You know better than you think you do

Massive inflows into the global equity / commodity markets in the month of April to me is an indication enough that repeated assertions by the talking heads – about money waiting in the sidelines - falls flat in their faces. I think now it’s getting very tenuous––the fund managers, retail investors across the board people are very nervous at these higher valuations. In that sense, I don’t endorse the capability of equity markets to forerun global economic fundamentals that are still weak, at least as weak as they were made out to be in the early days of liquidity crunch in Q1-Q2 of 2008. The expression I guess is, suspended disbelief - as in the super heroes in the movies, when you know humans cannot fly but you believe Superman can fly, so you can enjoy the movie.

That is not to say that we don’t enjoy the current rally while it lasts. The suspended disbelief here is in ignoring the reality of the economic fundamentals. At some point, delusions give way to reason and the tide ebbs all of a sudden. It’s hard to guess what can legitimately support equity valuations much higher than here, almost in any market around the world.

When you can’t guess it, it’s time you respect your fears and retrace a bit. Don’t repudiate your own instinct so much just because it comes to you free and it tells you to keep away from seemingly juicy opportunities, especially after a long, dry spell. Trust your own instinct. Your mistakes might as well be your own, instead of someone else's. Good instincts usually tell you what to do long before your head has figured it out. You know more than you think you do.

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Parsing the crisis

T.T.Rammohan squeals in Business Standard

On risk management and quality of leveraged assets

“The top investment banks have vanished as a class [not] because they were highly leveraged: In financial institutions, leverage or the ratio of debt to total assets, can be misleading as a measure of financial risk. The management of asset risks is equally important. A financial institution can be highly leveraged but if its assets are of high quality or are highly diversified, the institution is not exposed to high risk….

Investment banks may have had a leverage of more than 20:1 but some high-profile banks in Europe today have even higher leverage. What counts is leverage after adjusting for the risks of various assets. The European banks in question would not be allowed to operate if their leverage was not in conformity with regulatory norms. ….The trouble with the investment banks was not so much leverage as poor asset quality and heavy dependence on short-term funds.”

On short selling

“Short-sellers were right on Lehman, so short-selling should not be banned: Yes, short-sellers were right in sensing that Lehman had more problems than it had disclosed. But, in times of crises, it makes sense to ban short-selling because a fall in share prices sets off a vicious spiral that pushes an institution quickly into bankruptcy. A fall in the value of equity causes leverage to rise, which causes the debt rating to fall. This, in turn, prompts demands for higher collateral, which forces distress sale of assets, which erodes equity value. Before you could say ‘Hank Paulson’, the firm is gone. In financial crises, as in times of war, the normal rules of information must stand suspended and this applies to price discovery [enabled] by short-sellers.”

Splendid. Wonder how well K.V.Kamath’s defense goes down with people!

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FCCB has a short fuse

The Rupee appreciation and market declines have struck a double whammy to Indian corporates – especially those who have raised funds thro FCCB route during the boom times. I am not surprised. Most of them raised FCCB debt because it was available or worse, I-bankers goaded them into it. Now they grieve. Here is the Business Standard story.

It says “Non-conversion into equity may erode profits by 12% in FY09: Study”. I fear the erosion could be lot more if the study has provided only for annual interest outgo on FCCB borrowings. Let’s figure it out by a case study.

Take Amtek Auto (featured first in the list of companies in that report). It has $250 M (Rs.1000 cr.) in outstanding FCCB liability. I checked its operating profits [BSE CODE:520077] for CY 2007 (being the trailing four previous quarters) and its operating income is Rs.460 crores. (I hope the company follows prudent norms and accordingly assume the pro-rata interest on FCCB is included in the interest figure for respective quarters.) Now, after providing for depreciation and taxes, the company has a net income of Rs.257 crores.

As per the table, the market price of the stock is currently quoting at a 35.2% discount to the agreed conversion price of Rs.414. FCCB is due for maturity on June 2011. If the stock price goes further down or if it maintains below the conversion price, the liability shall remain as debt in its balance sheet and the company will have to provide for its repayment. Given the gloomy outlook, I don’t see the market getting back to its Jan 2008 peak levels any sooner and so would recommend providing for repayment of its principal (Rs.1000 cr) out of current profits. That would call for creation of a FCCB redemption reserve and transfer a sum of Rs.250 crore each year for 4 years between 2008-11. That would leave a net income of Rs.7 crores.

Now imagine the dent in the EPS. It’s earnings are currently at about Rs.16 per share. After creating the FCCB redemption reserve, it’s net income would stand reduced to Rs.7 crores and the resultant EPS would be Rs.0.63. Give it a liberal PE ratio of 16 as at present, even then the stock price would be a dismal Rs.9.90. That’s the emerging picture if FCCB leverage is taken out. The company may either choose to recap it with other means of finance of equal amount to sustain its liquidity and operating leverage. Even then, with the cost of debt going up, it may not be able to borrow at those low FCCB levels of 5.5%. This means higher interest outgo and lower EPS in the event the company is not able to accelerate its revenues or improve its margins. Both the options are unlikely since the company caters to auto sector that is rate sensitive and runs on low cost financing for sale of vehicles. That spells disaster for shareholders.

Now I have nothing against Amtek Auto as such. I just picked it up as it was figuring on top of the list in that table. But then this is a sufficient case study that highlights what over-indulgence during boom times can entail. Don’t bite off more than what you can chew.

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