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Why Investing in Utility Companies is a Good Idea...

Mar 2, 2016

In this issue:
» Corporate taxes in India remain high
» RBI's move to improve core capital of banks
» ...and more!
0:00
Radhika Pandit, Managing Editor of ValuePro

Warren Buffett's annual shareholders meeting is the most anticipated event in the investing world. And for the die-hard value investor, the letter that Buffett writes to shareholders is something to really look forward to. For this is no ordinary letter. Indeed, besides the usual update on Berkshire's business and investments, Warren Buffett also doles out nuggets of investment wisdom. And these are always interesting.

The 2015 annual letter is no exception. Buffett touched upon a variety of topics - his four big investments, the importance of productivity gains especially in a country like the US, and his views on BNSF and BHE.

Today, I will focus on those two businesses.

Burlington Northern Santa Fe and Berkshire Hathaway Energy are utility companies. In that sense, they are different from your typical 'Buffett-would-buy' company.

How so?

Buffett has always favoured companies with strong competitive advantages little or no debt on the books, and robust dividend payouts.

Utility companies are a different lot altogether. As Buffett himself states in his 2015 letter:

  • We have two major operations, BNSF and BHE, that share important characteristics distinguishing them from our other businesses. A key characteristic of both companies is their huge investment in very long-lived, regulated assets, with these partially funded by large amounts of long-term debt that is not guaranteed by Berkshire.

So they operate in a regulated environment, and these companies do have a fair bit of debt on their books. What does Buffett like about them then?

Buffett explains in his latest shareholder letter:

  • Each company has earning power that even under terrible economic conditions would far exceed its interest requirements. Last year, for example, in a disappointing year for railroads, BNSF's interest coverage was more than 8:1.
  • Both enjoy a factor common to all utilities: recession-resistant earnings, which result from these companies offering an essential service on an exclusive basis.

Society will always need huge investments in both transportation and energy. And it is in the self-interest of governments to treat capital providers in a manner that will ensure the continued flow of funds to essential projects.

We agree. While managing ValuePro, not only do I scout for the typical Buffett-style company with strong brands, but I keep an eye on utilities as well.

In fact, my team and I have already recommended two utility companies in the ValuePro portfolios. Besides providing an essential service, these companies have very little or no debt on their books. This is quite commendable given that both these companies have capital intensive businesses. And near-term hiccups aside, we believe that they have the potential to add to shareholder wealth in the longer run.

Do you think that utility companies are good value creators in the long term? Let us know your comments or share your views in the Equitymaster Club.


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3:03 Chart of the day

If India has to realize its dream of 'Make in India' then it needs to improve the ease of doing business in the country. One of the factors impacting business is the incidence of corporate taxes. The corporate taxes in India, at over 33%, are still higher than most of the other countries. However, this is only one side of the coin.

The average tax rate, in fact, works out to 24.67% due to various exemptions, incentives, and deductions availed by companies. The companies operating in the infrastructure, mining, IT and drugs and pharmaceuticals sectors are subject to lower effective tax rates on account of numerous deductions enjoyed by them.

To ensure that the corporate tax burden remains equitable, the government has laid down the framework of reducing corporate tax rates from 30% to 25% along with rationalization or phasing out of corporate tax exemptions. In the Union Budget 2016-17, the government is in active consideration of phasing out of tax incentives and exemptions. Principal among them are, restricting the accelerated depreciation for IT companies to 40% from FY18 and limiting the deductions allowed for Research & Development to 150% from FY18 and to 100% from FY21 onwards. Since the additional revenues from phase-out of exemptions would be available gradually, the government would be rationalizing the corporate tax rates in a staggered manner.

In the Union Budget 2016-17, the government has allowed new companies formed after 1st March 2016 to be taxed at 25% provided they do not claim any tax benefits. Additionally, small companies with turnover of less than Rs 50 million would be taxed at a lower rate of 29% from FY17 onwards. These measures are expected to bring down the corporate tax rates in an even manner.

Indian Cos Continue to Face High Tax Burden

4:01

Moving from corporate tax rates, another factor that can impede economic recovery is the bad loans clogging the banking system. Public sector banks (PSBs) have been battling the demon of bad loans for quite some time now.

As if this was not enough, sluggish credit offtake along with jump in provisioning after the recent asset quality review by RBI have severely constricted their earnings with some of them posting losses in the December 2015 quarter. This has greatly impacted the capital adequacy of a number of PSBs at a time when they also need to fulfil Basel III requirements.

The capital infusion of Rs 250 billion provided in the Union Budget 2016-17 remains grossly inadequate. To address this issue, the Reserve Bank of India has relaxed some regulations in the computation of Tier I capital or core capital of banks.

As per the revised norms, additional reserves arising out of revaluation of properties would be considered as Tier I capital after a 55% discount. This is likely to help unlock the value of large amount of real estate holdings of PSBs and shore up their capital strength. Additionally, RBI has also permitted part of foreign currency translation reserves and deferred taxes to be included in Tier I capital. This move by RBI is likely to ease some of the capital constraints being faced by PSBs presently.

4:45

Indian markets traded firm today on the back of sustained buying momentum in the index heavyweights. At the time of writing, BSE Sensex was trading higher by around 448 points. Barring FMCG, all the sectoral indices were finding favour, with stocks from banking and IT notching the most gains. Stocks from both the smallcap and midcap spaces also did well. The BSE Midcap and BSE Smallcap were trading higher by 2% each.

4:55 Today's investment mantra

"Absent a lot of surprises, stocks are relatively predictable over twenty years. As to whether they're going to be higher or lower in two to three years, you might as well flip a coin to decide." - Peter Lynch

This edition of The 5 Minute WrapUp is authored by Radhika Pandit (Research Analyst) and Madhu Gupta (Research Analyst).

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