Introduction to April Issue

How would you feel if you make a doomsday prediction and the real doomsday arrives? You can't be happy for sure. When I wrote about Brokelyn Ltd, in Anatomy of a Debt Trap, I got many queries on the real identity of the fictitious company I had analyzed. People asked me, "Is it Aurobindo Pharma?". The next issue of Unfair Value detailed the issue of excessive leverage in Leverage Explained and I took the example of Workhardt. Again I got queries on whether Wockhardt is the next Brokelyn?

I had used a fictitious name because this was a systematic problem with many high-flying companies having dug their own grave by taking excessive debt. In last six months, the fonts in the epitaphs are becoming bolder: "Here lies a company that thought it can acquire the world on borrowed money." The debt burden is becoming increasingly heavier due to depreciation of the rupee, hardening of interest rates and the sorry state of capital markets. When the foreign currency debt matures, these companies will have to repay the principal amount of debt plus the premium plus the mark-to-market losses. Together these factors will erode the networth so drastically that no fresh loans can be taken because the debt to equity ratios on outstanding debt will rise to unheard levels. Without being able to raise fresh loans, these companies are effectively crippled. Some will sell their assets, some will be able to rollover the loans at sky high interest rates and others will simply go under the creditors' control. BIFR, the dirty word of 90s, will be back with a bang.

The government understands this. It has issued a notification dated 31 March 2009 to amend AS 11 "The Effects of Changes in Foreign Exchange Rates". As per the amendment, companies would be allowed as an alternative treatment to amortize/capitalize foreign exchange differences arising on long-term monetary items. To me, this amendment is equivalent to delivering a bad news softly, over the years, but that doesn't change the nature and enormity of the problem. It will surely reduce the volatility of reported earnings but this will create excellent value traps. Investors who are trying to do bottom fishing may end up investing in a company which is sitting on a pile of unamortized foreign exchange losses.

But debt explains only a part of the problem. The other problem is derivatives. In the article The Great Hedging Hogwash I explained how the corporates are indulging in rampant speculation in the name of hedging their currency risk. I had explained that for the companies who are working on huge net profit margins (like IT companies), hedging serves only one purpose, to smoothen the profits. I was not wrong to accuse the mighty software companies of trying to smoothen their results. They were short on dollars and as it appreciated, you got hundreds of crores of foreign exchange losses. It was simply not required.

Infosys, the most conservative among the IT lot, changed its hedging policy this year. It reduced exposure to hedging in the currency market to $576 million from $932 million. It played safe by taking a short term view on the dollar-rupee variation, while others like TCS, Wipro and HCL continued to hedge their receivables for more than a year. Another difference is that Infosys deals only in range forward options. The exposure of the company is limited to the range of the option. For instance, if the range is 1.3-1.6 for a dollar-euro contract, then the company will get the spot exchange rate as long as it falls within the range. If on the settlement day, the spot rate falls below 1.3, it gets the lower rate of 1.3 and if the rate moves above 1.6, it gets a higher rate. The results are quite clear. While Infosys escaped unhurt, other companies reported huge exchange losses. More on this in SNAFU.

The coming years are going to be stock pickers' paradise and a nightmare for casual investors (!) who don't do their homework. The coming years will separate men from boys, both in business and in investments. The balance sheets of banks give the early indications. ICICI Bank, for example, reported Gross NPAs at 4.32% of advances. BusinessLine reports: "Gross non-performing assets of the banking sector are likely to touch 5 per cent by 2011, from 2.3 per cent in 2008." Rather than jumping on to the wrong conclusion, "Let's avoid the banking sector", you have to see where these NPAs are coming from. You have to avoid being an investor in companies that may default on their debt. The shareholders are the last ones to get their share of spoils when the companies go bankrupt.

Many corporates are coming out with fixed deposits in their desperate bid to raise resources. Do not invest into these, thinking that these instruments are as safe as Fixed Deposits of the banks. They are not and that's what explains the high interest rates. Do the analysis of these like your analyze bonds or else stay away.

GOI Notification on The Effects of Changes in Foreign Exchange Rates

Who will gain from AS-11 change?
BusinessLine Apr 12, 2009


Neeraj said...

This is quite an interesting article.

It was also interesting how ICICI Bank was beaten down late last year and now the stock has more than doubled since then!

Kamlesh Pandey said...

Speculative stocks give the highest amount of returns from their lows. That doesn't mean anything for investors because there is no way you can predict how low such a stock can fall. In hindsight, it always looks like a missed opportunity but you rarely make money on such things.

I would rather head for a poker table in Las Vegas than invest in a speculative stock.

Anonymous said...

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