November 25, 2016

Losing your wallet

We had two major events in the last few weeks – The election of Donald Trump as the president of US and the Demonetization of the 500/1000 Re notes

Let’s look at the impact from these two events.
Let me start with the first event, which somehow was in the news for the last few weeks and I felt no need to respond or react. The event was a surprise for many and in a way similar to the Congress win in India in 2004. There was a sense that the market would crash if Donald trump is elected as president. I had no clue about what would happen if this event occurred, but to be frank I could not care less.

You will hear all kinds of reasons why some event will cause a cascade and impact a particular company in question. I personally think this is complete nonsense and one can link any number of remote factors together to make a case.
In investing, the key is to focus on the few critical factors which may impact your investment thesis and ignore the rest. I find it difficult to see why the election of a particular individual in a foreign company will have an impact on most of the companies in India at a micro level. Will consumers buy less soap or stop buying cars or going to movies just because Donald trump is elected in the US?

A final point on this count – Look at what has happened to the US market after the election. After an initial drop, the market is up. So much for predictions from all kind of pundits.
The more important event
The more relevant event for us has been the demonization of the high value currency. I personally think this a watershed event for the country. There are a lot of people looking at the interest rate and tax implications for the country, which I agree is quite good. However the bigger impact is from the signaling effect of this decision.

For starters, it creates a lot of positive emotion for the honest tax payer/ companies as they now feel that they are not idiots for paying their fair share.  This event is a positive boost for them.
The second impact of this decision is that it sends a message that the government is serious about reducing tax evasion and corruption. A combination of GST, JAM trinity and now demonetization could be effective in reducing tax evasion (but not necessarily eliminate it). This would apply to a lot of unorganized sector companies where there is substantial evasion of taxes. These events are creating a level playing field in terms of taxation and will benefit the organized companies in the long run.

Although the long term benefits are huge, the short term is going to be tough. This kind of event has first, second and higher order effects. On the surface real estate, gold, high value durables and other such purchases are likely to get impacted. However if you think further, this drop is likely to cause a ripple effect in other sectors such as lending, construction materials, auto components and so on.
Analyzing the impact on your portfolio
The key point in the analysis of any major event is to evaluate the long term impact to the business model and profitability of the company.

There will definitely be a short term impact of varying degrees to all the companies from a slowdown in the economy. The next 1-2 quarters are going to be ugly for a lot of companies and stock prices have started dropping in response to that. As we approach the end of the year, the selloff could increase as a lot of mutual funds and FIIs try to window dress their portfolio.
I have no such plans for my portfolio. I made an argument in a prior post that we need to be ready for short term volatility and 15% or more drops from time to time. If one cannot handle these swings, then equities are not an appropriate vehicle. I will not sell any stocks where I think the long term prospects continue to be good, even if the near term appears horrible.

An example
Let’s take the example of NBFCs to see how this event would impact some companies

A lot of NBFCs deal with customers who operate on cash due to lack of access to banking services. It is expected that these companies will be impacted as these customers are unable to make timely payments. We are most likely to see a large expansion of NPA in the next 1-2 quarters.
We should however keep in mind that an NPA is not the same as a loss. An NPA means that the borrower has not made a timely payment and as a result, the lender has to mark the loan as non performing, stop accruing the interest income and add provisions (set aside some part of the profits) to account for the higher risk of non-payment.

Even in the event of a loan going bad, the recovery varies from 30-70% based on the nature of the asset and the level of collateral. If the asset is a steel plant, it is quite obvious that it is large, illiquid and will require special skills to operate. In such cases, the recovery for the lender is on the lower side. In the case of other assets such as real estate, there is a large liquid market for the asset where it can be auctioned and hence the level of recovery is usually on the higher side.
Let’s look at a worst case scenario. Let’s say a company has around 1000 crs of assets on its books. Let’s make a very aggressive assumption that 10% of the assets will become NPAs with no hope that the borrower can become current on the loan. We can assume a 50% recovery rate on these NPA. So the eventual loss for the company would be to the tune of 50 crs.

So what does a loss of 50 Crs translate to? A company with 1000 Crs of asset will generally have an equity of around 150-180 crs and would be earning close to 30-40 crs pre-tax, pre-provision profits (profits before accounting for taxes and loan loss provisions). So in an extreme loss scenario, an average NBFC should be able to cover these losses in 1-1.5 years.
Keep in mind that the above loss scenario is quite high in nature. Most of our poorly managed PSU banks have much lower level of losses inspite of much more illiquid assets and lower recovery rates.

Losing your wallet
I had written a post on first principles thinking as applied to investing here. As noted in the post, the intrinsic value of a company is the discounted sum of all its future cash flows. If you think of a company in that fashion, then by how much will you reduce the future value of the NBFC?

To answer the above question, we need to consider a few points. Do we think that the long term prospects of the company have been harmed by the demonetization issue? Will the demand for credit reduce on a permanent basis due to this issue?
I think no matter how pessimistic you may be about the whole demonetization episode and the slow response of the government, it would be hard to argue that this issue will cause a permanent drop in demand for credit in the long run..

If that is the case, then this event is more like a finite loss event. I am not saying that this loss cannot be bigger than what I have discussed earlier, but it is not equivalent to a loss of earning power for the company. The competitive strengths for the company remain the same even after the event.
As an analogy, let’s say you are carrying 5000 Rs (in 100 Re notes J ) and you lose your wallet. It is a loss of 5000 and your net worth went down by that amount. However you future earning power which depends on your skills and other factors did not change due to this event.

This analogy is not perfect and we are making several simplifying assumptions, but this is broadly what is happening to most of the companies. The same is not true if the fundamental business model depends on black money (casino or some real estate developers) or if the business cannot sustain a period of loss (as in the case of several small business operators).
The market reaction has been far more severe with some NBFCs losing almost 30% of their value in the last one month (almost 3-4 times our loss estimate).

Cash + courage = opportunity
We need to be prepared for a very ugly Q3. The demonetization event is likely to be quite disruptive to businesses in the short term, especially in the rural areas where banking services are poorly developed.

The stock market is already reflecting this impact. I am not thrilled about it but it is not shocking for me as such surprises happen from time to time. This is part of equity investing and one cannot make high returns unless one is emotionally prepared for such gyrations.
It will not feel good to keep losing money every day as the market corrects, but I plan to deploy some cash as bargains develop.

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.


Sarang Anajwala said...

As usual, Excellent post. On competitiveness front, this event can be a competitive advantage for companies in sectors where we have unorganized players have significant market share. While the socio-economic developments are already contributing to the move from unorganized players to organized players, this event can expedite the move.

The correction presents opportunities in local companies where they serve primarily "white momey customers" (salaried class) or export mkt because those are also getting dragged down due to sentimental churn in the market.

Satish Rajan said...

Well covered. The NBFC analysis is spot on. I think that there cannot be a better time to invest as in the next one or two months.

Unknown said...

Great... Very insightful

Phani said...

I was just thinking that a loss in a NBFC will reduce its equity => this increases its debt / equity ratio => decreases ability to raise debt or increases cost of funds => affects future growth of NBFC or reduces net interest margin.

Hence unlike other businesses where a loss in one year may not have affect on its ability to generate profits (losing wallet), in the case of NBFC there could be a long term impact.

Unknown said...

Hello Rohit Sir, I am new to your blog and find your posts really helpful. Today I developed a different perspective on the whole demonetization move and I thank you for that.
I have started my investment journey and have started learning Fundamental Analysis. Thus, I have decided to document this journey of mine at this blog..
Do give a read!