In conversation with – Kenneth Andrade…

Contributed by: Shravan Kumar Sreenivasula, CFA, IAIP and Birla Sun Life AMC

Kenneth Andrade is known by the moniker “Midcap Moghul”. It is a very apt description of a fund manager who likes to be benchmark agnostic and aims to pick stocks that are wealth creators for his investors. He currently runs his own PMS by the name of Old Bridge Capital Management with a corpus of USD 150 mn. In a conversation with the very inquisitive Sonia Gandhi on a Friday evening in front of IAIP members, Kenneth covered from topics ranging from his role models, his market view, lucrative market opportunity he is sighting and his philosophy of investing. He always makes investing look simple and yet he picks up differentiated bets which run up to be multi-baggers.

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Here are some of the key take-aways for me and hope it will be helpful for others who may have missed it.

  • On his view of the markets, he mentioned that the P/E ratio across the global markets is high. Investors have been looking for “E”. It is like looking for a corner in a room that has no corner. The reason why the P/E is high is due to lower bond yields and liquidity chasing assets that have atleast some yield. Infact, more liquidity is chasing equities as interest rates are increased by central banks leading to rise in bond yields (and hence capital losses)
  • On what could cause the most waited corrected, he warned that it is always an unknown and unexpected event which could bring down the valuations across the world. Today, it is difficult to point out which one
  • He cautioned that one has to take note that this decade has by far been the calmest in past many decades. There was the Global financial crisis in the previous decade, dot come crisis & Asian financial crisis in the previous one, junk bond crisis in the previous one and so on and so forth
  • He believes that the private capex is some time away as there seems to be no equity being put into companies which would typically lever it up to kick start the capex cycle. He has missed out on the recent financials rally and would be glad to be out of it going forward as well as he is wary of such high valuations for private banks and NBFCs
  • On his investment philosophy, he looks at companies which are distressed in an industry that is making money and pick those which are earning (ROCE) better than hurdle rate. He further mentioned that those companies that are garnering market share in the down cycle could be good investment bets as they are the ones to bounce back faster incase of up cycle. He has reiterated his guideline of liking companies that respect capital because equities is about buying efficient capital. He advised that most important point to note is to buy at right valuations
  • On an audience question as to how to evaluate corporate governance of a company, he mentioned that he would look how the four stake holders of the company are treated – Customer, Employee, Bond holders and Share holders. The customer through the kind of products offered and constant improvement of the same. The employee by way of compensation, opportunities and retention plan. The bond holders through the timely payment of coupons. The share holders through the efficient use of capital and payment of dividends. This should objectively measure the corporate governance of the company
  • He is most bullish on the entire value chain of the farmer. The focus of the government on rural (particularly farmer), increasing in MSP prices, soil health cards, crop insurance, direct fertilizer subsidies etc. augur well for the farmers. Government is paying 7:1 for crop insurance and farmer literally has downside protection incase of crop failure. The overall farm waiver could be 2.15 lakh crore rupees in three years which is 15% stimulus to the farmers. So, the entire farm value chain from seeds – fertilizers – mechanization etc. would get benefitted atleast for the next 2-3 years

 

  • SKS
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Demystifying Early Stage Startup Investing – The Opportunities & Challenges

By: Chetan G. Shah, CFA, Director, IAIP

The Indian Private Equity and Venture Capital industry has become sizeable over the last few years in terms of funds raised annually. Around 33 funds raised $4.9bn for investments in Indian start-ups in CY16 compared to 21 funds amounting to $4.5bn the previous calendar year as per Venture Intelligence. Compare this with around $7.0bn net inflows witnessed in the local mutual funds industry in CY16. Looking at the interests in this industry and the start-ups, IAIP organized a timely panel discussion on the opportunities and challenges faced by the industry. It invited Anil Joshi, Managing Partner, Unicorn India Ventures, Nikhil Vora, Founder & CEO, Sixth Sense Ventures Advisors and Vikram Gupta, Founder & Managing Partner at IvyCap Ventures Advisors. Akshay Mittal, CFA, an angel investor himself, moderated the session.

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Apart from sharing their experiences & journeys, hits & misses, the panelists provided interesting insights on valuations. With little to look at in the past in a start-up, one as to make assessment of its products or services, size of the opportunity, founders’ vision & track record, management team and potential value it can create for the investors over 3 to 4 years. Valuations can become murkier if the industry the investee company is catering to is suddenly in demand like e-commerce, or taxi aggregation or foodtech, each one of which was the flavor of the month. The greater fool’s theory is at work at such times. The investors too have different objectives with some capturing value as a strategic fit with their other businesses and others having clear mandate & exit timeline to manage. Hence valuation initially is sort of negotiation between the founders and private investors. Sometimes too much value is captured by the investors and sometimes by the founders. Neither is helpful in the long term.

As far as involvement in the operations of the investee companies are concerned they were frank that ultimately they are banking on the founders and their teams for executing the plans. However, they help management in getting customers, investors, provide insights on competing technologies or processes, and provide access to alumni network especially for B2B companies. Some of them have started and institutionalized mentorship programs. Overall the business works a lot on trust, relationships and alumni network.

  • CGS

 

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Investing vs Trading: An analogy with Cricket…

By: Sitaraman Iyer, CFA

I believe the world of sports and investments have a lot in common. Being an Indian, I will take theliberty of drawing comparisons between cricket and investments. Over the next few weeks,I will try to cover some themes that are common to these two professions.

Are you a Trader or an Investor?

For me, this is most important question one has to ask before indulging in any form of investing because if you are not certain, it could be detrimental. The ability to cut losses and not turn into an investor when you are a trader, or the ability to not cash out early and turn into a trader when you are an investor goes a long way in defining your success in the field of investment.

For me, the equivalent of short-term trading and long-term investing would be batting in T20 and test cricket, respectively. Both disciplines require completely different skills and mindsets.Very few people have been successful in juggling both the fields.

 

 

No matter how boring a player looks while playing test cricket, it is his ability to leave deliveries (avoid bad stocks and be patient), play risk-free cricket (stick to one’s core competencies),and adapt to different situations(identify optimistic/pessimistic market conditions) that stands him in good stead. Test cricket, like investing, is about planning, analysing, and utilising all information around before taking a decision.

In T20 cricket,you have to be restless, attack (quick churn), make impactful contributions (quick gains), and have the ability to ride your luck when the momentum (directional trading) is right. You also have to quickly assess a good score for a particular pitch to plan your innings (identify market pulse in order to time your exit). T20 cricket, like trading, is about predicting short-term flows and taking decisions without the luxury of having all the data points.

Definition of Success

Just as a T20 player scoring a quick-fire 30 will be as valuable as a player scoring a patient 150 in test cricket, gaining 3-4% in a day while trading would be as valuable as doubling your returns over 2-3 years while investing.

I have a confession to make: just as a novice gets attracted to T20 cricket because of the glitz and glamour associated with it, I too was attracted to the markets because of the stories that floated around during the famous bull run of 2003 and 2008.

However, my investment philosophies have evolved over time. I have realised that short-term investing/trading is not my cup of tea. With all due respect, the stalwarts of the markets, just like in cricket, are those who have done well over the long term.

 

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Feeling The Heat? – A view On Indian VC Industry

Contributed by: Meera Siva, CFA

IMG_20170602_195112400

June 2, 2017, Chennai

Is the start-up investment eco-system hot or feeling the heat? K A Srinivasan (KAS), Partner & CFO – Ventureast shared his views on the past and present state of VC investments, challenges in the Indian start-up ecosystem and the future, especially of tech ventures.

KAS focuses on Fintech and Food tech sectors and oversees fund administration, investor reporting, valuation and deal structuring besides helping portfolio companies in designing their internal controls and monitoring processes. He has over 25 years of experience in finance & accounting and operations across multiple verticals – Manufacturing, Processing and Services. Prior to Ventureast, he ran his own Finance and Accounting Outsourcing (FAO) business, and sold it to Aditya Birla group. Earlier, he was the Global Finance Controller for Sutherland Global Services and had held several senior positions in A V Thomas group and managed their agro operation. KAS is a Chartered and Cost Accountant.

Return expectations

Start-ups typically start bootstrapped operations with funds from family and friends, followed by angel funding and/or seed funding. The first institutional level fund raising from Venture Capital firms starts from Series A or sometimes from Pre Series A. VC firm will participate at least two more rounds and post that PE will enter.

Investing in early stages means there are higher risks as there is not much data/numbers available. One needs to understand the operations, segment to place a bet. About 25% of investments give good returns 8-10x. About a fourth give 1-2x return. Another fourth may give 0.5-1x return and the rest is written off. So, for the portfolio, a return of 3x is a decent expectation. Ventureast’s first fund gave a 6x return, in mid 2000s.

On individual investments, VCs look for 10x return (to make up for the many that may fail). The return expectation for PE is 3x as failures are lower. At angel stage, risks are higher and return expectation is 20-30x. More and more later stage investors are moving to earlier stage to catch start-ups young and at lower valuations (with hopes of higher returns).

E-commerce story

There was a valuation boom and now gloom in the e-commerce segment. But the fact is that e-commerce has great potential and much of the pain is self-inflicted. Back-end technologies – such as helping to reduce return rates in shoes, clothing – as well as personalization options without adding to inventory, will aid e-commerce penetration. India lags China big time and as internet and mobile penetration increases, there is huge potential. In segments such as grocery, the likes of BigBasket are making good inroads. Convenience, which is leading to adoption by the newer generation will help its growth to become a billion-dollar company.

Cash on delivery (CoD) is a big issue for e-commerce, as return rates are over 60% in this segment. Moving to digital payment methods will help etailers. Also adding charges for delivery if the goods are not accepted may be needed to reduce losses.

There is less investment seen in brick and mortar businesses, except for hospitals. Others such as retail, food, infra and energy are not seeing much interest. In food, though overall sector CAGR is 10-15% growth, the same store sales growth for restaurants are not good and there is a lot of churn due to changing user tastes.

Promising tech story

Technology – artificial intelligence, big data analysis – hold a lot of promise and many firms are getting funded. AI based service industry is gaining traction. One example is Docsapp where initial data gathering is done through machines, saving doctors time.

Fintech is a space which is not a winner-take-all model (unlike marketplaces such as Amazon or cab aggregation such as Uber).  Technology plays a major role in loan origination, credit appraisal, Disbursement and collection. Algorithm based credit appraisal and risk analysis are gaining momentum. Aadhar makes eKYC faster and social network crawling, CIBIIL score, bank statement through Perfios makes the credit appraisal quicker and reduce the Turn Around Time. Fintech companies are focusing on getting primary data of the borrowers through POS or WEBPOS which makes the credit appraisal more robust. SMS crawling, contact filtering makes the collection better.   

Issues to sort out

While the outlook is good, there are issues to sort out. One is the scale up challenge, Two, there is still challenge in finding good talent, for example, a suitable co-founder.

Three, there are high expectations from founders on valuations at Series A level. If series B is not able to live up to Series A valuation, it becomes tough to raise money at Series B since new investors will be reluctant to come in at the down round. It is advisable to have a convertible structure at Series A with more management incentive if the promoters able to raise the value. that will be more sustainable.

Four, founders should be numbers savvy. They should understand the business metrics very well. Else, they should rope in a good financial expert from the start.

-MS

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THE ECONOMIC REALITY OF NON-CASH CHARGES

By Gaurang S. Trivedi, CFA

The Art in Fundamental Analysis

Financial statement analysis, which represents the art in the fundamental approach to valuation of equities, enables creditors and investors to make better economic decisions. Statutory statements prepared for reporting purposes are a combination of accounting rules formulated to characterize the accrual process, management estimates based on past experience applied to projected events, and managerial judgment that is subject to cost-benefit rationale. An interested reader has to just glance through a corporate press release of a quarterly earnings announcement to assimilate what the aforementioned signifies. The net earnings per share number, which in the ultimate analysis increases shareholders’ equity, is mostly neglected in management discussions and analysis. A majority of the managerial analysis is concentrated on alternative numbers arrived at by massaging the earnings information. The current use of pro-forma (read alternate) numbers to represent true operating earnings stems from the very real need for corporate managements to meet earnings estimates and support stock prices for companies that have meager, if any, positive net earnings to report. The ensuing treatise is an endeavor to reconnect the economic implications of the accounting for depreciation, goodwill amortization/impairment charges (universally assumed to be non-cash charges), as well as other one-time charges, that are being neglected by most investors when analyzing manipulated pro-forma earnings reports from corporate managements.

Case for Pro-Forma Adjustments

The theoretical support for pro-forma earnings stems from the perception that they depict the real economics of a business. Accounting earnings, though universally accepted to be the uniform language of business, are not considered representative of true economic income. To substantiate this premise let me first walk through the accounting treatment of depreciation and goodwill amortization/impairment in the corporate books.

Depreciation may be defined as a fall in an asset’s value and a reduction in the future benefits to be derived from its ownership due to normal business usage. Since depreciation is a charged expense, it is accounted as a reduction in earnings. However, as no corresponding cash outflow takes place, there is justification to add to earnings for arriving at economic (cash) income or in computing cash flow from operations.

Table A – Depreciation Accounting

·         When an asset is purchased Asset = (Cash) (a)
·         When depreciation is recorded Depreciation = Asset – Depreciated Asset (b)
·         Substituting (1) in (2) Depreciation = (Cash) – Depreciated Asset (c)
·         From (3), always (Cash) > Depreciated Asset (d)
·         From (3) and (4) Depreciation = (Cash) (e)
·         Or, (Depreciation) = Cash (f)

Parentheses represent a negative number or outflow

Goodwill is created as a result of a merger or an acquisition when the purchase price (transaction value) exceeds the fair value of net assets acquired. Irrespective of the exchanged currency (cash, stock, or some combination of both), the goodwill amount recorded as a result of the transaction will be the same. It thus represents expected future benefits (intangible) to the acquiring entity as a result of integrating the target entity’s operations. Since amortization/impairment of goodwill symbolizes a reduction in the future benefits to be derived from ownership of the net assets acquired, it is charged as an expense to current income. However as no corresponding cash outflow occurs, there is a reasonable basis to add to earnings for arriving at economic (read cash) income or in computing cash flow from operations.

Table B: Goodwill Accounting

Assuming goodwill is created by a cash acquisition
·         When a company is acquired Net Assets Acquired + Goodwill = (Cash) (g)
·         By rearranging (1) Goodwill = (Cash) – Net Assets Acquired (h)
·         From (2), always (Cash) > Net Assets Acquired (i)
·         From (2) and (3) Goodwill = (Cash) (j)
·         When goodwill is written off (Goodwill) = Cash (k)

 

Building a Case against Pro-Forma Adjustments

Observe that both depreciation and goodwill amortization/impairment charges do reduce reported earnings and as a pass through effect via retained earnings result in a diminished equity accumulation. Therefore, in order to examine the validity of the premise of depreciation and goodwill amortization/impairment adjustments for reconciling accounting earnings to economic income (EBITDA and/or cash flow analysis), I have presented my ensuing arguments in economic terms. The espoused rationales are an attempt to shed new light in the controversy surrounding pro-forma earnings and its brethren cash earnings. Exhibit 1 summarizes the framework used in the presentation of different relationships that develop as a result of corporate activity to support my inferences.

Exhibit 1: Framework for Illustrating Corporate Activity Relationships

  • Asset accounts affected by the purchase of an asset or purchase method acquisition

Cash

Net Assets Acquired

  • Equity accounts affected by a purchase method acquisition

Shareholders’ Equity comprising Equity Share Capital, Share Premium (APIC) and Retained Earnings

  • Nominal account depicting a diminution in future benefits from a purchased asset

Depreciation

  • Nominal Account representing a diminution in future benefits from acquired net assets

Goodwill

Logic Gap

The above summarization of depreciation and goodwill treatment for cash flow computation involves converting accounting earnings to economic income. This conversion process, however, is a result of cognitive dissonance, which simply put, is lack of consistency in knowledge and belief. Economic theory is a decision enabling mechanism for rational allocation of scarce resources (cash for this research purpose) among alternative uses. Thus in economic analysis, investments in any tangible or intangible assets are just another form of holding cash. After all, the net worth of a corporate entity holding $1 million in cash, or immovable/intangible property of equivalent value, is the same. Excluding initiated bankruptcy protection proceedings, a corporate entity is theoretically expected to exist in perpetuity. Hence, asset liquidity is generally not regarded as a predominant issue when conducting a valuation exercise. Consequently, the corporate entity is indifferent between the nature of its assets as long as their ownership satisfies the shareholder objective of maximizing wealth. Also, recall that the purchase of any movable, immovable, or intangible property for cash affects only the asset side of the balance sheet. The individual asset values may change, but the total asset value remains the same. Now, with this knowledge, visualize the whole process from an economic perspective, absent the accounting language for business transactions and see how that translates in the economic (cash) income model and free cash flow computations.

Exhibit 2 Simplified Accounting Statements

Balance Sheet as at the beginning of a given financial year
Equity Capital 200 Cash 100
Retained Earnings 100 Fixed Assets 200
Total 300 Total 300
Income Statement for the given financial year
Sales 500
Costs 300
Depreciation 100
Net Income 100
Cash Flow from Operations for the given financial year based on above:
Net Income 100
Depreciation 100
Total 200
Balance Sheet as at the end of the given financial year
Equity Capital 200 Cash 300
Retained Earnings 200 Fixed Assets 100
Total 400 Total 400

 

Exhibit 2 enumerates the basic accounting statements used for reporting purposes in any given year. The accounts are simplified for purposes of enabling easier comprehension of the concepts to be discussed. The cash flow from operations is arrived at by adding back depreciation charges to net income. Exhibit 3 mathematically illustrates the enumerated income statement.

Exhibit 3 Mathematical Representation of Income Statement

S – C – D = N (01)
Where,
S = Sales
C = Costs excluding depreciation
D = Depreciation
N = Net Income
Also (01) can be rewritten as:
S – C = N + D (02)

A close look at the reformulation in equation (02) reveals that the right hand side of the equation is nothing but the cash flow from operations computation using the indirect method. However in reality, the cash flow of 200 in our illustration, is generated by the corporate activities represented on the left-hand side of the equation i.e. Sales minus Costs excluding depreciation. This can be confirmed by observing the difference in the values for cash on the balance sheets at the beginning and at the end of the year. However depreciation charges have resulted in reducing the net value of fixed assets by the booked amount i.e. 100. More importantly, the total asset and equity amounts have increased only by 100, an amount corresponding to net income for the period. This negates the notion that depreciation is a non-cash expense in the economic sense as currently perceived and previously described. Exhibit 4 and the supporting analysis that follows will further evince the above observations.

 

Exhibit 4 Depreciation in an Economic Framework

Assuming purchase of an asset is just another form of holding cash
·         When an asset is purchased Asset = Cash (03)
·         When depreciation is recorded Depreciation = Asset – Depreciated Asset (04)
·         Substituting (03) in (04) Depreciation = Cash – Depreciated Asset (05)
·         From (03), (04) and (05) Cash > Depreciated Asset (06)
·         Let Change in Cash (CC) denote CC = Cash – Depreciated Asset (07)
·         From (05), (06), and (07) Depreciation = CC (08)
·         From (08) when charged to income (Depreciation) = (CC) (09)
  • Parentheses represent a negative number or outflow

 

In the economic framework as presented in Exhibit 4, depreciation represents a reduction in cash. Consequently, the net effect of a depreciation charge is a cash outflow, and hence there is no justification to add to earnings for arriving at economic (or cash) income. A base case scenario of a subsequent disposal of an asset for book value (original cost less accumulated depreciation) will enable a better understanding of this analysis. Instrumental in this explication is the fact that the purchase of an asset has no bearing on the income statement i.e. the purchase is not recorded on the income statement as an expense. In the above referenced scenario, upon the disposal of an asset, the company will receive an amount that is less than the original cost. The difference in original cost and realized price represented by depreciation is thus a real cash reduction, and hence should be treated as a cash outflow. This analysis may generate a counter argument of incorporating the time value of money, which would necessitate that such treatment should be considered only when the actual event of disposal takes place i.e. when reduction in value is realized. As a resolution to this counter proposition, we need to recognize that theoretically, corporate managements are expected to act as fiduciaries of corporate assets and maximize shareholder value. Thus, any estimate of value erosion represented by depreciation should be considered as realized, accounted for, and analyzed in that context. Moreover, current cash based earnings valuation techniques do not reverse the positive adjustments to earnings from depreciation when assets are disposed or written off completely, thereby creating and maintaining a systematic upward bias in both income and valuation.

 

Exhibit 5 Goodwill as a Result of Merger or Acquisition in an Economic Framework

·         In case of acquisition for cash Net Assets Acquired + Goodwill = Cash -10
·         By rearranging (10) Goodwill = Cash – Net Assets Acquired -11
·         From (10) and (11) Cash > Net Assets Acquired -12
·         Let Change in Cash (CC) denote CC = Cash – Net Assets Acquired -13
·         From (10), (11), (12) and (13) Goodwill = CC -14
·         From (14) and when written off (Goodwill) = (CC) -15
·         In case of acquisition for equity Net Assets Acquired + Goodwill = Equity -16
·         By rearranging (16) Goodwill = Equity – Net Assets Acquired -17
·         From (16) and (17) Equity > Net Assets Acquired -18
·         Let Change in Equity (CQ) denote CQ = Equity – Net Assets Acquired -19
·         From (16), (17), (18) and (19) Goodwill = CQ -20
·         From (20) when written off (GI) = (CQ) -21
·         From (15) and (21) for all charges (CC) = (CQ) -22

 

As depicted in Exhibit 5, the entire process of goodwill creation and its attendant amortization/impairment charge can be economically modeled in the context of changing the form of holding cash (acquisition for cash), or new issue of equity for cash and the subsequent acquisition of net assets at a premium represented by goodwill with that cash (acquisition for equity). An acquisition using a combination of cash and equity can be analyzed similarly. As such, there is no justification to add the amortization/impairment charge to earnings for arriving at economic (cash) income. In materiality, equation (22) reveals that all charges appearing on the income statement can be modeled in the economic framework to represent a reduction in cash and therefore do not merit an upward adjustment in free cash flow computations. Implicit in this interpretation is the fact that cumulative past earnings and operating cash flows are virtually identical. The variance in operating cash flows and reported earnings associated with charges in one time period results from the difference in the timing of the flows, not the actual nature and value of the flows. Restructuring charges and other assorted non-recurring expenses (one-time charges) do matter to the equity holder as they reduce the accrual of profits (economic rent) to their ownership stakes and should therefore be incorporated in the valuation process when they’re recorded and not when they’re paid out, to negate any potential earnings management motivations.

Application for Investment Management

Concomitant with the foregoing economic rationale and the financial implications of the accounting of corporate activities, the computation of free cash flow supports the upward adjustment in earnings for depreciation because it considers the effect of capital expenditures (asset purchases) at the outset as a cash outflow. Recognize also, that it still does not require upward adjustments for goodwill impairment charges or other charges deemed non-cash (e.g. restructuring charges) in computing free cash flow. Although there are a number of predications for mergers and acquisitions such as taking advantage of tax loss carry-forwards of the target, increasing liquidity or to bring a better balance to the capital structure of the acquiring firm, etc., most of them are short term in nature. The fundamental economic premise underlying a majority of mergers and acquisitions is usually adding to current capacity (growth through increased market share) or expanding the product line (growth through diversification) and the associated cost savings from leveraging economies of scale. This is logically the same as incurring capital expenditures for expansion plans, albeit with the economic advantage of synergies and time savings realizable in bringing added capacity online and marketing the expanded product offering. Thus in analyzing the impact of mergers and acquisitions, subsequent goodwill amortization/impairment charge should be added back to earnings for free cash flow computation only after an initial cash outflow is recognized at the time of a merger or acquisition, i.e. the merger or acquisition is treated as a capital expenditure. A common justification against this interpretation in the case of mergers and acquisitions where equity is exchanged is that the initial cash outflow implication is considered by the increase in the number of shares outstanding. This assertion however is mired in fallacy. It takes into consideration only one effect of the transaction, i.e. an increase in equity. Ordinarily, when equity capital is raised, the ownership of shares is exchanged for cash. In the case of mergers and acquisitions involving exchange of equity, this cash is assumed to be expended on the purchase of net assets and goodwill (if any) i.e. a treatment akin to capital expenditure. Thus, currently practiced free cash flow based valuation techniques allow the acquiring company to have the cake and eat it too. Not only is the initial cash outflow not recognized, but also, goodwill amortization/impairment is added back in free cash flow computation as a bonus. The process systematically creates and maintains an upward bias in current and future free cash flows thereby manifesting into higher stock price of the acquiring company. It favors the growth through acquisition strategy over organic growth strategy. This treatment is analogous to viewing one ton of steel as heavier than one ton of cotton. The proposed methodology of computing free cash flow is thus strategy neutral, i.e. it treats companies that grow through internally generated funds equally with companies that grow through acquisitions thereby facilitating equitable comparisons for investment purposes.

Final Thoughts

Like a golfer who struggles with the putter, an investor lacking full cognizance of the interaction of accounting, finance, and economics makes decisions with a major handicap. The purpose of this research is to generate a healthy debate amongst accounting, finance, and other professionals who are consumers of company information to evaluate the efficacy of reported financial statements, management discussion and analysis that accompanies them, and current valuation methodologies practiced. Contrary to popular notions, if cognitive biases are removed, one may find that accounting earnings do mirror economic reality. The preceding analysis and proposed free cash flow computation methodology showcases the fallacy of pro-forma earnings presentation and the doctoring of earnings by corporate managements and analysts to meet estimates and justify high stock prices. It could well explain the observed frenzy in using bloated stock prices as a currency for a majority of unsuccessful mergers and acquisitions. It also brings to light ethical issues that managements face when preparing and reporting financial information. It is also an attempt to help streamline the analysis of corporate information; conforming it to a principles based approach to render it more objective and unbiased. All types of equity pricing methods are susceptible to manipulations in the short run. In the long run however, equity prices always reflect the underlying fundamentals and will adjust for any innovative accounting. Equities investment begins with computing expected returns and concludes with comparison and analysis of actual returns with the expected returns. Since earnings comprise an integral part of expected returns, a sound knowledge of accounting theory and concepts is essential for conducting insightful financial analysis. In conclusion, users of financial statements will be better served if they take cue from their animal friends and sniff before they consume anything given to them.

– GT

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China’s Belt and Road Initiative: Pax Sinica Redux or Economic Black Hole?

Contributed by: Ishwar Chidambaram, CFA, CIPM

“… (We must) hide our capabilities and bide our time, never try to take the lead…”

-Deng Xiaoping, Paramount Leader of the People’s Republic of China (1978-1989)

On May 14, 2017, Deng Xiaoping would have been spinning in his grave at China’s flagrant disregard for his sage dictum, when the heads of state of 29 nations converged on Beijing for the inaugural Belt and Road Forum. The 2-day extravaganza, touted as the biggest diplomatic event of the year, was designed to promote China’s leadership of Eurasia under the Belt and Road initiative, an ambitious plan to realize President Xi Jinping’s strategic vision. This vision calls for constructing a land economic belt to Central Asia and Europe, and a Maritime Silk Route to connect the Pacific Rim with the Indian Ocean and Africa. China has pledged more than $100 billion under this initiative, popularly known as One Belt, One Road (OBOR).

Prominent attendees to the Forum included Russian President Vladimir Putin, Turkish President Erdogan, seven ASEAN leaders, the Prime Ministers of Pakistan and Sri Lanka, and heads of the United Nations, IMF and World Bank. Bucking the rising tide of protectionism in the Western world, 130 nations on 5 continents flocked to the event.  Prima facie, this would appear to affirm China’s position as a beacon of globalization, in an era where the Trump administration has slashed foreign aid and erected trade barriers in the name of “America First”. OBOR might also be expected to consolidate the position and perpetuate the legacy of Chinese President Xi Jinping, arguably the nation’s most powerful leader since the revered Deng Xiaoping. In his speech at the Forum, President Xi announced that total trade between China and other OBOR countries has already surpassed $3 trillion from 2014 to 2016. China’s investments in those nations have exceeded $50 billion, with a target of $4 trillion. It has set up 56 Special Economic Zones in 20 countries, which have collectively generated $1.1 billion in tax revenues and created 180,000 jobs. But the project is not without risks, as outlined below, and has drawn criticism from various quarters.

Critics of the project contend that the entire scheme is poorly conceived and simply an ego trip for the powers that be in Beijing. They point out that China is merely exporting overseas its domestic model of debt-driven development. They contend that this model is unsustainable in the long run, and that any escalation of credit risk could lead to spiralling bad debts, which would severely burden the fragile economies of peripheral nations. In fact, the UN has itself expressed concerns over economic, financial, social and environmental risks of OBOR. A recently concluded UN Economic and Social Commission for Asia and the Pacific Study (UNESCAP) has warned of financial risks in countries in south and central Asia where China’s announced investment value under OBOR is high compared to the relative size of the economy of the recipient country. The $15 billion China-Uzbekistan investment deal signed in late 2013 is roughly equivalent to a quarter of Uzbekistan’s GDP. Similarly, the $37 billion China-Kazakhstan cooperation agreement signed in late 2014 and early 2015 and the $46 billion China-Pakistan agreement in April 2015 each represent over a fifth of GDP level in Kazakhstan and Pakistan, according to the UN study. “External account indicators for some of these economies are relatively weak”, as per the report, which also expresses concerns over upheavals on the social and environmental fronts in the region.

Another concern is ratings firm Moody’s recent downgrade of China’s long-term local and foreign currency issuer ratings by one notch to an A1 rating from AA3. Moody’s cited expectations that the financial strength of the world’s second biggest economy would “erode in future, with economy-wide debt continuing to rise even as potential growth slows”. The downgrade is yet another signal to the international community that all is not well with the Dragon, even as it has embarked upon its expansive OBOR initiative, targeting global dominance. Some Western nations have also expressed reservations about the Forum, as they see it as an attempt to hard sell China’s soft power, with complete Sinification being the ultimate objective. Already there are grim assessments to the effect that weaker economies like Pakistan would be fully subjugated and reduced to an economic colony by China.  Western countries are also bothered by the perceived lack of openness and transparency in awarding contracts. According to one US investment research firm, it is also open to question “how much political sovereignty is sacrificed, and what is the risk to completion of projects in the event of a disorderly slowdown in the domestic Chinese economy”. Nevertheless, this has failed to dent enthusiasm for the Forum.

Peering into history, commerce along the ancient Silk Road was pivotal to the emergence and flourishing of the ancient civilizations in East Asia. The Chinese, in particular, were the greatest beneficiaries of that free trade, which led directly to the establishment of the first Pax Sinica (Chinese peace), when China maintained the dominant influence in Asia due to the combined might of its soft and hard power. In its current avatar, the Belt and Road initiative is widely regarded as China’s tour de force, heralding its emergence as a superpower on the world stage and shifting the planet’s economic centre of gravity towards Eurasia. It envisages extensive investments (as much as $ 1 trillion by some estimates) in infrastructure, such as roads, railways, airports, seaports, transnational electric grids, oil pipelines and fibre optic lines of communication. If successful, it would represent the culmination of China’s ascendance, and transform the face of Eurasia beyond recognition.  

The initiative showcases China’s global ambition on an epic scale. The motivations behind this proposal are ubiquitous, with economics being chief among them. China needs to find and develop the untapped markets in its hinterland to export its excess capacity in cement, steel and industrial materials. The Dragon has a burgeoning war chest of over $3 trillion in foreign exchange reserves, most of which is parked in low-interest-yielding US Treasury securities, and which need to be redeployed to more profitable alternatives. Another imperative is to quell the unrest in China’s troubled western provinces of Tibet and Xinjiang, by strengthening the fragile economies of Central Asia, thereby creating a more stable environment. And last, but not least, the Maritime Silk Route could possibly bolster China’s territorial claims in the South China Sea, a region long coveted by Beijing.

The Initiative has already begun to attract significant financing. In 2015, The People’s Bank of China transferred over $80 billion to three state-owned banks mandated to provide funds for OBOR projects. A new Silk Road Fund worth almost $40 billion was promoted by China’s sovereign wealth fund. The most significant milestone was the inception of the Asian Infrastructure Investment Bank (AIIB) by the Chinese government, with $100 billion in initial capital. Like a freight train pulling away from the station, the OBOR project is slowly gathering momentum. Now China’s omnipotent state resources are mobilising, with over two-thirds of China’s provinces incorporating OBOR in their development objectives.

Despite these efforts at coherence, the initiative is beset with teething troubles, especially in South and East Asia, with disputes over a railway line through Thailand and clamour for renegotiating projects in Sri Lanka and Myanmar. There is also a profound dearth of feasible projects for the enormous sums of money allocated. Moreover, OBOR lacks a strong central leadership, with its present leader- Mr. Zhang Gaoli- perceived to be out of favour in Beijing. Even more critically, there exists a vast cacophony of internally competing bureaucratic voices within China- the ministry of commerce, the foreign ministry, the planning commission and China’s provinces, to name but a few- each competing for their share of the lucrative OBOR pie. These will need to be reconciled for the OBOR orchestra to hit all the right notes and play a fluent symphony. Whether it results in a second Pax Sinica or collapses into an economic black hole-only time will tell; but one thing is certain: win or lose, the Dragon means business. Every chain is only as strong as its weakest link, however, and the Belt and Road Initiative is no exception.

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Sensex @ 30,000…What Next?

Contributed by: Shivani Chopra, CFA

As the CFA Institute celebrates its 70th Anniversary this year, it remembers the seminal event that shaped the geographical reach of CFA Society network. Even today these events deliver value to the members by providing forums to learn and discuss issues of common interest. We witnessed another such event on 13th May 2017 when the Delhi Chapter of CFA Society India had the privilege of hosting Mr. Navneet Munot, CFA who delivered a very interesting talk on the current topic. An acknowledged expert on the topic, Navneet is the Chief Investment Officer of SBI Mutual Fund and Board of Director, Indian Association of Investment Professionals (IAIP).

The list of variables affecting equity markets is interwoven in a complex web and the list itself is pretty lengthy. Navneet tried to discuss most of these factors currently affecting Indian stock market. He started the discussion by highlighting the structural reforms happened in India recently. These include Bankruptcy code, GST code, Aadhar Bill, Real estate regulatory bill, etc. Demonetisation of high value currencies has significantly expanded the tax payer base by adding 94 lakh new income tax payers. As finance is becoming more digital, it is leading to Financialization of assets. The household savings are entering the financial sector more rapidly and for longer term now. The situation in India can be compared to 401K movement in US. A reform with a simple motive – “Save more to have a better retirement”.

Digitization, Technology, Urbanisation and Rural revival

Navneet then discussed the growth drivers for India. Some of the growth drivers are correctly priced while others are not. Digitization will be one of the most important growth drivers. Infact, India is leading the digitization drive in the world as its migrating from data poor to data rich country. Many government programs are being tracked on live basis. Another growth driver closely linked to digitization is technology. The best way to change our country’s ‘DNA’ is through use of technology. We have a great potential to become one of most literate countries in the world as today being able to use technology is equivalent to literacy. Technology will continue to do wonders for the corporates as well. Jio is a brilliant example. It used Aadhar card information to expand its subscriber base to such high levels. Banks are considering the downsizing of their existing branches and may not be opening new branches at all. A point that was repeatedly stressed was that we as a country are massively underinvesting in technology. We need to invest much more in technology if we want to see the right results. Urbanisation and Rural revival was the next factor talked over. The government focus is on digital connectivity, rural electrification, crop insurance, road connectivity, financial connectivity, etc.

Leverage, Global Economy and Exports

Navneet went on to share some facts relating to leverage, reliance on global economy and exports .India is one of the least leveraged countries. During the last business cycle in 2007, the analysts predicted a 10%+ growth for extended period but this expectation busted due to policy inactions. India story today is strengthened by the regulatory and policy measures taken. Borrowing costs have come down and there is easier availability of credit in the retail sector. The private capex cycle will take some time to improve but the government capex looks good. Affordable housing schemes are fast gaining popularity. These schemes depend on idle land bank, tax incentives, latent demand, lower rates and easier credit. Real Estate Regulatory Act (RERA) is going to change the industry for good. The speaker expects the volumes to go up in the next few years in contrast to the prices that had gone up in the last few years. He also spoke about the importance of global trade. Though it is perceived that India is a domestically driven economy, the truth is that global economy also matters a lot to us. The continued pick up in India’s exports is a healthy sign. India has never lost its market share even in tough times. Our country is least affected by global trade volatility because of a well-diversified basket. Growing exports coupled with robust FII and FDI flows have led to the appreciation of the rupee. After the demonetization, the excess liquidity in the banks kept RBI intervention low as absorbing excess dollars could have added even more to the rupee liquidity.

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What Next ?

All the factors discussed above will have an important bearing on the Indian stock market. Things have just started to fall in the right place, be it liquidity or political stability. We have a reform oriented government and supply side economy is building up. Other than the twin balance sheet problem, macroeconomic situation is looking very bright. Taking clues from the past Sensex performance, there have been two set of periods when the market was down for two consecutive years (1995-96 and 2000-2001). After that we have not really seen any period and so logically the third year after two almost flat years should be good. Below are the contributors which will help sustain 30K level –

  • Earnings Quality and controlled costs – Navneet’s biggest worry is the earnings sustainability. The NIFTY PAT is expected to post a double digit growth but it is coming from only a few select sectors like Banks, Oil and gas, etc. In this cycle, wages and other key costs will remain controlled. So in future when revenues will improve, this level of 30K will sustain
  • Better leadership at state levels – We can see some major action happening in a few states. E.g. Uttar Pradesh (UP) which has historically been a drag can actually drive the growth agenda for India. A state with 16.5% of country’s population has ranked very poorly in terms of per capita income, literacy level, poverty ratio, etc. In terms of social conflict, UP can either be a biggest demographic dividend or demographic disaster.
  • New set of winners- India might be heading towards NICE era – Non Inflationary Continued Expansion but with a new set of winners. As the rising tide doesn’t always lift all the boats, likewise not all the corporates will do well. A few may even go out of business. With the help of technology and emergence of social media platforms, costs like advertising are very low today. This will help companies with new business models thrive at a faster pace. Active stock picking remains the key.
  • Liquidity- The biggest contributor is increase in liquidity. The retail participation is at all time high but the numbers are just a tip of the iceberg. Increased supply from IPOs, divestments and QIPs can absorb this liquidity. The need of the hour is to issue mega IPOs to revive the IPO market. Private PSUs have a good scope to go public as well.

There are risks to be considered too. Navneet mentioned a few important ones like geopolitical, GST implementation, twin balance sheet problem (over leveraged corporate balance sheet and NPAs in banking sector), disruptive forces faced the business, etc

The talk ended with attendees actively asking equity market related questions, all of which were answered very patiently by our eminent speaker, Mr Navneet Munot.

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