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A Grave Mistake Both Companies and Investors Make

Oct 12, 2017

Tanushree Banerjee, Editor, The 5 Minute Wrapup

One of my researchers, Radhika, and I were having a chat on the pharma sector. We are evaluating a pharma company for one of my recommendation services. One thing led to another and the discussion turned to the Israeli pharma company Teva.

Teva Pharmaceuticals right now is the largest generics company in the world. In the pharma generics (making copycat versions of patented drugs) industry, that's a big thing. The global pharma generics sector is very competitive. So the bigger a company is, the better it can enjoy economies of scale.

For the past several years, Teva had been in a sweet spot. Making all the right launches. Cornering a significant share of the American market. More importantly, it had its own patented drug on the market called Copaxone, which was making billions of dollars for the company every year.

Today, Teva is in the doldrums. Competition in the US has intensified and Teva is facing the heat. Copaxone has lost its patent, which means that the drug will no longer generate the kind of sales that it once did. To make things worse, Teva is saddled with huge debt. And the company has reacted by going in for massive cost cutting. That's just the start. It has many tough decisions to make in the coming months.

Teva, you see, has possibly made a mistake. Last year, it bought the generics business of Allergan for a price (around US$ 41 billion) that many consider expensive.

Now, drugs losing patents and competition intensifying is a way of life for the entire pharma industry. Sometimes there's not much a company can do there.

But buying Allergan - and at that obscene valuations - was a mistake. Because when the going gets tough and the operational environment becomes challenging, such acquisitions start hurting badly.

This is no different than us investors buying a stock at an overpriced valuation. Especially now with IPOs coming thick and fast - and companies pricing their issues too high - it's easy to get lured in.

But this simple fact is as true for businesses as it is for investors: Buying at high valuations - whether a share or a whole business - is a losing game.

If you do this, the returns generated in the longer run are likely to remain quite poor.

We have many examples of businesses doing this in India too. Tata Steel is a classic case. In FY07, Tata Steel acquired 100% of Corus Group Plc, a 21 million-tonne capacity steel producer with plants in the UK and the Netherlands. At the time, it was the biggest deal ever made by an Indian company.

The move, in one fell swoop, pushed the company into the global league of steel producers, and made it the world's sixth-largest integrated steel producer.

But then Tata Steel ran into problems. There was oversupply in the global steel market. Demand weakened. And steel prices crashed. Tata Steel's European operations were badly hit. The strain on its balance sheet was just too much - and the company was forced to put its European operations up for sale.

The lesson in all this is that the basic rule of valuing any asset is this: When buying shares, investors need to evaluate the business fundamentals of a company and then decide whether the price in relation to earnings is reasonable. And companies need to do the same.

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ValueTalk

Super Investors and Insiders are Scooping Up Stake in This Business

Bata, Liberty, Action, Paragon, Hero Honda, Ford (USA), Chrysler (USA), Ford (India), General Motors (India), Mahindra & Mahindra, Maruti Suzuki, Honda Motorcycles, Tata Motors, and Eicher Motors. Each of them get the supply of their crucial raw material from this plant in Rajasthan. The manufacturer has been around for over two decades and claims 15% market share of the product. But the business has such a strong moat and is so profitable that two of the most renowned super investors have bought stakes in this company.

What is even better is that the temporary impact of demonetisation and GST has brought the stock's valuations to very attractive levels. So, the company promoters and insiders are steadily increasing their stake.

The Smart Money Secrets team recently recommended this 'owner operator'.

Six State-of-the-art Italian coating lines

ValueTalk is a weekly idea box that brings you the best ideas for investing from across the Indian stock markets...

Offer for Sale Dominates IPO Activity

The initial Public Offering (IPO) activity is headed for a record in 2017. In the first nine months, the volume of IPOs has already exceeded the yearly total of 2016. In the first half of the current fiscal year, 19 companies garnered over Rs 267 billion through their respective IPOs. Compared to the same period in the last fiscal, this is much higher than the Rs 165 billion raised by 15 firms. The previous record was Rs 212 billion in the first half of 2007-08.

The IPO activity in FY17 is mainly driven by Offer for Sale (OFS) rather than fresh issues. An OFS is a route through which existing promoters and private equity investors offload their stake. Here, the money from the sale goes to the selling shareholder. Whereas, in a fresh issue, the money raised goes to the company, who, normally, utilizes this money for repaying debt, capital expenditure, etc.

The Rising proportion of OFS

As per Prime Database, in FY18, Rs 224.5 billion or nearly 85% of the IPO has been raised through OFS issuance. The increasing proportion of OFS can be clearly seen in the chart above.

One of the key reasons for this surge in OFS offering is due to a surge in the Indian equity market backed by liquidity and increasing investor demand for financial assets. Private equity investors and promoters are taking advantage of the absurd demand for IPOs.

With several big IPOs in the pipeline in the last few months of 2017, it looks like the OFS will dominate the IPO proceedings.

During such a time, it's beneficial to be very selective when investing in IPOs. Carefully analyse each company for its own merits and don't give in to the hype surrounding the public offering.

That's Ankit Shah's approach at Equitymaster Insider. He keeps a sharp eye on the developments in the IPO space and keeps his readers up-to-date on the big-ticket IPOs.

Ankit and his team of researchers constantly reference this handbook on investing in IPOs. You can download a copy for yourself. It's free. Just click here.

Private Banks and NBFCs Continue to Gain Market Share from PSBs

As per an article in Business Standard, private sector banks and non-banking financial companies (NBFCs) are gaining market share by lending to the commercial sector at the expense of public sector banks (PSBs). The market share of private sector banks increased from 30.8% in FY16 to 33.1% in FY17. Whereas, PSBs lost their market share during the same period from 70.9% to 64%.

In FY17, credit off-take was down to 5.1%, a 10-year low. This was despite a steady decline in the cost of borrowing. This is obvious as the balance sheets of PSBs are in a big mess. They already have a huge amount of bad loans piled up. And it's the private sector banks and NBFCs that have taken up the slack.

NBFCs registered a 13% growth in total credit off-take and the commercial loan book grew by 8.8% in FY17. As a result, NBFCs gained market share in commercial lending from 2% in FY16 to 2.9% in FY17.

No wonder the market cap of the private financial services firm as a percentage of the index's market cap has more than doubled, whereas the share of PSBs has come down. It looks like NBFCs and private banks would continue to gain market share because of their nimbleness, efficiency, and ability to fill the space vacated by PSBs owing to either capital constraints, flight to safety or limited ability to price in the risk.

What the Markets Look Like Today

Indian equity markets opened the day on a strong note. At the time of writing, BSE Sensex was trading higher by 82 points and NSE-Nifty was higher by 30 points. Both the mid cap and small cap indices are trading up by 0.4% and 0.7%, respectively. Stocks from the pharma and capital goods are among the gainers.

Investment Mantra of the Day

"Cash combined with courage in a time of crisis is priceless." - Warren Buffett

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