September 26, 2018

Blood on the streets

I sent out this note to the subscribers over the weekend. Reproduced below with edits

I am not going to talk about risk again. I have been speaking about it for the last 12-18 months. The time to prepare for the storm was when the skies were clear. We have a full storm now.

We started reducing some of the fully valued positions last year and raised our cash levels to almost 30% of the portfolio. We were at 29.1% of the portfolio in cash at the start of the year. We now have 33.3% of the portfolio in cash as of last week. In effect, we have shuffled between the existing positions, but have not changed the net cash position much since the start of the year.
There is no grand strategy or deep macro reasoning behind all of this. We have been exiting some of the positions which seemed overvalued and started positions in a few others with good long-term prospects. As I have shared in the past, I don’t invest based on macro factors such as interest rate changes, currency or inflation rate. I also ignore short term panics and euphoria in the market other than making decisions at a company level based on the valuations in each case.

My preferred approach is look at the long-term prospects of a company and invest in those cases where the we can make above average returns in the long run. In all these cases, the objective is to make multiples of the invested amount.

Why am I repeating this again? I am making this point because I have no plans to play the current panic for some quick gains. There are a lot of investors and traders who can jump in during intraday lows and make a good gain out of it. There are a handful who can even do this on a consistent basis.

I am not one of those. I know my temperament. I have a tendency to buy and hold to the point of overstaying in a position. In some of these cases, it would have been better to have exited earlier. However, on average I have found that, being patient and holding on has worked out better in the long run.

If you agree with my philosophy, then you will understand the reason why I have not reacted much in the last few months to the noise in the market. As always, I continue to analyze the current and new positions and will make buy or sell decisions slowly over time. I see no reason to speed up the decision making process unless the current events change the thesis for the existing or new positions.

This bring us to the events around the NBFC space.
An obscure term – ALM
There is an obscure or rarely discussed term – asset liability management in the case of all NBFCs. This is a critical part of managing the operations of a financial institution but is rarely discussed as it works smoothly most of the time.

What is ALM?

I will not get technical on this and will try to simplify the explanation as much as I can. Any financial institution borrows money to lend it onwards to its customers. This borrowing is done via commercial paper, Bank borrowings, Mutual funds, Bonds etc. These instruments have varying durations between a few days to years. 

On the asset side, the lending instruments also have varying durations depending on the nature of the loan and the time left on it. At one end of the spectrum are gold loans with a duration of 2-3 months  and at the other end are the long dated loans such as infrastructure loans with a duration of 5-15 years (as in case of ILFS which is in the center of the current storm).

If you layout all the borrowings on a graph with amount on the y – axis and duration on X axis, you will get the liability profile of the company. A similar curve can be generated for the assets too. A well managed ALM operation tries to match these two profiles as close as possible. This makes intuitive sense. You want the short term assets to be funded by short term borrowings and vice a versa

I have pasted below the ALM chart as an example below. As you can see the ALM profiles are reasonably matched.

ALM mismatch and funding issues
As a financial institution has a mix of long and short-term debt, it has to renew its debt on a regular basis. This means that if the company cannot renew its debt, it has no way of repaying it via the cash flow from assets, especially if the assets are long dated in nature.
Let’s look at the case of ILFS 

The company has a short term borrowing of around 25000 Crs out of total borrowing of 91000 Crs. This means that the company has renew to this borrowing on a regular basis.
The company does not break out the asset side duration, but if you look at the balance sheet almost 80% of the assets are long dated in the form of infrastructure assets and receivable claims etc.

This kind of a balance sheet works till the financial institution can refinance its debt on a regular basis. In the case of ILFS, they have been facing cash flow issues and losses due to various projects being stuck at different stages of completion with claims pending with the government. At the same time, the short term debt and interest has to be paid when it comes due. 

In the recent months, the company started facing liquidity issues and has not been able to make payment on its interest obligations as it cannot liquidate its assets quickly to make these payment (keep in mind the nature of assets such as roads and bridges which cannot be sold quickly).

As the company defaulted in the last few weeks, the debt held by mutual funds and other lenders had to be marked down. This has led to a cascade effect where these funds have had to liquidate other instruments to meet their liquidity requirements.

This is a classic run on the bank. ILFS may not have a solvency issue (I don’t have an insight on that) but has a liquidity issues which is now spilling over to the wider market. These liquidity issues mean that all other financial institutions, especially NBFCs which are funded via a mix of short and long-term debt could face a similar risk if the situation escalates.

The parallel with Lehman
There is a fear that this is similar to the Lehman crisis from 2008. There are similarities, but it is not identical. In the Lehman crisis, the company had leveraged up to around 100:1 and funded the derivative assets with short term funding.

When the housing market collapsed, the company had to write down its assets and as it was so highly leveraged, its net worth vaporized in an instant. As Lehman was bankrupt, the counterparties refused to extend credit and hence the liquidity dried up. The only way to save Lehman was to recapitalize it.

In the case of most financial institutions in India, we do not have an asset side problem and hence they don’t have a solvency issue. What we are seeing is a liquidity concern and hence if the government steps in and provides liquidity, the situation could normalize.

Position risks <edited out from this post>
Let’s review the risk at the individual company level now in terms of ALM and liquidity levels

Portfolio risk
Let’s look at the portfolio level risk. For starters, I have kept position size at 5-7% (at cost) and the sector level cap at around 15-20%. This is to ensure that we reduce the risk from an implosion in a company or sector at any point of time. 

This however does not eliminate some risks completely. I have focused on the company level and portfolio risks but cannot eliminate the second or third order effects. For example, the recent drop has been due to the problems at IL&FS, but as the liquidity concerns spread, it has started impacting the overall markets now. We saw midcap and small caps drop as a result of the fear last week.

There is a lot of commentary around what will happen. A lot of commentators feel that the market has over-reacted and we will back to normal soon. Anytime, I hear people prognosticate about the market, I am reminded of a simple fact – No one cannot predict what will happen next. If someone can, they will not share it with you as they will use that insight to make money in the market.

The reality of the situation is that we do have a serious situation with IL&FS which is a SIFI (systematically important financial institution). In simple words it means, that the company is so large that if it goes down, there will be a domino effect which will affect the entire financial sector.

As this is a private company, we have not seen any action from the government on it. However, we are now at a point where the contagion has started spreading and sooner or later there will be a bailout (government will have to back the company). If this happens soon, then fall out will be contained. However, if the government delays taking action due to political compulsion, then we have lots of turbulence ahead.

The first order impact would be in the financial services sector, but it will spread to all the other stocks as we are already seeing now.

Action plan
I don’t have to give false hope to anyone. The reality is that no one knows yet how this situation will evolve. If the government steps in quickly, further panic will be avoided. If, however, we do not see a firm action, then we need to ready for some tough times.

As I have shared in the past, I do not manage the portfolio with an eye on reducing the short term swings in the portfolio. I am always concerned with the long term intrinsic value of the companies we hold. In sharing the above analysis, I have tried to evaluate the impact of a liquidity squeeze on some of our holdings in the long run. Inspite of the logical analysis here, it does not mean that our other positions will not be affected if panic spreads in the market.

This is similar to the analysis I shared after the demonetization even in Nov 2016, when our portfolio dropped by more than 10% in a few weeks. The risk at that time was much more wide spread and was mainly on the asset side of the business (loans going bad). This time around a liquidity crunch will not have a direct impact on the asset side and is more of an issue from the liability side of the balance sheet.

If you are invested the same as the model portfolio, then you should not try to average down if you already have an allocation which matches with the recommended percentage. If however, you have not purchased any particular stock, then you should buy slowly over time keeping in mind the recommended percentage.

Although I don’t react to the day to day movements in the market, I do have an eye on it. I will update all of you if there is any change in my views. For now, we have to be prepared for some tough times

Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions. Please read disclaimer towards the end of blog.

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