It's fun to switch on a business news channel to hear morons talking in oxymoron. The world economy is going to witness negative growth this year. All major US banks are saddled with toxic securities that causing insecurity among investors. There aren't any truly bankable bank in US. The US govt plans to help banks dispose their toxic assets will give a boost to bank stocks.
What the hell is going on in here? Just few decades have passed when comedian Bob Hope said that a 'bank is a place that will lend you money if you can prove that you don't need it'. The banks of 21st century became a place that will lend you money if you can prove that you don't deserve it. I'm not joking. That's precisely what Ninja loans are. (Ninja stands for No Income, No Job, no Assets).
I'm glad that I'm watching this drama from sidelines. I'm glad I've no toxic assets to dispose off. When did I first think of toxic assets? I think it was 2005. Britney Spears displayed her assets so well on a song called titled 'Toxic' that she got a Grammy for best dance recording. It wasn't what music lovers would call 'music', yet it sounded like music to financial firms in wall street. Caution was thrown out of windows and in came craziness. The craze for 'toxic' securities saw the financial world going into a direction where people just forgot something very fundamental. A four letter world called risk.
The song 'toxic' says it all
'There's no escape
I can't wait
I need a hit
Baby, give me it
You're dangerous
I'm loving it'
And the hit came.. a bit late and a whole lot more powerful than asked for. It knocked out many financial giants and the rest were found leaning on government support. But the tremors were felt far and wide and we are still reeling under aftershocks.
Many would ask a question, could it have been predicted? The answer is a definite yes. Most of the times, common sense, open eyes and open ears are enough to keep you out of harms way but this precondition is stricter than it seems. We get biased by what we see and hear and start ignoring the writings on the wall. Before this crash came crash, we had precedents too. We had not completed even a decade from the last boom in 1999 where people were telling that profits doesn't matter…Eyeballs do. Many lost their balls in crash that came with the new millennium.
Seven years later( June 13th 2007), in US the interest-rate spread between the main junk-bond index and the ten-year Treasury bond shrank to 2.4 percentage points. People were willing to investing in junk bonds giving 7.7% when the safest for of fixed income instruments, US govt bonds were giving 5.3% yield. Such a small risk premium for such a big risk was unheard of.
In stocks the situation was even worse. Jeremy Grantham in his April 2007 letter reported the 'first ever negative sloping' risk return line which indicated that 'investors are paying for the privilege of taking risk'
And then there was real estate…mother of all manias. In Nov 2006, Peter Schiff gave a talk to the Mortgage Bankers Association where predicted the doom in real estate as well as the general economy. I have nothing to say about the speech (you better watch it if you haven't) except the climax that came during question answer session. A guy asked 'Peter, as a lender myself and as a property owner and wider [question] about real estate, on what's going on….Should I just slit my wrist?'
The pendulum is going slowly towards the other extreme. People are being extra cautious and hurting themselves even more in the process. Last month, Warren Buffett said in an interview to CNBC 'the interesting thing is that the toxic assets, if they're priced at market, are probably the best assets the banks has, because those toxic assets presently are being priced based on unleveraged buyers buying a fairly speculative asset. So the returns from this market value are probably better than almost anything else, assuming they've got a market-to-market value, you know, they have the best prospects for return going forward of anything the banks own.'
In US the banks are now unwilling to give loans even when the cost of capital has fallen to unprecedented lows due to government support. These banks are able to get money at 1% whereas the lending rates continue to be high. In India, although the banking sector is on strong footing, there is a definite unwillingness to part with the cash. Such a strong comeback of risk aversion is giving rise to irrational things happening all around.
Consider FCCBs. There are companies who are able to buyback their FCCBs at huge discounts, which implies that the bond holders fear that these companies aren't going to make it, yet the market capitalization of same companies is rising. This means that the stock holders, whose claim on returns and principal is secondary to the bondholders, are more confidant about the capability of their companies to come out of downturn alive.
Ok. Coming back to (oxy)morons. The entire economy, we are told, is a phase of deleveraging (Have you ever used a lever? Yes, try deleveraging!). The rally, you see, was just a bear market rally. The markets went down due to profit booking(if people are doing profit booking when market is half its peak, when the hell do they book losses?). The biggest question is the shape of recovery…whether it will be U shaped, V shaped or W shaped. Who said you need to know ABC of finance to talk about it. You can start with UVW.
References
Jeremy Grantham's letter
http://www.scribd.com/doc/7257647/Jeremy-Grantham-Letter-Q1-07
Peter Schiff Mortgage Bankers Speech
http://www.youtube.com/results?search_type=&search_query=Peter+Schiff+Mortgage+Bankers+Speech&aq=f
A bright summer afternoon in a hill station, I was taking a stroll along the lake shore with few friends. A paddle boat operator approached us and asked: "Boating … want go out for boating? Half rate."
His offer was surprising because he knew us. It was our hometown. The natives rarely indulge themselves with activities that are a favorite among tourists. In a second, we realized why he was asking us. There was an accident in the lake a few days ago where a paddle boat sank along with three tourists. Even after frantic efforts of the divers, the bodies couldn't be recovered. It was big news in the sleepy little town. The tourists were scared and didn't want to go out to the lake on their own. There was widespread fear that the paddle boats were inherently unsafe.
The business of paddle boat operators came to standstill. They added a few safety measures like rubber tubes (life jackets weren't popular in those days) but it didn't help. So the offer from the paddle boat operator was essentially a confidence building measure. He thought if we take the boats, perhaps the tourists will follow suit.
We showed no interest. He sweetened the deal. "Ok take it out for free…all yours." We were smiling but uninterested. Then he started pleading, "Tourists are scared like sheep…take the boat…please." Half of my friends were already tilting towards a 'yes' when the boat man made the offer irresistible: "Ok...free ride and free beer… enjoy."
So we went. Six people in six boats. And a crate of beer. It was a win-win deal. We had a gala time in the lake. It was completely free of traffic. We paddled, in formation, passing the beer and potato chips from boat to boat. We even did a boat race. As we returned to shore after a few hours of wild party, we could see tourist boats tricking back to the lake. In a few days, it was business as usual.
The story ends here. The question is, were we taking risks?
The answer is no. A risk is a risk before it is discovered and neutralized. Everyone who went on a paddle boat before the accident was taking that risk and three people paid for it with their lives. We were entering the scene after the accident when the boat operators had taken counter measures by providing safety rubber tubes. [drunken boating was definitely a risk but let's set it aside for now ]
I'm reminded of this incident in every market crash and subsequent fear wave that sweeps through the investing world. Two years ago, if you asked a 100 people: "Do you think investing in real estate is risky?", 99 would have said no. Ask the same question today and more than two third will answer in the affirmative.
In equities today, there are equivalents of the boat operator's free offer, i.e. buy at cash, and get fixed assets free. But the perception of risk is so high that people are ignoring the fact that there is a bigger margin of safety available today than there was in the last five years. Most people think that in investing, the risk-reward equation is such that the quest for higher returns always demands taking higher risk. It's a myth. The times when risks are highest are the times when the returns are lowest. Contrary to popular belief, for investors, the risks aren't highest at the time of recession, but they are highest at the peak of a boom.
The simplest logical explanation for this inversion of the risk-reward equation is this. When the risk appetite becomes bigger, the investors are willing to ignore the risks and that brings down the risk premium. The decrease in risk premium fuels the rise in prices. The value of each asset is driven by its fundamentals and there are limits to profitability of the companies. The higher the price, the lower is your return. If the best case scenario plays out in future, you gain a little because the expected profits are already built into the prices you paid. If the future disappoints, you my lose 80-90% of your investment. So the expected value of returns (probability-weighted sum of possible returns) hits a low exactly when you are taking highest risks.
This unintuitive result is a direct outcome of confusing the business risk with investment risk. If you invest in a business which is almost certain to grow, you are competing against millions of other investors who want a slice of the same cake. The desire to outbid the fellow investors results in a price which exposes you to a risk of having overpaid for the stock. Hence, a low risk business doesn't always translate into a low risk investment. You, as an investor, are subject to the business risks and valuation risks. If you don't take these in conjunction, you are bound to get negative surprises.
Similarly, high business risk doesn't always mean high risk for the investor. If the future profitability of a business is uncertain, yet you are fairly certain of it breaking even, you are taking very little risk when you buy such business below its net current assets after adjusting for debt. You are paying absolutely nothing for the profit potential of the assets. If by a stroke of luck, the company does well, you can get huge amount of returns.
People call this the 'contrarian approach' but I prefer calling it intelligent investing. The notion of going against public opinion doesn't excite me. If you ask a demented person to pick a correct answer among two choices, he will answer the question correctly roughly 50% of the time. You can't do better by merely picking the answer which he didn't pick. If you instead apply your own mind, you can get most of the questions right. So don't jump into buying the stocks just because everyone is selling them. Choose your investments carefully because choice is a luxury that has become affordable nowadays.
The world economy is in a bad shape. The markets have dropped to their lowest point in the millennium. A boat has sunk and no one is daring to venture out. Just take a stroll by the lake side and if you find a boatman giving you a free boat ride, take it.
If you ever apply the valuation criteria that you use for the non-financial businesses, to the banks, you would definitely get surprising results. For example, the debt to equity ratio in the range of 6 to 10, will spook you. When you look at the stock prices of banks, you will be surprised to see some banks perennially selling below the book value. In most cases, you will not see the banks losing money in their long history, partly because the ones which do lose money, either lose their solvency or their independence. They are bailed out by the government and merged with others. You would see that the banks which are doing well keep growing at steady pace. At the same time, you would note that the markets are not giving them the kind of P/E you would expect for a steadily growing services company.
What sets banking business apart from non financial businesses? How should we take into account these differences while valuing a bank? In this article we will delve into these questions.
A bank is more like a services company but the service it provides – intermediation between the savings and investment – has characteristics that make it a category in itself. The bank uses the deposits to lend money. The size of the bank's business is constrained by the deposits it can attract. The deposits aren't limited by its physical infrastructure of branches. A bank is able to use the deposits as a form of debt to generate returns. However there are many regulatory constraints on how this debt can be utilized by the bank. These regulations ensure that the bank is able to provide adequate safety to the depositors. Within these constraints the bank is free to lend its money to generate adequate returns at reasonable risk. Here is the list of factors which allow a bank to achieve this objective.
- Trust
The history of the bank, the financial strength of its promoters and strong branding, help in building trust. Scale also helps here. People feel safer with a bank which most of their relatives and colleagues bank with. So a higher deposit base begets more depositors.
Indicative Factors: The level of trust is a qualitative factor. But a sure shot indicator of the level of trust is the interest rate a bank pays for its long term fixed deposits. The banks which are considered less trustworthy have to shell out extra money to get deposits. The failed Global Trust bank, even in its heydays, used to pay 1% extra for fixed deposits. This data is readily present and can be used as a proxy.
- Asset Liability Management
The profitability of a bank in the long term depends on how well the bank manages its assets and liabilities.
Indicative Factors: The banks provide data about the maturity profiles of their assets and liability in the annual reports. This data should be read in conjunction with the guidelines on Asset Liability Management from regulators.
- Risk Management
The risk management of the bank is important not only to protect its income but also for the survival of the bank. The Non Performing Assets (NPA) of SBI were 7.18% of its advances in March 1999. But for the government support, the bank would not have survived.
Indicative Factors: Gross NPA, the ratio of gross non performing assets to the total advances is a good indicator of the quality of risk management. This ratio is also dependent on the state of the economy, hence a relative comparison among banks will give you more credible information.
The level of Net NPA, which is Gross NPAs minus provisions made for future losses, gives an indication of the extent to which the bank has covered for the losses. However, I feel that Gross NPA is a better indicator. A bank, which keeps losing money to bad loans and then keeps taking out a chunk from the income to provide for these losses, is not a good bank even if its net NPAs are low.
The annual reports also contain information about the risk management policies adopted by the banks to counter various types of risks like credit risk, market risk, liquidity risk, operational risk etc which can be used to judge risk management in a bank.
- Quality of credit portfolio
Indicative factors: Most banks report distribution of credit risk exposure by industry sector in their annual reports. You can watch out for excessive exposure here.
- Capital Adequacy
The capital adequacy ratio (also called Capital to Risk Weighted Assets Ratio (CRAR)), sets an upper limit on growth. A bank which is seeing good growth in business, yet lacks adequate capital, is forced to augment its capital. For investors, this is an aspect that must be kept in mind while making assumptions on growth.
Indicative Factors: Capital adequacy ratio is mentioned in the results and annual reports. For the year 2007-08, the average CRAR of the nationalized banks stood at 12.10 per cent while that of foreign banks was at 13.10 per cent and of private banks at 14.30 per cent.
- Cost of deposits
Indicative Factors: The higher is the ratio of CASA deposits (Current Account/Savings account) to total deposits, the better for the bank. This ratio is provided in the annual reports. Another metric is the cost of deposits which gives an indication not only of lower interest costs but also the level of trust the bank enjoys.
- Interest magins
Indicative Factors: Net Interest Margin gives an indication of the profitability. However, it should be used in conjunction with other factors. A bank with cost of funds at 5% and returns on loans at 8% is much better than a bank with cost of funds at 8% and returns at 11%, even though the Net Interest Margin is same. The first one has lower risk.
- Operating efficiency
Indicative Factors: The annul reports of the banks include yearly data about the business per branch, business per employee, profit per employee etc. which give an fair indication of the operating efficacy of the bank and changes in operating efficiency. The cost to income ratio is another handy tool to learn what percentage of interest income goes to support operations.
- Asset Composition
Over and above the minimum requirements specified by the RBI, the banks may keep more money in govt securities and other liquid securities. Although the major portion of the earnings come from advances, the volatility in interest rates can change the carrying value of the govt. securities resulting in the treasury gains/losses. The current market regulations allow banks to define what portion of their govt. securities portfolio is held till maturity and what portion is available for sale (AFS). The mark-to-market requirements, which call for valuing the bonds at the market prices, apply only to the AFS portion.
The public sector banks may give loans to priority sectors like farmers, and small scale industries at subsidized rates of interest. Again, this portion of the assets is not profitable. Banks are also allowed to invest up to 5% of their assets in equities. These investments may become a source of returns or troubles depending on how well the bank manages its investments.
Indicative Factors: The Credit/Deposit ratio gives an indication of the percentage of the deposits that have been disbursed as loans. The ratio should not be too low because that would mean the bank hasn't been able to deploy the deposit money profitably. Low Credit/Deposit ratio also means that a major portion of bank's assets is in form of govt securities which makes the bank susceptible to changes in interest rates.
- Quality of earning
If the other income is a significant portion of total income, you should see the composition of the other income. The income from treasury gains, profits from sale of investments and derivatives, should not be considered recurring income. On the other hand, dividends from subsidiaries, fee based income in form of commissions and brokerages may be relatively stable.
Indicative Factors: Interest income as a percentage of total income.Fee based income as a percentage of total income.
- Quality of service
Indicative Factors: This is a qualitative factor and little hard to judge. The investors should not go by stray incidents to term the service good or bad. However, the factors like availability of branches, ATM and other banking channels should be weighed in while evaluating a bank.
Even this lengthy description of factors does not adequately cover the key determinants in the success of a banking business. There are other factors that assume critical importance on a case-to-case basis. For some banks the exposure to currency risks and derivatives can be significant. Similarly, independence on decision making can be a big factor in case of public sector banks which are, at times, forced by the government to lend to certain sectors at lower rates which do not compensate for the associated risks. The waiver of loans and the moral hazard associated with it is another key concern for these banks.
Some banks have large subsidiaries dealing in stocks, brokerages, insurance and other financial sectors. If the subsidiaries are large, you cannot use standalone accounts to correctly judge the strength of the bank.
The banks are a good proxy for participating in the growth of the economy. They should be present in every investor's menu but yes, their accounts are hard to digest. If you want to invest in banks, never be shy of number crunching.
Further Readings
Low-cost deposits key to banks' survival
http://www.livemint.com/2008/08/18004847/Lowcost-deposits-key-to-banks.html
Asset - Liability Management System in banks - Guidelineshttp://rbidocs.rbi.org.in/rdocs/PressRelease/PDFs/3204.pdf
Prudential Norms on Capital Adequacyhttp://rbidocs.rbi.org.in/rdocs/notification/PDFs/85410.pdf
Banks witness fall in low-cost deposits' share in Dec quarter
http://www.thehindubusinessline.com/2009/02/04/stories/2009020451650600.htm
- It's a text book case of how the promoters manage to take advantage of the volatility in prices, in a perfectly legal way, by issuing new stocks during booms and buying them back when times are bad. I feel that the analysis of the case will equip the readers of this newsletter with reasoning to handle such cases in future.
- Unlike the case of buying or selling from regular markets, where the price is offered to you, the exiting investors of the company are supposed to quote the price at which they want to sell. Most small investors do not have the skills required to arrive at a valuation of the company. They look at the market prices as a guide. But in this case the price of the stock has been quite volatile as it is thinly traded and it has been party to a mammoth restructuring attempt last year to put an elephant's head on the shoulder of a human child. Except in Hindu mythology, such attempts are doomed to fail. This restructuring attempt, to merge group company Sterlite's aluminum and energy businesses to MALCO, the latter being one tenth in size, fell flat on its face in a matter of a week. This week-long euphoria catapulted the price of MALCO to 225 Rs and the inevitable post-euphoric gloom brought it crashing down to Rs 34. The talk of delisting has given a dose of Viagra to MALCO and it has shot beyond Rs. 100. Now the task in front of the small investor is: Name the price at which you want to sell! If you own MALCO yet can't answer this question, this artcile will help you.
- MALCO is the second biggest holding in my portfolio and this stock on its own has earned me more profits in my investing career than all my other stocks combined. Naturally, I'm not willing to sell my precious holding without getting a good price for it. But the actions of my fellow shareholders affect me because if they sell out cheap, I may be forced to sell out or become a private investor. I'm not averse to the second option (which, as a matter of fact, I did choose, and quite profitably, in case of Eicher Ltd.). However, the prospect of being at the mercy of promoters, to send me dividend, makes me rate selling out as the first option. Hence, this attempt to help the MALCO investors in determining the price they should seek from the promoters, indeed, has a very personal objective too (and I feel it is most fair to take up the issue through my ‘unfair' means).
Sterlite Industries is the largest non ferrous metals producer in India. In the 1990s, Sterlite produced only copper but during the disinvestment in 2001, it managed to get hold of two large PSUs, BALCO and Hindustan Zinc. The controversy regarding the price of BALCO led to agitation which caused production shutdown at the company?. This led to a major fall in the price of Sterlite (and I managed to buy stocks of Sterlite at dirt cheap prices). The promoters of Sterlite were aware of the gap in price and value. The company proposed to buy back 50% of its equity at a price slightly above the then prevailing depressed price. They went to the extent that any shareholder who did not, explicitly, reject the buyback offer, was deemed to have given acceptance to sell. The court ratified this crazy buyback arrangement. Many investors, like myself, did not receive the forms to be able to decline the buyback offer. After pressure from investor groups, the promoters gave 3 months time to the investors, who had not yet returned the forms to decline the buyback (and I screamed NO.Under normal circumstances, I would sell off my stake in any company that tries to cheat the investors but in this case, the eagerness of the promoters to buy back, was a clear endorsement my own valuation of Sterlite.)
After delisting, the promoters created a holding company Vedanta and listed it in the UK for a few billions. In one single stroke of financial wizardry, the Sterlite promoters created billions for themselves in a perfectly legal yet utterly dishonest way.
Sterlite, using the cash from the UK listing (transferred via rights issue), increased its capacity manifold and became a non ferrous metal giant even by global standards. Last year, Sterlite (consolidated) produced 0.34 MMT copper, 0.42 MMT zinc and 0.36 MMT aluminium and earned around 1.5 billion dollars in profit. They are still hungry for growth and each line of business has plans to expand the capacity further.
- The book building process allows them to ask for any price above Rs 74.77. If they quote a price too high, say 225 Rs and the promoters manage to get the desired 10% stake at a price well below, say 150 Rs, they will still get 6 months to sell out at the same price as offered to the other shareholders.
- As they are selling out to a long term investor, the valuations should not be based on recent results or depressed commodity prices or the prevailing market condition.
- The stakes for the acquirer are high. They would not like to fail for the second time because it raises the price of acquisition. Secondly, this delisting will decide the fate of their restructuring plan. If they believe that restructuring is beneficial for the group, they wouldn't mind paying a little bit extra for the 30% stake left with the public.
- The public stake in the company is concentrated among a few strong hands. Out of 20%, the financial institutions hold 12.33%, corporates hold 3.62%. Only 3.31% is held by small investors.
The acquirer has vide its resolution dated February 25, 2009, approved a price not exceeding Rs 105 per equity share for the Delisting Offer. However, this should in no way be construed as (i) a ceiling or maximum price for the purposes of the reverse book building process contemplated herein, and the Shareholders are free to tender their equity shares at any price higher than the Floor Price; or (ii) a commitment by the Acquirer to purchase 2,25,00,000 equity shares of the Company if the Discovered Price is Rs 105 or less; or (iii) any restriction on the ability of the board of directors of the Acquirer to modify the aforesaid resolution
Only the last line has some meaning. Forget Rs 105. Quote your price. Accepting or not it their business.
Valuation
Let's try to arrive at the value of the stock.
The methodology I'll follow here is what I call “Common Sense” method. (those preferring fancy discounted cashflows valuation are free to do it on their own)
This method, includes separating the assets which have diverse characteristics and valuing them individually and then adding them up.
With this methodology there are 3 key contributors to MALCO's value.
- The cash and bank balances
- The value of future earning
- The value of its 3.97% stake in Sterlite
You can value the stake in Sterlite in different ways. You can use the average market price of the stock. You can also say that Sterlite itself is undervalued today and ask for a price by capitalizing the earnings of Sterlite at a conservative multiple.
With different criteria, here are the valuations we arrive at.
Basis | Valuation of MALCO | Valuation of MALCO | Valuation of Sterlite |
---|---|---|---|
Rs Million | Rs Per share | Rs Per share | |
Malco at book value | 9820.3 | 87.3 | 235.4 |
Malco at 10 times average earning + Sterlite stake at book value | 13875.5 | 123.3 | 235.4 |
Malco at 10 times average earning + Sterlite stake at market price | 14145.0 | 125.7 | 245.0 |
Malco at 10 times average earning + Sterlite stake at 6 month average market prive | 15995.8 | 142.2 | 310.0 |
Malco at 10 times average earning + Sterlite stake at 3 year average market price | 23493.1 | 208.8 | 577.4 |
Malco at 10 times average earning + Sterlite stake at 10 times average earning | 18539.9 | 164.8 | 401.3 |
Unfair Value vide its resolution dated March 1, 2009, approves a price not less than Rs 197.76 per equity share for accepting the Delisting Offer. However, this should in no way be construed as a ceiling or maximum price for the purposes of the reverse book building process contemplated herein, and the Shareholders are free to tender their equity shares at any price higher than this price.
As per SECURITIES AND EXCHANGE BOARD OF INDIA (DELISTING OF SECURITIES) GUIDELINES – 2003, section 8.5, In the event of MALCO being delisted at a price less than 197.76 rs per share, the acquirer will allow a further period of 6 months for any of the remaining shareholders to tender securities at the same price. If that happens we reserve the right to reconsider the price and decide to sell out or continue as a private shareholder.
References
2. Vedanta Resources - Aborted restructuring Plan
http://www.vedantaresources.com/uploads/restructuringrelease_final.pdfhttp://www.vedantaresources.com/uploads/restructuringpresentation.pdf
3. MALCO Valuation SpreadSheet
http://spreadsheets.google.com/ccc?key=pgthdN0ecm21lkpLePwASGA
4. MALCO Financials