that we might have lost 3 Bn $ but we have raised 1 Bn $ yesterday.
• Literally from the beaches of Bermuda, he saved the face of the firm – simply due to bold, honest and timely communication.

Watch webinar at : https://www.youtube.com/watch?v=rKMDRDfQTlE

 

 

 

Market Outlook- May 2020

Contributed By : Navneet Munot, CFA , CIO, SBI Funds Management Pvt Ltd and Chairman, CFA Society India

The toughest month for humanity in recent times turned out to be one of the best for stock markets. Even as Covid-19 infections multiplied and economic activity plunged, stocks rejoiced perhaps reflecting faith in human ingenuity on one hand, and reacting to unprecedented liquidity amid low valuations on the other. Not all assets shared the optimism though with front-month crude contract plunging below zero for the first time ever, and US treasuries and dollar staying well supported suggesting that the deflationary pulse is still alive. As major economies begin to reopen, markets will keenly watch how successful they are, with a second wave of virus spread being the key risk.

Public discourse may start moving from avoiding the virus completely towards better managing it while allowing economic activity to continue. While antibody tests show promise, effective treatment may take several months and a successful vaccine even longer. The new normal may involve innovative precautionary measures, increasing testing infrastructure and letting people return to work, with adequate distancing, protective gear and frequent testing. A critical aspect remains the protection of old and vulnerable people. With that, the focus is likely to shift from survival to revival.

Back home, India appears to have done a decent job at controlling the virus so far. The economic fallout is real and a matter of concern though. It is important that we stand ready to shift gears as needed. We have strong foreign currency reserves and must leverage them now including for securing long term oil supply. Global geopolitics will change meaningfully post this crisis and therein lies our opportunity. Global firms will look to diversify supply chains as they weigh reliability against efficiency, at the same time as distrust for China continues to grow. We must present ourselves as a strong alternative. This will need a strong growth focus and mindset for pro-business policies. The window of opportunity may not be too wide as several countries vie for the same pie.

It is also important to note that the easy global liquidity will not last forever. The current recession will ensure unprecedented monetary accommodation over the next several quarters. Yet, as we have argued in the past, monetary policy is reaching its limits in effectively reviving the economy globally and is leading to rising wealth inequality as an unwelcome side effect. To top it all, the current crisis has hit the bottom strata the most. The stage therefore is set for massive fiscal stimuli globally to complement the monetary effort. This could set the stage for an end of the 40-year-old bull market in bonds. When inflation perks up and global rates begin to rise in years to come, capital may not stay as abundant and become much more discerning. We are a country deficient in risk capital and must therefore act quickly and decisively.

At a transformational juncture as this, one thing that’s critical in a nation’s success is its social capital. That 1.3 billion have complied to the lockdown in a rather peaceful manner is a testimony to our social capital. Several mass-focused measures of the past years such as the Ujjwala scheme for LPG connections, the JAM trinity (Jan Dhan bank accounts, Aadhar cards and Mobile connections) and focus on sanitation and cleanliness through Swachh Bharat have helped us better tide this health crisis as also help build social capital. We must be mindful that a prolonged economic disruption may erode some of these gains.

While the government is addressing the first order impact on the poor, a lot more needs to be done to help businesses and avoid second order impacts. Social agenda needs resources that can only be generated by reviving growth and expanding the pie. Versus most countries, we have been high on stringency of the lockdown and low on fiscal support. While our fiscal room may be limited, we must be cautious of the “paradox of thrift”. Given the environment, both corporate sector and households may remain thrifty and risk-averse, the onus is on government to lever up and spend.

With tax collections expected to fall, non-tax sources will need to be explored ranging from asset monetization to perhaps government backed municipal bonds (Pandemic bonds just like War bonds?). While direct support to poor was critical during the lockdown, as the economy opens fiscal multiplier should be the driving force in prioritizing expenditure. Infrastructure projects such as rural roads, urban infrastructure, slum redevelopment, and the likes should be prioritised to create immediate employment (support consumption) as well as build productive assets. Fortunately, rural economy is in decent shape and must be shielded from supply chain disruptions as well as from the virus that returning migrant workers may bring along.

The RBI on its part has been aggressive in policy response so far. And is doing an even better job at communicating that it stands ready to do whatever it takes to revive the economy. Yet it has only met with partial success in achieving the desired outcomes. The big disconnect between macro and micro level liquidity stays. The yield curve has continued to steepen, and corporate spreads stay elevated. Muted growth and high nominal rates can lead to debt ratios spiraling out of control. The tepid response to TLTRO 2.0 suggests lack of risk appetite and therefore the real economy stays starved for funds. Government providing first loss guarantee, further relaxation in prudential norms, and RBI capping absorption through the reverse repo window along with aggressive OMOs are some measures that should help transmission.

This month credit markets witnessed an unprecedented event when a US$ 3 billion bond portfolio was left wanting for liquidity in a US$ 3 trillion economy. This should be our moment to bring about next generation financial system reforms such as deepening of corporate bond markets, securitization market, channelizing patient capital through the AIF route and creating lenders of last resort, to name a few. Banks’ lending behaviour is largely pro-cyclical and therefore we need a strong institutional framework to facilitate access to capital across the credit spectrum when the cycle is at its worst and its need to sustain the economy is the highest. If access to formal capital stays blocked, there is a risk of return to informal money lenders and in turn reverse the gains of formalization.

One positive rub-off of the Covid-19 crisis has been an explosion in digital adoption. The recent rally in US stocks has once again been driven by Tech stocks. A marquee deal announced recently is testimony to the potential in India. With the right ecosystem, ensuring net neutrality and cyber security, India has the potential to become a digital powerhouse from e-governance and e-payments to e-health and e-education. Can we, for example, move to e-judiciary and leverage data for dispute resolution which currently takes several years? Data, they say, is the new oil and as India transforms from being data poor to data rich, the possibilities are immense for governance, businesses and society at large. If we can incentivize Indian talent abroad to return to the country it will be a big boost in this direction.

Amidst the recent challenges in the debt market, our fund house’s conservatism and prudent credit assessment has helped. Given the growth-inflation-external account dynamic, we stay long duration. On equities, we had argued that several valuation measures were in the vicinity of GFC lows in late March. However, the run-up since has been too sharp given the challenging economic backdrop, and therefore further bouts of  volatility shouldn’t be ruled out.

The world will change meaningfully post this crisis and the next few decades will be very different from the past few. Consumer behavior will be materially altered. Businesses will have to keep reinventing themselves. Evaluating businesses on size- large caps versus small caps- may become less relevant as agility and nimbleness become the key success traits. Another Zoom could zoom out of nowhere to become a fancied business. While all other costs will have to be reimagined, innovation will be critical, and R&D should remain the only indispensable cost head. This will also be a test of firms’ ESG commitments. The way businesses treat various stakeholders in these times will determine their long term outcomes.

There will be significant implications for investors from pricing tail risks to dealing with unpredictability, from enhanced ESG focus to asset allocation choices. The fundamental tenets of investing will always remain unaltered; however, investors will have to adapt to the changing paradigm and evolve.

Session on “Company Insights: How are Boards & Companies Responding to the Crisis “ By Dr. Punita Kumar Sinha, CFA

Speaker : Dr. Punita Kumar Sinha, CFA, Founder and Managing Partner, Pacific Paradigm Advisors

Moderator: Vidhu Shekhar, CFA, CIPM, Country head of CFA Institute in India

Contributed By : Shivani Chopra, CFA, Public Awareness Committee of CFA Society India

Webinar Notes:

Corporates are navigating through unprecedented times as the Covid-19 scare has shut the world down for businesses. A number of dynamics have converged against the companies and the situation remains chaotic .Consequently, the senior management and board members of a company are discussing a wide array of issues to tide over these turbulent times. In this interactive webinar, Dr. Punita Kumar Sinha, CFA, shared her insights on ways in which companies and boards are responding to the crisis. Key themes emerge as follows-

Capital Allocation and M&A

Senior management and boards are trying to ensure sufficient liquidity, exploring alternative sources of raising cash, taking capital allocation decisions regarding dividends and reviewing M&A possibilities:

• Liquidity- The first and foremost priority of every company is to ensure that there are sufficient liquid reserves. On one hand, there is partial or complete loss of revenues during the lockdown and on the other hand, organizations have to bear significant operating costs. Servicing debt has become a challenge but thankfully many governments have announced supporting schemes to ease the burden
• Alternative sources of liquidity- Such as rights issue from the existing investors, refinancing of loans, tapping credit lines, selling investment portfolios, etc. Companies are being advised to draw down all their available credit facilities even if the cash is not needed now. This will help later as the recovery is expected to be arduous
• Capital allocation decisions- Whether to pay dividends now or defer to a later date
• Emergency reserve fund- Key lesson is to have an emergency reserve fund in place at all times
• Mergers and acquisitions (M&A) – The idea is not to have an aggressive M&A strategy in place right now but to be ready for the time when the situation normalizes. Managements can utilize this time to identify potential targets available at distressed valuations

Business Models

In order to stay relevant and survive the crisis, many businesses are venturing into unchartered territories. Looks like agility and adaptability is going to be the only way forward:

• Pivoting of business models-Governments in every country have identified a list of essential and non-essential businesses. It is observed that the firms are pivoting (changing) their business models where possible to supply essential goods. For instance, several manufacturing firms globally are trying to use their facilities to make masks and ventilators. In some situations, the idea is to contribute towards society as well
• Several departments like IT and HR are busy ensuring the safety of workers to further ensure that the current supply ecosystem remains healthy
• People are working harder than ever and thinking of novel ways to continue business operations. This may be a lockdown of physical world but not of virtual work environment

Personnel

Companies are debating about salary cuts, lay-offs, work from home constraints and succession planning:

• As revenues come under severe pressure, it is becoming difficult to bear employee costs. While lay-offs are being considered by some firms, there are others who would only like to implement salary cuts for the time being
• There are instances where even if firms are keen to retain workers, many are leaving for better pay structures. For instance, Amazon has experienced an overwhelming demand in US and to mitigate the shortage of staff, it is willing to hire and pay more to those willing to work amidst the Covid scare.
• As many people are compelled to work out of home, constraints relating to bandwidth issues are also being resolved
• Succession planning is going on for Key Management Personnel(KMPs) given the risk to lives due to corona virus

Risks

There is a need to manage risks due to rise in cyber attacks, client confidentiality, etc. as most of the employees work out of home.

Board Format

Board meeting are being conducted in a different set-up to address more near term issues:

• Earlier a minimum number of in-person attendance was required and an all virtual board meeting format was unheard of. But now the regulators have relaxed the conditions and most of the meetings are being held online
• Conferences are of shorter duration with greater focus on immediate key issues. A typical march quarter meeting would mostly discuss the financials, in contrast, it is being admitted that it is difficult to forecast & build annual budgets during this time (due to the severity of the lockdown). Hence, it is prudent to shift gears and show readiness to overcome current matters

Communication and Investors

Boards are encouraging companies to have a robust communications strategy with all the stakeholders on matters such as business continuity for building greater confidence in the corporate ecosystem

Conclusion

The virus has spotlighted the need to address several new challenges which the corporate honchos could not envisage before the global pandemic. CFOs are busy looking at their cash reserves to ensure that they are able to pay the bills, pivoting of business models is being tested and IT & HR personnel are ensuring the safety of workforce. Several decisions regarding employee costs, mitigation of risks and business continuity are being taken. Lastly, having an effective stakeholder communication plan is the need of the hour.

The crisis has undoubtedly unveiled the dark side of globalization. Going forward, the governments & corporates will have an inward focus i.e. domestically oriented manufacturing base to mitigate disruptions in supply chain and changes in many other policies. Coming out of the Covid-19 outbreak, the entities are going to have a wealth of lessons learned but for now, they more fixated on sailing through it.

Watch webinar at : https://www.youtube.com/watch?v=5Q8zniv5mQI

 

 

 

 

Session on “Angel Investing: Why, Who, and How to Angel Invest” by Ms. Padmaja Ruparel

Speaker: Padmaja Ruparel – Co-founder of Indian Angel Network (IAN), Founding Partner of IAN Fund and Co-chair of Global Business Angel Network (GBAN)

Moderator: Deepak Mundra, CFA – Valuation Services Manager at KP Synergies

Contributed by: Srividhya Venkatesan, CFA

India is at the forefront of the start-up boom, with homegrown brands like Flipkart, Byju’s, Paytm, Ola, etc. competing head-on with their global counterparts. One of the most crucial factors that have helped the start-ups succeed is the backing of investors at the right time –especially the Angel Investors.

This fascinating ecosystem of Angel Investing was covered in a very engaging webinar by Padmaja, who has been at the forefront of the entire start-up ecosystem evolution in India through Indian Angel Network(IAN). In this webinar, she covered the three critical aspects of Angel Investing – the Why, Who, and How.

Evolution of start-ups and their impact

Innovation could be the real engine for creating employment and economic growth in a country. Start-ups challenge the existing setup with innovations, fill in the market gaps, solve customer’s main pain points and create jobs.Furthermore, these start-ups deliver this value rather quickly, with lower capital and in lesser time.

Often when established corporations find innovation and R&D expensive, niche start-ups exhibit better capital efficiency with sharper minds with innovative technologies, with a speed which is unimaginable at large organizations due to bureaucracy. A case in point being,multiple start-ups that are working today on developing in-need solutions like manufacturing economic ventilators for tackling the current pandemic. These start-ups by young entrepreneurs are challenging the established large players and catering to the new challenges of this new world.

India: The booming start-up ecosystem

India is one of the fastest-growing start-up nation. From about 1,000 start-ups in 2004, the count grew to around 7,000 in 2008 and from there to approximately 50,000 by 2019.Some of these start-ups have managed to establish a niche place in their segment and command a billion-dollar valuation.A total of approximately $39 billion in funding has been injected by investors in the Indian start-up ecosystem since 2014.

Besides India, innovation is most prevalent in countries like Luxembourg, Chile, and the US. India is estimated to have around 125 unicorns by 2025 (pre-Covid19 estimate).

So, what makes India one of the fastest-growing start-up hubs in the world?

• Young country with a median age of 31 for founders (vis-à-vis the late 30s in the US and 40s in Europe)
• Diverse and large population with varied customer preferences (creating demand for a variety of products and services)
• Different price points
• Growing talent base of knowledge workers
• Opening up of new sectors, demanding innovations like electric vehicles, clean-tech, consumer IoT, biotech to name a few

For these start-ups, success is synergistically linked to capital availability.With initial funding from family-friends and own savings; start-ups look for financial capital for their survival and growth. And that’s where the Angel Investors step in. 

Why do start-ups need Angel Investing?

Angel Investing is the financial kick-start that most start-ups need to begin production or fund their marketing strategy. With limited operational history, they often find it difficult to get traditional bank lending.

With only a prototype ready or limited revenue, Angel Investment is their only viable source of funding. Angel Investors bet their money on the entrepreneur, market size, and the viability of the product while making an investment call.

Angel Investors also provide critical hand-holding, strategic inputs, operational guidance, team mentoring,and global network access that is extremely useful for the start-ups in their initial stages of growth.

Who does Angel Investing?

Angel Investment is an investment in start-ups by strangers, who are betting on the investment proposition and the founder(s)

• They are very similar to venture capital investment, but typically come in at seed stage
• Its typically an equity investment done with a significant minority stake
• It’s a high risk – high return investment
• Investors look for capital gains and not dividend returns, with a typical Internal Rate of Return (“IRR”) expectation of around 30-40% (there is no standard IRR, it may vary on a case-to-case basis)
• Typical sweet spot of INR 25 Lac – INR 3 Crore (there is no standard rule on investment size)
• Done professionally, with proper due diligence, research, and legal documentation

How is Angel Investing done and what structures are used?

Along with the traditional investment classes like real estate, fixed deposits, or public equity, most high net worth individual’s portfolios have started featuring a new asset class – Angel Investment, due to the high return potential. These investors have dispensable capital and a high risk-taking ability.

Angel Investment is the highest risk asset class.On an average 4 out of 10 investments fail, 4 breakeven, and only 1-2 give bumper returns. Hence, investors often follow a risk mitigation and diversification strategy to protect their interests.

They often diversify their portfolio across multiple start-ups operating in varied sectors, geographies, etc. and co-invest with peers,to leverage on the domain expertise of fellow angels and not just the founders.

Angel Investors do proper diligence on the investment proposition before taking an investment call. In evaluating the start-ups, they look for answers to some of the key aspects of the business like:

• How large is the addressable market?
• Is it rapidly growing?
• Who are the key competitors?
• Is the opportunity arising from market fragmentation or a greenfield opportunity?
• What is the need for the customer to pay for the product/service?
• What are the alternative products in use?
• Execution strategy of the firm
• Track record of the founder and his/her team
• Coverage of skills among team members
• Team retention strategy
• Customer acquisition cost
• Risks mitigation strategy
• Financial performance – historical and projected (both top-line and bottom-line are key)

In evaluating projected financials, they look at aspects like:

• Have all revenue possibilities been covered in the model?
• Has there been enough sound and deep research on the business proposition?
• What is the amount of funding required?
• What is the valuation expectation?
• How can the investment be monetized (exit strategy)?
• What would be the expected term of investment?

There is usually one Lead Angel Investor who leads the due diligence, sits on the Board of the company, and keeps an eye on all critical activities of the start-up, keeping the point of interface alive between the investors and the start-up.

Angel investors eventually make their return when either next-round investors give them an exit or the investee company gets acquired by a strategic investor.

Key Takeaway

Angel Investing is a high-risk, high-return investment route that’s here to stay as (a) risk-taking investors look at alternative medium to multiply their returns; and (b) the start-up ecosystem look at non-traditional funding to scale up their revenue and growth.

 

Session on “Practitioners’ Insights: Valuation in Stressed Times “By Ms. Nimisha Pandit, CFA

Speaker : Nimisha Pandit, CFA, Associate Director and Head of Equity Research at Multi-Act Trade & Investments Pvt. Ltd

Moderator: Anil Ghelani, CFA, Vice Chairman, CFA Society India (IAIP) and Senior Vice President, DSP Mutual Fund

Contributed By : Shivani Chopra, CFA

Webinar notes-

Valuation Methods-

• Conventions of valuation (Market based)
  • Historical valuation- Use of company’s past price multiples
  • Relative valuation – Can be used when historical valuation is not available or relevant. Also, when market participants want to assess the relative expensiveness or cheapness of a company as compared to its peers
• Normative valuation (Absolute)
  • Discounted Cash Flow (DCF) – Used to estimate company’s true intrinsic value.
  • Net assets valuation – Methods like Replacement cost of assets (RCA), Book value (BV), NAV, etc. are used
• Which method to choose during distressed times- Use normative /absolute valuation methods:
  • In a trend market either bull or bear market, the historical prices/multiples reflect the current or recent sentiment. So, as long as the market continues to hold that sentiment, historical valuation might be right but once the attitude of investors changes, the historical reference point also changes. The market sentiment has indeed changed post the outbreak of Covid-19, hence its prudent to employ absolute valuation models

Valuation Tools- One size doesn’t fit all

• Valuation methodology of a company should be chosen given the unique dynamics of that firm. Focus on quality of a company and nature of business-
  • Pay close attention to quality of earnings, cash flows, strong or weak balance sheet, sustainable company advantage, barriers to entry, etc.
  • Check if the company can survive during economic downturn

Classification of companies based on three quality buckets

Companies can be classified as low quality, average quality or high quality.

• Bucket #1 (Low quality) – Companies suspected to have engaged in accounting manipulations or having untrustworthy management. Red flags could be lack of Free Cash Flows(FCF), poor returns, excessive leverage, suspicious related party transactions and complex structures like lot of subsidiaries, cross holdings, etc. Read more about the quality of earnings – (a) Book titled “Financial Shenanigans” by Howard M. Schilit or (b) Blogs available on CFA institute website and Multi-Act website

All other companies can be placed in remaining two buckets depending upon sustainable competitive advantage like “Economic moat”

• How to determine if a company has an economic moat or not- seek an answer to the below:
  • “Can a competent and well financed entity enter into this business and compete effectively with the existing players ?”. If the answer is “yes”, then it is a non moat business else it is a moat business
  • Read more about this topic by going through, (a) Warren Buffet’s letters to shareholders, (b) Pat Dorsey’s “The Little Book That Builds Wealth” or (c) Blogs available on Multi-Act website
• Bucket #2 (Average quality) – Place all non-moat businesses here. They will generate long-term returns less than or equal to cost of capital.
• Bucket #3 (High quality) – Place all moat businesses here. They will generate long-term returns more than the cost of capital

Valuation and Quality Buckets

The idea behind classifying companies in these buckets is to identify the valuation methods appropriate for each set of companies. One should avoid low quality companies and hence there is no need to conduct a valuation exercise. Use asset based methods to value average quality businesses and income statement based methods to value high quality firms

• Bucket #1 – Stay away from such companies. If the quality of earnings is poor, no amount of margin of safety is sufficient enough to protect yourself from permanent loss of capital. A case example of Gitanjali Gems was presented. Using a net net valuation method (an approach advocated by Benjamin Graham), we get a value of INR 305 as of 2013. Net net value is computed by deducting all liabilities from current assets and provides a floor value to the equity of the company (since fixed assets and other long term assets are not even considered). At that time, market value of Gitanjali Gems reflected a 25% discount to net net and after one month fell to 75% discount.
• Bucket #2 – It’s prudent to value non-moat firms based on the assets which they employ. Valuation methods such as Historical P/B, P/ Net net, Adjusted PB, Replacement cost of assets (RCA), Net asset value (NAV), Asset based valuation (ABA), etc
• Bucket #3 – For high quality businesses, earnings will add value to shareholders, so we should use income statement based valuation methods like DCF, historical multiples such as P/E, P/S, EV/EBIT, etc.
• Valuation tools- Rather than using fancy elaborative valuation models, one can focus more on quality of business and company dynamics. Also, the principle of mean reversion is used which assumes that a company’s historical performance is a good indicator of its future performance. In other words, future will mirror company’s long term average historical performance
  • The same mean reversion principle is used while deciding cost of capital and a constant discount rate is used over a market cycle. Also, a country wise cost of capital is used. E.g. for India, a 14% nominal rate and a 8% real rate of cost of equity is assumed

Asset Based Normative Valuation methods

1. Net- net: As discussed before, formula is Current assets – (All ST + LT liabilities). Be extra cautious if a company is available at a discount to its net net value. Probably, the market knows something which you may not. Look through all line items of current assets carefully- Account receivables may be of low quality or inventories may be obsolete
2. Book value:
   1. Tangible Book value (TBV)= Net wortth- Intangibles
   2. For Banks and NBFCs , we can employ a bearish view by adjusting the formula as Adjusted Book Value = TBV- ( Gross NPAs – Provision for NPAs).In uncertain times, even the assets under the watch list can be deducted

3. Justified P/B multiple = Normalized ROCE vs Cost of Debt. E.g.

Co A: Avg ROCE = 11%, Cost of Debt = 11%, Justified P/B = 1x

Co B: Avg ROCE = 9%,   Cost of Debt = 11%, Justified P/B = 0.8x (A lower P/B multiple since Avg ROCE< Cost of Debt)

4. Replacement cost of assets (RCA): This method can be used where capacities of plant & machinery of companies in a sector is standard. Below are the key steps-
   1. Check existing capacity either in annual report or any other source
   2. Get data of latest capital expenditure by companies in the industry
   3. Estimate replacement cost of company’s capacity

CASE STUDY of a sugar company was presented- The firm has a plant with cane crushing capacity of 76,500 tons per day and industry capex data indicates a cost of INR 450,000 per ton. This converts into a value of INR 34,425 million. Using this replacement cost of the primary asset – sugar, we can get total enterprise value (TEV) and equity value. In this instance, the RCA method gives INR 165 as against a book value of INR 66. However, during stressed times, one should be conservative and consider the book value of INR 66 and RCA value of INR 165 can be more appropriate in an optimistic market as some other entity might buy this company rather than setting its own. During normal times, one can also consider market multiples based EV/RCA valuation. Using this approach, we get a range of INR 78 to INR 156 (-1SD to + 1SD)

Earnings Based Absolute Valuation

DCF technique–

• CASE STUDY of an adhesive company having an economic moat was presented. For key points and assumptions, refer to the data below-

• Focus should be on organic growth while building projections
• Use of real growth rate and real discount rate
• DCF model yields a value of INR 455
• During normal times, a valuation based on P/DCF can also be considered which gives a range of INR 342 to INR 862 (-1SD to + 1SD). But during distressed times, a naïve DCF approach will work best
• Stress test of DCF value can be performed as well. Considering today’s situation, impact on near time earnings (loss of revenue and supply side constraints) and long term business (change in business practices, impact on competitors and government regulations) should be analyzed
• The subject company has a defensive business and hence even during a volatile market situation, the overall impact of stress test will not be that severe. As a worst case scenario consider zero FCF generation for the next one year (e.g. for 2021FY due to Covid-19 outbreak) and run the model to check the result. You will notice that the value doesn’t fall significantly. So when the long term growth story of a company is intact, DCF value will just show a minor drop.
• It’s worth noting that in this case example, ~75% of the value is coming from the terminal value and one may question the effectiveness of the model. In such cases, we can probe the quality of terminal value by using 3TV approach

3TV Approach

Depending upon the valuation drivers of a business, we can have three tranches:

• Tranche 1 (Asset value): Tranche 1 is the value of the tangible assets( or the value of the regular assets of the company)
• Tranche 2 (No growth value): Tranche 2 is the value of current earning power (or franchise value from current competitive advantage )
• Tranche 3 (Total value): Tranche 3 is the value of growth (or ability to protect and grow firm’s competitive advantage)

Going back to our Adhesives company example, Tranche 1 is INR 58, Tranche 2 is INR 109 and Tranche 3 is INR 455 (DCF value). The moot question now is whether you feel comfortable paying a premium of ~ INR 346(Tranche 3- Tranche 2) for sustainable growth value and invest accordingly.

Link to complete video – https://www.youtube.com/watch?v=Z7gwCchA3ts&t=3151s

Link to session presentation- https://www.cfasociety.org/india/Presentations/Valuation%20in%20Stressed%20Times%2031st%20March%20by%20Nimisha%20Pandit.pdf