Think again before you bet on firms coming out of debt

Sep 19, 2014

In this issue:
» Fed lowers GDP growth estimates since tapering started
» Indian stock markets trade at a huge premium to Chinese markets
» Surge in rupee value could be detrimental to India
» IMF suggests RBI to raise policy rates
» ...and more!

High debt levels of a firm scare investors away. An attempt to bring down the same is often viewed in positive light. No wonder debt reduction theme is doing the rounds these days. As markets continue to remain buoyant, a lot of debt ridden companies are planning to lure investors by paring debt. And investors seem to be sold on this theme. Even a buzz of such news is enough to drive share prices significantly. A recent case in point is small cap firm Ramky Infra Ltd where share prices jumped 12% on media buzz of sale in assets.

As an article in Business Today suggests, in last 15 months, around 21 firms have announced 36 deals to sell assets or equity. The amount raised from these deals is around Rs 800 bn, around 20% of the debt levels in these firms. Most of these firms are from the relatively riskier small cap stocks or mid cap stocks.

Long term investors need to be cautious and aware of what kind of assets is being sold in such cases. And whether the deal will have a meaningful impact on the balance sheet and operational performance. For example, firms that are being forced by banks to service debt may end up selling operational and cash generating assets. The same is likely to backfire in the long term. Similarly, firms that are raising equity to retire debt on stuck projects are unlikely to reflect better fundamentals unless the bottlenecks are removed.

Hence, while such deals may lead to lower debt levels, they might not translate into a recovery for these firms. Further, at current valuations, the risk reward ratio for investing in high debt companies on the prospect of their coming out of a debt trap is hugely skewed in favor of the former. As companies rush to sell assets and fresh equity offers get lined up at a time when risk appetite has gone up, investors must exercise due diligence before betting on these firms.

Do you agree that investing in stocks based on debt reduction theme could be a risky proposition? Let us know your comments or share your views in the Equitymaster Club.

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 Chart of the day
There is a general tendency amongst analysts to be optimistic about their growth forecasts. It is behavioral in nature. Not only analysts, even organizations with sane heads are prone to chronic optimism. Today's chart of the day is a reflection of that. It shows the estimates made by the US Federal Reserve for economic growth over the last one year. As can be seen they have revised downwards on 5 occasions. A downward revision in the first place indicates that the original forecast itself was quite optimistic.

In fact, a gradual tapering by the Fed should have led to an increase in growth projections. Fed's decision to taper the bond buying program was on behest of signs of economic revival. But its projections do not reflect so. This example just shows how sometimes forecasting is nothing but a mere number game to lure the street. It reflects mere optimism and perhaps lacks logic. Hence, investors should always be careful about relying on forecasts. Be it from management or from reputed organizations. One should rather use common sense and try to find out the reason behind any forecast rather than merely believing in it.

Fed lowers projections for GDP growth

The Chinese economy is bigger than India's. Growth rates in the country are faster than India's. Despite that, stocks in the dragon nation are trading cheap. And how! The benchmark index - the SSE 180 is trading at a multiple of 7.7 times on a trailing twelve months basis. In comparison, the Nifty is trading at 18.6 times. A discount of about 60%! As reported by the Business Standard, in the past five years, the BSE Sensex has gained by about 175% while the Chinese markets are up by a fourth. On a YoY basis, the former is up by about 35% while the latter has remained flat.

Why this major discrepancy? Well... it turns out that return ratios of the Indian companies are much better than those of Chinese companies. To add to that, growth rates in China have been on a decline while those in India have remained flat and are expected to rise over time. And going by the words of some major fund managers who have burnt their fingers trying their hand at investing in China, corporate governance is a major hurdle in the country. Thus, one may feel that lower valuations may be justified. Nevertheless, it seems that valuations in China are way below their long term averages.

Buoyancy in Indian stock markets and euphoric mood may not bring all the good news. For in the wake of upbeat environment, the rupee turning south is unlikely. And what makes this a concern? Well, just delve into these facts first. India at this juncture cannot afford an overvalued currency. A review of the country's balance of payments as put forth by a leading news daily suggests that the rupee should be allowed to drift downwards. And every available opportunity should rather be utilized to build up forex reserves.

Here we provide a candid insight into the above argument. Understand this! India's external sector stands quite vulnerable. It runs afoul of the high trade and current account deficits coupled with huge short-term external debt and over dependence on foreign inflows. Moreover, the quantum of forex reserves has observed a moderate uptick in last six years. Quite unfortunately, little can be done by the policymakers to boost these reserves. For forex reserves are nothing but the residual of the current-account deficits that are funded by net forex inflows. What more? At present, rupee is overvalued by about 35% against the US dollars in real terms. Any further surge in rupee value would be detrimental to the India's balance of payment position as explained earlier. Therefore, the authorities need to have a seminal approach towards managing the exchange rate. High time we stop getting carried away with the jubilation in markets and economy alike; and address the endemic concerns.

For a country such as India where the growth has slowed down, there were expectations that RBI would cut interest rates to spur growth. But the RBI has been in no mood to relent. Given that inflation still remains firm, the RBI is quite clear about not easing off rates until it is brought within control. Now the IMF has come out saying that for inflation to come down, the RBI will have to raise policy rates. It believes that the Indian central bank needs to be more aggressive in tackling inflation and also follow a simple monetary framework. We are not sure that further rate hikes will completely solve India's inflation problem. For that the government will have to do its bit too. A large part of inflation in India is because of high food prices. And food prices have been high because of production getting hampered on the back of erratic monsoons, poor storage facilities and hoarding. This means that government will have to ramp up agricultural infrastructure, build more storage and warehouse facilities among other things. This will ensure that inflation will remain lower on a sustained basis going forward.

Indian stock markets pared early gains but remained buoyant in the post noon trading session. At the time of writing, the BSE-Sensex was trading up by 34 points (0.1%). Barring IT and pharma, all the sectoral indices were trading in the red. Capital goods stocks and realty stocks were the biggest losers. All the Asian markets were trading firm led by Japan and China. European markets have also opened the day on a strong note.

 Today's investing mantra
"Behind every stock is a company. Find out what it's doing." - Peter Lynch

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2 Responses to "Think again before you bet on firms coming out of debt"

ISS Gupta

Sep 19, 2014

Yes, your observations are very precise and correct. In fact, it is a kind of WINDOW DRESSING. The investors should not be carried away by mere reduction in the debt. The other relevant factor need to be looked into before taking an investment decision.



Sep 19, 2014

yes i agree

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