• DECEMBER 14, 2009

Be careful of 'The great Indian growth story'

The Indian telecom story was an enticing one. India's huge market for telecom to capitalise on, its low teledensity, high growth rate of subscriber additions, increasing mobile usage, increasing per capita incomes, the large rural population that could be tapped etc. all made for quite a convincing story. All you had to do was to look at the immense potential of the industry and you were almost sure to be bowled over.

Riding on this enthusiasm from the public, Idea Cellular made its initial public offering (IPO) debut on February 12, 2007. The response was tremendous. The issue was oversubscribed almost 50 times.

Investors were falling head over heels to get a pie of the Indian telecom industry. As on the closing date for Idea's IPO, the demand of approximately US$ 25.5 bn for the QIB (Qualified Institutional Buyers) category was the highest for any Indian issue in US dollar terms until that date. This, despite the fact that the issue was priced exorbitantly. At a price to earnings ratio of almost 48 times.

But price wasn't seen as a problem. Earnings were sure to increase in such a fast growing and lucrative industry. And when earnings are said to increase fast enough in future, a high price can always be justified.

Guess how investors who were smart enough to buy at the time performed after a little under the three years that have gone by since. Your long wait till now would have fetched you a loss of 23% at the level of about Rs 60 that the stock is trading for currently.

If you had missed it in the IPO and bought in on the first day of its listing (9th March, 2007- when it closed at about Rs 85), you would be sitting on an even bigger loss of 33%. Compare that to a simple bank fixed deposit earning about 8%. If you had put the same money in such an FD, you would have made a total return of about 26% in those same three years.

So what went wrong? Would you have made a mistake by buying into Idea Cellular and India's booming telecom story? Or was it just plain bad luck.

Idea Cellular is mainly suffering from the way things have shaped up in the telecom industry. Competition has heated up like never before. The potential of the industry and the growth it was witnessing attracted numerous Indian and foreign players to it. There are now about 12 to 14 players in the market, many of them backed by large parents with a lot of financial resources. They are all pitting their might against each other, no holds barred. The last few months have seen tariffs being cut to ultra low levels in a bid by new entrants to gain market share. The big established players have had to respond by reluctantly cutting their own tariffs. Thus revenues and profits have been put in the limbo. And until some sanity returns to the proceedings in the industry, many companies are sure to bleed.

What's the lesson for investors? By being aware of one fundamental law of investing, you could have made a much more informed and wise decision -

"Obvious prospects for physical growth in a business do not translate into obvious profits for investors" said Benjamin Graham many years ago in his seminal book 'The Intelligent Investor'.

"The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors" said Warren Buffett, the world's most successful investor.

The fact of the matter is that even if an industry is poised for major growth, potential future competitive forces can never be ignored. Even if they might be less at that moment, they are almost sure to intensify in any industry that is poised for major growth. Over the long term, competitive forces exert a downward force on the profitability of every company. In such a scenario, only companies that have a strong solid advantage that will help them maintain their profitability are the ones that will come out winners. Indeed, much of the qualitative understanding of a business should go towards identifying if a company actually possesses any such advantage.

Infact, the same would apply to even countries as a whole. So, India may be said to be on the cusp of high GDP growth for many years to come. But it does not automatically mean that all the companies in the country will witness unbridled profitability. For as markets, industries and companies evolve, you can expect the competitive environment to get tougher as we go along. And only companies that posses that elusive 'competitive advantage' will make it through without any nasty surprises for investors.

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