Should you give India Inc money to reduce their debt? - The 5 Minute WrapUp by Equitymaster
Investing in India - 5 Minute WrapUp by Equitymaster
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Should you give India Inc money to reduce their debt? 

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In this issue:
» Warning: An IPO mania is all set to hit the markets!
» A top value investor buys into an Indian bank
» Realty firms get a taste of their own medicine
» Are central banks changing their policy on guidance?
» ...and more!


00:00
 
The change in government has certainly improved the mood of India Inc in a big way. Optimism levels are high and the market sentiment is undoubtedly bullish. While investors have seen gains in their stock portfolios, Indian companies are also cashing in, quite literally. Corporate India seems to be on a fund raising spree. The sheer speed and the amounts being raised are indeed eyebrow raising. As per a leading financial news agency, Indian corporates have already tapped US$ 5.4 bn in equity financing in the first half of the year. And there will be a lot more share issuances by corporates in the coming months. So how should investors respond?

A quick look at the companies that have raised money via the equity route so far reveals the real story. The main reason for raising funds is to repay existing debt. Companies in sectors like infra, power, metals, telecom etc are at the forefront of this rush. The companies in these capital intensive sectors had borrowed heavily in the last few years from India and abroad. The combination of high interest rates and the fall in the Indian Rupee have hit the ability of these firms to repay the loans. When these debt laden firms approached banks to refinance the loans when they became due, the banks refused. The financial situation of these firms was dire. Now however, things have changed. The new government has promised to boost the economy by adopting a business friendly approach. The stock markets have shot up to all time highs in anticipation of an economic recovery. This has provided these firms with a much needed lifeline. By selling shares to institutional investors, they hope to clean up their balance sheets. By reducing leverage in this way, they believe that they will be well placed to ride the growth wave.

The lesson for investors here is quite clear we believe. Investing in firms on the basis of improving balance sheets should be done with great care. As we have pointed out before, nothing has changed fundamentally for these firms on the ground. They are not paying down their debt with improved cash flows. Instead these firms have tapped the equity markets to raise funds and pay down debt. We wish to emphasize that such equity financing does not come free. These debt laden companies have not been given a free lunch by the stock markets. The only reason they have found any buyers for their shares is because investors (mostly FIIs) are betting on the pickup in the Indian economy. This does not guarantee an improved financial situation for individual firms. If they do not return to profitable growth soon, their stock prices will be punished. Thus we would like to caution retail investors not to get carried away by the improving debt situation of corporate India. While the debt level on the balance sheet is very important, it is not the only thing that investors must consider. Investments must be made in only those companies where the future cash flows and profitability are assured. Any investment made in stocks only on the basis of a reduction in the debt on the balance sheet would be speculative and must be avoided.

Do you think investing in companies on the basis of improving balance sheets is a good idea? Let us know in the Equitymaster Club or share your comments below.

By the way, this Thursday (10th July) we will send out a special edition of the 5 Minute Wrapup covering the key takeaways from the Union Budget. Along with that a Budget Impact report, analyzing sector wise impact, will also be available for download within hours of the Budget announcement.

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02:10  Chart of the day
 
Realty prices defy the rules of gravity. At least this is what seems to be the case in India, and certainly applies to the city of Mumbai. Making the most of the surge in realty prices over the past few years, companies have been selling off their land parcels and properties to realty players. The reasons for the same are varied; right from paring debt levels to unlocking value.

Today's chart of the day provides details of some of the large valued deals that have occurred in the recent past. The latest addition to this list is Reliance Communications which plans to raise Rs 50 bn by selling off its many real estate assets. This it seems to be doing to curb its massive debt levels which stand at Rs 340 bn.

In any case, what investors can make from such developments is that these would be good for companies that are high quality businesses having healthy balance sheets and strong cash flows. This we say as such companies could share windfall profits with shareholders or either plough back funds into their above average returns earning businesses. As such, what investors need to gauge is how and where companies invest such funds - especially considering the quality of their businesses.

Will investors see some of this money?


02:35
 
With markets breaching the psychological 25,000 mark, there is a renewed sense of optimism on Dalal Street. Slowly this optimism is spreading its wings into the IPO markets as well. And the promoter-merchant banker duo seems to have sensed an opportunity to capitalize on this euphoria. Lavasa Corporation has opened the deadlock in the IPO market. And there could be others who may beeline soon amidst market buoyancy.

So, what should investors do in such times? Well, our readers may know that we are not big fans of buying companies that hit the street via IPO mode. And there are many reasons for it. For one, gauging management competency of such companies is a tall task. Plus, there is limited financial history to judge their operating consistency. Lastly, since promoters would often, if not always, want to maximize their company's valuation, the deal happens to be pricey. Thus, we believe that investors have to be extremely careful while investing in IPOs. Unless there is a really lucrative opportunity, IPOs remain shorthand for Imaginary Profits Only!

03:05
 
What is the sign that a sector is turning around? An improvement in the financials of course. Yes that's true but it is difficult to see how an investor can benefit using this strategy. Simply because by the time the improvement in financials takes place, the stock already runs up. In other words, markets have this tendency to anticipate events much before they actually take place. As a result, a better approach to participate in a turnaround story is watching what other savvy investors are doing. One such savvy investor according to us is Mr. Mohnish Pabrai. Now, not many in India would have heard about this gentleman but he's had a very successful career in long term value investing. Therefore, if he is bullish on something, it's at least worth having a look. Turns out Mr. Pabrai recently bought a small stake in a private sector bank in the country. Interestingly, this development comes close on the heels of another billionaire investor snapping up a sizeable chunk in the same bank.

Mind you these are not the only investors who are betting on the turnaround in the Indian banking sector. Lot of other successful investors also hold a similar view. Therefore, is the Indian banking space finally turning around? Could be. However, it would be a mistake to follow these investors blindly. Doing one's own due diligence always helps. After all, one is not right because the crowd agrees with you. One is right because one's data and reasoning are right.

03:40
 
While sentiments are positive on Indian economy with Modi Government coming to power, the ground realities continue to give a harsh reality check. Take the case of real estate and infrastructure - the sectors on which hopes are pinned for an economic revival. The sector is already facing tough times due to high input costs such as steel, labor and funding. The recent challenge for it comes in the form of high cement prices. The latter have gone up by 50% in a matter of few weeks. The hike, when most of the plants are working at low capacity utilization levels and during monsoons when construction activity slows down, suggest that the supply-demand factors have little to do with high prices.

In response, the builders have stopped buying cement. They have moved to CCI, alleging cartelization. The ultimate burden as per the builders comes to around Rs 200 per square feet that consumer is unlikely to accept. In defense, cement companies have said that they need to increase prices to stay viable. While this is an unfortunate development, it seems like builders are being given a taste of their own medicine. Even property prices in India are unjustifiably high suggesting a bubble. But wherever the fault lines exist, the worst shock will be borne by the common man unfortunately.

04:15
 
As their policy making is getting increasingly challenged, central bankers are looking to get defensive. Right from the US Federal Reserve to the central banks in the UK and Japan, most are facing criticism. Their means and methods to stoke GDP growth and stimulate economic recovery through cheap liquidity hardly yielded results. On the other hand, the unemployment problem that they chose to address remained stagnant. To top that, their short term targets on inflation and borrowing costs became their biggest stumbling blocks. The western central banks had begun offering short term pledges to pull down long-term borrowing costs. But the prospect of the US Fed winding up its bond buying program had a negative impact on long term rates.

The central bankers are therefore of the opinion that broad guidance as against specific targets could work better to maintain market stability. Going forward, not just the US Fed but its counterparts in the Euro zone and Japan are likely to get less transparent. We do not think it is a good thing for the central banks to target lesser transparency. Instead, we think that the RBI's focus on long term targets instead of short term ones is more acceptable to investors.

04:40
 
In the meanwhile, the Indian stock markets continued to remain buoyant during the post noon trading session. At the time of writing, the BSE-Sensex was trading higher by 57 points or 0.2%. Majority of the sectoral indices were trading in the green led by IT and power stocks. Banking and Oil & gas were among the few sectors trading in the red. Asian markets were trading strong led by Indonesia; however Japan was trading in the red. European markets have opened the day on a weak note.

04:55  Today's investing mantra
"Time is on your side when you own shares of superior companies" - Peter Lynch
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