The Safe Stocks Series: How to Avoid Unsafe Companies Like IL&FS

Nov 28, 2018

Editor's Note: Dear reader, if a stock crashes 70%, 80%, 90%...then all your hard-earned wealth is at risk. Today safe stock guru Tanushree Banerjee shows you how to avoid investing in unsafe companies like IL&FS. As you know she always recommends investing ONLY in Safe Stocks. This is vital if you want to build long-term wealth for yourself. Today, in the second of Tanushree's 4-part Safe Stocks series about building long-term wealth with safe stocks, you will learn from the IL&FS fiasco. Read on for a crucial safe investing approach...

Tanushree Banerjee, Editor, The 5 Minute Wrapup

Yesterday, in the first part of my 4-part Safe Stocks series, I wrote to you about why you should not sell any of your safe stocks. I believe this is the first step in your journey to build long-term wealth for yourself.

If you missed it, you can read it here.

But I would like to emphasise, this is not enough.

To build long-term wealth with safe stocks, you need to know which stocks to avoid. In other words, which companies are not safe for investing your hard-earned money.

The prime example is IL&FS. Thank God it's not a listed company. I shudder to think about the damage it would have caused to investor's portfolios.

But many other wealth destroying stocks - Vakrangee, Manpasand Berevages, PC Jeweller, Jet Airways - come to mind.

Today, I'll show you how to identify in such companies by using IL&FS as an example.

The most important thing in this regard is...

If it seems too good to be true, it probably is.

This is not a logic that can make any analyst sound super smart or diligent. But my experience, over the past decade, says that it is extremely useful in filtering out bad stocks.

Standing frozen with fear is no way to move ahead. As an investor, you cannot fear that every other company will turn out to be the next IL&FS or Vakrangee or Manpasand Beverages.

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But, the 60-90% crash in stocks like them serve as reminders. That just as deep analysis could be smart, not averting bad stocks can be just as foolish. Pursuit of return must be balanced against aversion to risk.

Like in the case of most others stocks that crashed before IL&FS and wiped out investor wealth, rating agencies were late to ring the alarm bells this time as well. However, IL&FS' rating documents were helpful enough to investors who cared to read the numbers carefully.

I first noticed the deterioration in IL&FS' fortunes in the rating analysis of IL&FS Financial Services, an unlisted subsidiary of IL&FS. Of course IL&FS has a host of other subsidiaries including...

  • IL&FS Energy Development Company Ltd,
  • IL&FS Transportation Networks Ltd. (ITNL)
  • IL&FS Engineering and Construction Company Ltd. (IECCL)
  • IL&FS Maritime Infrastructure Company Ltd (IMIC)

But the business model of IL&FS Financial Services (IFIN) seemed relatively easier to understand. Which is why I chose to look at it more carefully.

Now, no doubt, rating agency ICRA kept upholding IL&FS' AAA rating until August 2018. But the rating documents over the years, that lay down financial numbers, clearly showed a risky trend.

Even as IL&FS Financial Services' debt to equity ratio shot up over the past six years, the ratio of NPA to networth kept ballooning. And as I have written earlier for PSU banks, the NPA to networth ratio is something I stay extremely wary of.

For IL&FS Financial Services, the NPA to networth ratio rang alarm bells by 2016 itself.

But then again, this was just one of the subsidiaries. Not enough to cast a doubt on the feasibility of the parent entity.

Rising NPAs and Debt - Early Indicators of IL&FS' Liquidity Crisis

A glance at IL&FS' 2017 annual report told me that the company had 23 direct subsidiaries, 141 indirect subsidiaries (which include special purpose vehicles for individual projects), 6 joint ventures and 4 associate companies.

I looked carefully at the financial entity's Capital Adequacy Ratio (CAR), which determines if the entity will stay liquid and be in business, despite the risks in its loan book. The CAR of IL&FS Financial Services, seemed very healthy (as confirmed by the rating documents), all through the years. It hardly showed the impact of rising risks in the balance sheet.

And that's something that surprised me.

Rating Agencies' Confirmation of IL&FS Financial Services Capital Adequacy

Capital Adequacy Ratio (%)20.221.921.621.620.421.118.5
Source: Rating Documents

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The Stock we Rejected In 2016 - IL&FS Investment Managers

Meanwhile, the stock of one of the listed subsidiaries, IL&FS Investment Managers, came up in our research discussion in 2016. Primarily because of its growth prospects.

But one glimpse at this chart, in the 2016 annual report, told me that the growth prospects of this entity, has very little to offer shareholders. As the company was clearly not keen to see the additional equity capital being raised deliver commensurate revenues and profits.

IL&FS Investment Managers' Pitiable Profit Track Record

Of course, as most experts claim, IL&FS's business model is different from other financial entities. It is neither the oldest nor the youngest of the Indian infrastructure finance firms. IFCI, IDBI and ICICI all pre-date it. And IDFC followed it.

But IL&FS' uniqueness lay in the breadth of its operations. IL&FS' presentations boasted of providing every service to all kinds of infrastructure projects in India. In short, it offered everything to everybody. And it's that breadth and complexity of operations that may have come back to bite IL&FS.

Here is yet another table that showed the wide gap between the assets and liabilities in the books of IL&FS Investment Managers' subsidiaries. So, the possibility of unknown off balance items and big difference in the profitability of similar businesses, made us uncomfortable.

IL&FS Investment Managers' Maze of Subsidiary Financials

Yes, given the wide variety of businesses, there were good chances of growth. But the claim of making each of them eventually profitable seemed too good to be true.

The stock of IL&FS Investment Managers more than doubled between October and December 2017.

But we reminded ourselves of what Buffett wrote in his 2014 letter to shareholders...

  • Periodically, financial markets will become divorced from reality - you can count on that. Managements will look and sound authoritative. The press will hang on their every word. Bankers will fight for their business. What they are saying will recently have "worked." Their early followers will be feeling very clever. Our suggestion: Whatever their line, never forget that 2+2 will always equal 4. And when someone tells you how old-fashioned that math is - zip up your wallet, take a vacation and come back in a few years to buy stocks at cheap prices.

Well, sticking to the math and not going by sentiments may at times lead to missed opportunities. But just like Vakrangee I do not regret erring on the side of caution.

I will never stray from the path of recommending Safe Stocks.

And I believe you shoundn't stray from the path of investing in Safe Stocks.

Tomorrow, I'll write to you about the volatility in the market due to the ongoing state elections and next year's general election. So hopefully I will see you back here...

Warm regards,

Tanushree Banerjee
Tanushree Banerjee (Research Analyst)
Editor, The 5 Minute WrapUp

PS: Tanushree, believes the recent market correction has thrown up some great investing opportunities. She has put together a special report, 7 Stocks to Profit from This Market Crash, to share with her subscribers. If you claim this report now, you can get an additional year of access to StockSelect, absolutely free. This offer ends promptly at 11:59 PM, 30th November. Full details here.

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Nov 28, 2018

Hello! With the present turmoil in "YES BANK", is it still a 'Safe Stock'?


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