Beware! These firms may be reporting false earnings - The 5 Minute WrapUp by Equitymaster
Investing in India - 5 Minute WrapUp by Equitymaster

Beware! These firms may be reporting false earnings 

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In this issue:
» Chinese cities on a borrowing spree
» US corporates that have better ratings than the US
» The mistake that the US Fed made as per Greenspan
» India's power sector isn't quite showing the spark
» ...and more!

----------------------------- Mark Your Calendar. Global Crisis Starts August 2nd. -----------------------------

The global economy is in a crisis... And things are only going to get worse.

In fact, this crisis could get really bad on August 2nd and thereafter...

That's the day the US government could run out of money i.e. it will no longer be able to pay its bills.

You can well imagine the fall out of this on the global economy... there will be utter chaos, and stock markets could reflect this sentiment as well.

But how does that affect you?

Well, the chaos that this will trigger in the global economy will not leave India untouched.

And that's why you need to be really sure that your portfolio of stocks is Crash Proof.

How can you do that right away? Just read on to get access to a proven solution to crash proof your portfolio...


Do you know what would happen if all the depositors in a country go to withdraw their money from banks at about the same time? Well, under no intervention, the banking system will soon run out of funds and may even collapse. This is because banks keep only a part of depositors' money as cash and lend out the rest. Strange, isn't it? Well, there is one more unique feature of a modern day economy. And it has to do with the authority given to central banks. It seems they are the only entity that can print money. Thus, they have the ability to flood the system with cash as and when the need may be.

As though the economy wasn't a complex beast already. The above mentioned features certainly make it even more complicated. None more so than taking investment decisions we believe. Consider the low interest rate and a loose monetary environment for example. Here, it is very difficult to ascertain whether the excess money available in the system has come from genuine savings or because of pumping of money by the central bank which again has a multiplier effect courtesy the banking system. It turns out that on most occasions, it is the latter case that is more dominant.

However, businesses don't realise this. They borrow money and undertake projects in the hope that all the available money is real and here to stay. Steadily though, the reality begins to dawn on them. As loose monetary policy gives way to a tighter one, it occurs to them that not only the money is not there but the rates at which they previously borrowed have also become much steeper. The end result? Severe cash flow problems and even bankruptcy in cases where borrowings are on the much higher side.

This situation presents challenges for investors as well. When interest rates are low, it appears as if all the companies are doing well and growing at an impressive rate. In fact, the ones that continue to take on debt grow faster than the ones that don't as financial leverage plays it part. But once tightening happens, the wheat is certainly separated from chaff. It turns out that companies that were growing fast and taking on debt did not have real earnings after all. Their growth was a result of easy money policy by central banks rather than the one coming from some competitive advantage or productive improvements. Hence, it is very important that one avoids company loaded with debt for its earnings growth may not be real after all. A company that has a long track of growing without debt and also paying out part of it as dividends is certainly the one to look for.

False earnings can also arise from incorrect financial reporting. We recently conducted a poll on the website to find out which are the business groups whose financial reporting investors trust the most. You can view the poll results here.

01:33  Chart of the day
Do you think India features on the list of countries with largest cattle population? It certainly does given the fact that cows are worshipped here. Today's chart of the day confirms this further. Sadly though, India does not have the largest cattle population. That honour goes to beef loving Brazil where its enormous land mass also works to its advantage. India, on the other hand, comes a close second. However, the country loses its standing a bit when the same population is shown on a per capita basis.

Source: The Economist (2009 data)

It is being believed that to spur the growth of the Chinese economy post the 2009 global crisis, scores of cities across the country have borrowed heavily to build roads, commercial centers, and subways. Local governments have sold more than Yuan 400 bn of bonds since 2008. This is a slice of as much as Yuan 14.2 trillion in local borrowing. It does not end there. The governments have set up more than 10,000 financing vehicles in the past decade to get around laws prohibiting them from taking direct loans. One third of those financing vehicles do not have sufficient cash flow to service their loans. Local governments have been caught in a vicious cycle. In order to repay these loans, they have increased the sales of government owned properties. This has then resulted in prices of residential houses slumping by around 30% this year. And so the revenues from property sales are barely enough to cover interest payments let alone the principle. Indeed, there is a sense of deja vu here since a default would certainly hit the Chinese banks badly. How the Chinese government intends to get out of this mess is anybody's guess

Spoilt brats of rich parents! This phrase perfectly defines the big American banks and their relationship with the US government. Every time the big banks falter, the government rushes to their rescue with a bag full of money. But be it kids or banks, simply doling out money is a really bad thing to do. It gives them the impression that they are always going to be protected, no matter what.

Alan Greenspan, the former chairman of the US central bank is reprimanding policymakers for the same reasons. He opines that the government should have allowed banks to fail. In fact, if Bear Stearns had been allowed to crumple, the other banks such AIG and Lehman Brothers would have straightened themselves. By bailing out Bear Stearns, the government sent out a very wrong signal.

Banks are now having a free ride on the US Fed money which is actually public money. They are earning interest at no risk. What a super deal that is! Where in the world do you get rewarded for behaving badly and creating havoc? Isn't this is a show of utterly bad parenting?

In investment analysis, it is usually recommended that one looks for companies giving returns that are higher than that offered by the government bonds. The reason for this is simple. Since equities are riskier than government securities, they should therefore give a higher return. This is to compensate investors for the additional risk taken. But what happens when the government securities become riskier than companies? Well this is exactly what appears to be happening in US. As per the leading credit rating agency, Moody's, US is at a serious risk to lose its 'risk free status'. This is due to the increased risk of debt default from the country. But at the same time, the top 4 companies in the US appear to have a better rating than the country itself. These are Exxon Mobil, Microsoft, J&J and ADP. They are all leaders in their businesses, are highly profitable and have very low levels of debt. Although they can never compete with US in terms of size and liquidity, their efficient management has made them less risky as compared to the country itself.

If it is poor execution then nothing other than the Indian power sector's track record over the past 5 years fits the bill better. What else will you call an execution track record of 25% of the target? Or a downward revision of the target itself by more than 20%? The Eleventh Plan (2007-2012) was to see power capacity addition to the tune of 78,700 MW. This was later revised to 62,000 MW as the private sector players who were supposed to contribute 1/3rd of the capex shied away. Policy inaction, steep rise in fuel costs, lack of coal linkages and land acquisition problems put several projects on hold. Out of the 12 planned ultra-mega power projects only 4 were awarded during this period.

Fuel security has been the biggest hurdle to the addition of power capacities in India. More than 44% of Coal India's mining areas now fall under the 'no go mining areas' as per the Environment Ministry! Availability of the most commonly used fuel therefore remains the key to the government's plan to add 1,00,000 MW capacity in the next five years. While the domestic availability of coal this year is said to be 554 m tonnes (mt), the demand is 142 mt higher. More than 50% of the additional requirement is to be imported at a time when the import prices too are getting prohibitive. Equipment supplier for the power plants BHEL could meet only 51% of its target in the latest completed fiscal. Further huge losses of State Electricity Boards have deprived the sector of funding needs from banks. With so many problems, we only hope that one of the brightest sparks for India's future does not get dim.

Meanwhile, weakness in the Indian stock market continued to make its presence felt today as well. The Sensex was trading lower by around 140 points at the time of writing. Heavyweights like RIL and Infosys were seen adding the most pressure. Other Asian indices also closed weak today. Europe too has opened on a negative note.

04:52  Today's investing mantra
"We would rather buy 10% of Wonderful Business T at X per share than 100% of T at 2X per share. Most corporate managers prefer just the reverse, and have no shortage of stated rationale for their behaviour." - Warren Buffett
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6 Responses to "Beware! These firms may be reporting false earnings"


Jul 29, 2011

This story is again creating more confusion -i would go on to say more misinformation. The recurring stories are worse than the mindless and useless chatter one keeps hearing on so called 'news channels'. But the worst part is we pay princely sums for subscribing to EM whereas the 'news channels' are free or almost free.



Jul 28, 2011

Confusion.I wonder whether your people try to just test how much readers know and read or your people themselves are confused.



Jul 28, 2011

Opening statement of today's 5min-wrap is a class apart!: "Do you know what would happen if all the depositors in a country go to withdraw their money from banks at about the same time? Well, under no intervention, the banking system will soon run out of funds and may even collapse. This is because banks keep only a part of depositors' money...."

Well, well, "if all banks are required to keep all the money in their hand every day, as any day all depositors may walk-in and ask for their money?" - Presto, banks will vanish as the function called banking has already vanished!! Banks are supposed to receive money (deposit) and pay interest for what is parked with them; simultaneously lend what they have on hand at a higher rate (the operative word 'higher', if the bank has any intention to exist), manage down bad loans (another reason why banks can vanish, if NPAs were high!) and keep their operating costs down (well the good ole mantra of survival, for any thing, not excluding banks!!).

Today's 5min wrap on 'theory of banking', takes away the cake from so called Economic Advisor to GOI, Mr Kausik Basu who said 'to eradicate endemic corruption in India, let us make bribe-giving legal...' and some other gem of a statements too, deserving nothing less than ig-Nobel prize!!

PS: I think that the editor is putting the 'writers' of 5min-crap (oops! it should read 5min-wrap) under lots of pressure, to write a 5 page essay on 8 topics in one day, on every day!! Boys, its no harm if a day's 5min-wrap is much shorter than the usual rant and address only one topic of 'wisdom' running to no more than 400 words, as long as it is well done. Dear Editor: Your pressure for more meat everyday, causes indigestion on us, the readers!!



Jul 28, 2011

cash profit



Jul 28, 2011

I'm not sure the writer understands Central Banking vs Fractional Reserve Banking. The first 2-3 paragraphs are well written with utterly confusing statements.
For the benefit of readers, Fractional Reserve Lending (or Banking) is allowed by regular banks (both Nationalized/Private) to lend to Businesses and Individuals. Fractional Reserve Lending is not money creation at all, it is merely extension of liquidity. Liquid money is lent against illiquid collateral (that money is typically re-deposited into the system and may be lent again against more collateral). This is similar to the old fable of the thirsty crow (remember that one?) where the crow put stones in the pot to raise the water levels and was able to quench his thirst with just the little water remaining.
As opposed to this, Central Bank Lending is done only by the Central Bank and exclusively to the Central Govt to finance its deficits. THIS IS pure money creation! The writer has confused both these concepts in the very first para. Imagine, if even the expert is confused, how easy it is for the Govt to keep the regular guy confused!! The Central Bank may choose to douse the freshly printed money by auctioning Govt bonds or not choose to douse it (which happens when the CB tries to keep interest rates low), in which case the printed money starts to flow through the economy, starting to raise the prices along the way and shows up as: (you guessed it) INFLATION!
So please, understand the key difference between Fractional Reserve Banking and Central Bank Lending and which one is the real money printer.



Jul 28, 2011

One of the most confusing lead stories I've ever come across in the 5 Minute Wrapup! Also, this statement seems incorrect - "A company that has a long track of growing without debt and also paying out 'part of it' as dividends is certainly the one to look for." Part of what? Regards.

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