Should investors be tempted by 'turnaround stocks'? - The 5 Minute WrapUp by Equitymaster
Investing in India - 5 Minute WrapUp by Equitymaster

Should investors be tempted by 'turnaround stocks'? 

A  A  A
In this issue:
» Which way will the Rupee go?
» Fed is likely to end its bond-buying program this year.
» Will the Chinese Yuan collapse?
» India's internet penetration level is lowest amongst BRIC nations.
» ...and more!

It was not long ago when a large portion of Indian companies were reeling under the pressure of mounting debt levels on their books. During the boom period - one that was expected to continue for many years to come - India Inc was on an expansion spree; increasing capacities and venturing into unrelated businesses. However, when the tide turned, it definitely did separate the wheat from the chaff.

An economic slowdown coupled with rising interest rates led to cash flows being impacted, thereby making it difficult for companies to service or repay their debt obligations. The almost doubling of nonperforming asset (NPA) levels of public sector banks over two-year period ended 2012, gives an indication of the stress levels in the system.

While there have been reports of the relationships between the bank executives and the businesses houses - and the lack of proper appraisal and due diligences - there are some opinions that the rising NPA levels are not entirely on account of crony capitalism, but also are on account of the economy slowing down, coupled with the government failing to carry out structural reforms and boost investments. But that's a story for another day.

Amidst all of this, there would be few companies that would manage to ride the wave and survive the current tough times. And it seems that the process of improving their health positions has already begun.

As reported by global rating agency S&P, the credit profiles of India Inc. is expected to improve given that companies are focusing towards reducing debt. This is happening by them selling off their assets and raising more capital through equity, while some are paying off debt through internal accruals i.e. by curbing their capex plans. Selling of non-core assets and divesting entire businesses is also something that is occurring.

This kind of a trend is mainly being witnessed in infrastructure related companies. Being a beaten down sector (and for a while now), there have also been couple of reports of these being strong turnaround opportunities - as an investment strategy. And thus the potential of them being multi-baggers in the process!

While a turnaround theme as a strategy may not be a bad approach, it would not be worth the effort in our view; and would most definitely be an aggressive approach. We believe that there are quite a lot of value traps that lurk in turnaround type stocks. Therefore, even if you buy these at huge discounts to their so called intrinsic values, chances are that the stock prices never reach those values. Given this situation of turnarounds seldom turning, we believe that one's efforts are much better devoted towards buying quality businesses at decent valuations.

Investors would especially do well to study strength of the competitive advantages that good quality companies have. And for doing so, studying trends over longer periods - which cover various business cycles, would be essential.

What is your take on the turnaround investing strategy? Let us know in the Equitymaster Club or share your comments below.

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01:40  Chart of the day
We are living in the Internet age. However, India's internet penetration levels reveal a different story all together. As can be seen in today's chart, India's internet penetration level is lowest amongst BRIC nations, and miniscule when compared to the developed nations. However, the internet demographics are changing fast in India. The incremental subscriber addition is growing at a quick pace thanks to the advent of mobile internet. Also, the e-commerce industry is growing at a fast pace in India. Nearly half of the transactions that happen in the e-commerce space are from non-metros. This signifies that internet penetration is rising fast in the tier 2-3 cities. Thus, it seems that India is at the cusp of internet penetration boom. In fact, as per Morgan Stanley research, India's internet penetration is likely to increase from 16% in 2013 to about 25% by 2016. And if this does happen, the gap in penetration levels between India and other emerging nations may narrow soon.

India's Internet access: Still a long way to go
Can. - Canada, Fra. - France, Ger. - Germany, Rus. - Russia

Those following currency movements couldn't help but notice the sudden turnaround the rupee has managed against the dollar. It was not long back that the Indian currency was staring down the barrel. Level 68 was comfortably breached and 70 looked like a possibility. But then came the dramatic turnaround. The rupee changed course and as we write, it is up more than 11% since its lows. Of course the RBI's strong measures and India's improving trade balance did help matters. However, it would be naive to rule out the so called Modi factor behind the turnaround in rupee's fortunes. As the probability of Narendra Modi bagging the prime minister's seat is getting louder by the day, foreign investors are flocking towards Indian markets in large numbers. And this is helping further bolster rupee's position vis-a-vis the US greenback. As a matter of fact, a level of 57 is well within the realms of possibility if there is a decisive majority of some sort at the national level. However, this is pure speculation we reckon. Unless we bring about a structural change in our trade balance, volatility in our currency movement is likely to be the order of the day. So while today it's the Modi factor that will impact the currency the most, tomorrow it could be something else. For the medium term though, a level of Rs 55-60 could be a reasonable figure to bet on.

The US central bank has been banking on a huge, unprecedented monetary experiment to revive the economy. Whether it has done any good for the economy is highly questionable. But it has given a big, artificial boost to stock markets. One is by infusing a lot of cheap liquidity. The other is by keeping interest rates near zero. The near-zero interest rates have boosted corporate earnings. At the same time, they have punished savers and forced investors to pour money into riskier assets such as stock markets.

But how long will this party last? If the latest signs from the new Federal Reserve chair, Janet Yellen, are anything to go by, the Fed is likely to end its massive bond-buying program in the latter part of this year. And from April 2015 onwards, the central bank is likely to start increasing interest rates. After the announcement, stocks and bonds have tumbled across the globe. With the global economy still in a fragile situation, the winding up of this monetary stimulus would not be a very smooth affair.

The Chinese Yuan seems to be feeling the heat. The last few years had seen speculators selling either the US dollar, or Japanese Yen or the Euro in order to buy the Yuan. The Chinese currency was then used to purchase commodities; most notably copper. Copper was then used to finance credit. More credit means that this money was used to finance working capital needs or real estate purchases. As a result, both real estate and copper prices rose. With more credit available, this was once again used to buy the Yuan thereby starting the cycle all over again.

But now this cycle is beginning to see a break. As liquidity is beginning to dry up, copper is being sold to meet cash flow needs. Because of this, copper prices have dipped. Credit contracting has also taken its toll on real estate prices. And thus the demand for the Chinese Yuan has waned, thereby putting pressure on the currency. Whether the Chinese Yuan is on the verge of collapsing is hard to tell. But the financing of these carry trades through debt and the subsequent contraction in credit is leading to a significant unwinding of positions.

The recent CERC regulation has been a major unsettling factor for power utilities in India. On account of low power tariffs, companies are already finding it unviable to add capacities. To top that off, the CERC guideline has proposed changes in respect of the payment of generation incentives. The metric for payment of incentive to generators will change from plant availability factor (PAF) to plant load factor (PLF). While PAF means capacity availability for generation, PLF stands for actual electricity generation by a plant. PSU major NTPC has been enjoying one of the highest incentives being one of the largest power generators (high PAF) in the country. However with the shift to PLF, the company's incentives could fall substantially. As per Business Standard, NTPC has appealed against CERC's decision. It has contended that while it has control over PAF, PLF could vary. This is because PLF depends on factors like fuel availability and off take of electricity by distribution companies. Also given the acute coal shortage, linking incentive payment to PLF could make matters worse for NTPC. We believe that PLF may be a better metric for incentivizing power companies in the long term. However, before taking such a step, the government must assure fuel supply to power generators.

In the meanwhile, Indian stock markets continued to languish in the red. At the time of writing, the benchmark BSE Sensex was down by 47 points (-0.2%). Capital goods and realty stocks were the biggest losers. Majority of the Asian stock markets were trading negative led by Indonesia and Hong Kong. Most of the European indices have also opened the day in the red.

04:55  Today's investing mantra
"Being early on the way down looks a great deal like being wrong, but it isn't. It turns out you won't be able to accurately tell who's been swimming naked until after the tide comes back in." - Seth Klarman
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