Introduction to november issue

A careful look at India’s history would suggest that the country has not been as tolerant to thought schools other than the dominant thinking of the days. Among the casualty of the suppression of free thought is a great tradition of atheism in India. Long before the advent of existentialism in Europe, India had a materialistic and atheistic line of thought with the Indian philosopher Charvak being a leading proponent of it. One of lines attributed to him is:

Yavaj jeevet sukham jeevet, rinam kritva ghritam pibet.
Bhasmeebhootasya dehasya, punaragamanam kutah.

(“So long as you live, live a happy life, incur debt eat ghee [lead a rich life]
[because] once the body turns into ashes, there is no rebirth.”)

Apart from denying the existence of god, and rebirth, his thinking went against the conventional Indian thought of living well within your own means. So there should be no surprise that “rinam kritva ghritam pibet” was buried under load of the holy books.

Then in the early 20th century, suddenly, the entire world embraced Charvak. All over the world individuals took debt to enjoy life – to buy cars they didn’t afford, to buy homes they didn’t afford… to buy a life of borrowed affluence. The companies took loans to do acquisitions for which there was no pressing hurry. The phenomenon was global and all pervasive. However, it would not have been possible for the global economy as a whole to increase the amount of debt unless the lenders reduced their lending standards and gave loans to the people/companies who didn’t afford those loans. I fail to understand how, but it so happened that for every debtor seeking a loan there appeared a lender willing to provide loan. For every lender willing to provide a loan, there appeared an insurer willing to assume a major part of the risk of default. And thus started a wave that took to unprecedented heights, the global economy and every financial market you can think of – stocks, debt, commodities, real estate, art…

But Charvak wasn’t talking about the greedy pursuit of more and more money when he said “incur debt”. He was just talking about leading a good life. There is a limited amount of money that can chase consumption. There are limits to what a given number of human beings consume. However the limits to what they can invest in, are elastic. Although, in the long run, a free market will never allocate investment to the areas where there can not be any returns, the short term story is very different.

The return on investment is a variable that gets its value in future. The perception of ‘risk adjusted return’ is what drives investment. This perception is what drives markets into boom and bust cycles. In most forms of gambles the increased returns are usually associated with increased risk, but, it is very surprising that the booms are characterized by not only irrational expectations about high returns but a simultaneous (and fatal) lowering of risk perception. When the prospects look mouth watering people turn a blind eye to risk. In the past few years whenever I talked about the risk in investing in real estate, almost every time I had people telling me: “Real estate doesn’t go down”. And they were so fanatic in their belief that I used to leave them with their mistaken beliefs the same way I leave the religious fanatics when they talk about God.

Times have changed. The chickens have come home to roost. The question is no longer about growth or the future. For the individuals it about how to save their job, how to pay the next installment on their home loans to avoid foreclosure. For the companies it about how to pay the employee salaries, how to pay the suppliers, how to repay the loans maturing next year…

Indian companies are not going to be left unscathed. In the financial years ending 2005, 2006, 2007 and 2008 the Indian companies raised loans worth 13.5, 17.2, 25.4 and 31 billion dollars respectively. Starting 2009, the repayments will start kicking in. Given the state of financial markets, it’s hard to raise any kind of funding. The debt has become the Achilles heel of corporate India.

It is about time the equity investors realize that their claim on a business is subordinate to senior securities. When a company goes bankrupt, the creditors must be paid in full before a penny accrues to the stockholders. In such a scenario, before analyzing the attractiveness of the stock of a debt ridden company, we have to see the attractiveness of the bonds of the company. If a company’s debt is rated as junk, the common stock is, automatically, junk. It is a time where the stock analysts have to throw their discounted cashflow models and analyze whether the company is in a position to repay its debt.

The news on this front isn’t good. Business Standard reports that the bonds of many Indian companies which raised debt from external markets are selling at such huge discounts that their yields are as high as 30 to 50 per cent. In simple terms, it means that the investors are unwilling to buy bonds of these companies even when the current prices give them 30 to 50 per cent interest assuming the company doesn’t go bankrupt at the time of redemption of the bonds.

This is a wakeup call to all the investors in debt ridden companies (myself included). The growth in revenues or operating profits that gets highlighted in quarterly results doesn’t matter. What is hidden in the balance sheet does. The inevitable bankruptcy is dogging many Indian companies. There are big names in the list of corporates haunted by debt.

This, relatively somber issue of Unfair Value is focusing on analyzing how to avoid landmines in your pursuit of good investment returns. It is also riddled with unavoidable complexities because the subject matter at hand demands it.

If you think Charvak was wrong when he said “Bhasmeebhootasya dehasya, punaragamanam kutah” (once the body turns into ashes, there is no rebirth , I would leave you alone, for your belief can never be proven wrong even if it is false (when you cease to exist, how will I tell you, “You see my friend, you were wrong!”)

But I must tell you one thing for which there is ample evidence in the history of corporate finance.
Once a company goes into a debt trap there is no coming back.

References

  1. Foreign funds sell FCCBs at hefty discounts, Business Standard, November 4, 2008 view
  2. RBI data on External Commercial Borrowings view

1 comments:

vishnu said...

Hi Kamlesh,

A lot of guys I have read or know have from time to time told the world that they were value investors but very few showed that they were and you are one of those.

I am very glad and fortunate to have read your emails and now your magazine regularly. If I may be of any assistance to you in this endeavor, just send me a howler :) and I will promptly comply.

Regards,
Vishnu

P.S :- I am also one those guys who says I am a value investor.

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