Poor governance, capital allocation common to value traps

Written by Saikat Neogi | Updated: Oct 14 2014, 08:07am hrs
The goal of value investors is to identify genuine opportunities that are either being ignored or misunderstood by the market. Rahul Saraogi, managing director, Atyant Capital Advisors, and author of Investing in India (published by Wiley), in an interview with Saikat Neogi, says India is one of the biggest untapped opportunities in the world and its stockmarket will be one of the strongest wealth creators in coming years.

A lot of companies, especially in realty and infrastructure, remain vulnerable to sudden changes in fortunes, with their financial statements having little connect with the underlying reality of the business. How should investors evaluate such companies for short-, medium- and long-term investments

There is a five-step framework for identifying successful investments. The first two steps, the most important ones, are corporate governance and capital allocation. Investors often get carried away by themes such as infra or housing. When looking at corporate governance, it is important to see if the promoters treat minority investors fairly and like equal partners. As for capital allocation, it is important to evaluate whether the management is running the company for maximising return, or if it has other aspirations.

While companies in realty and infrastructure are affected by the vagaries of policy changes, the bigger problem is that many of them have poor standards of corporate governance and capital allocation. At the same time, companies in these sectors that have sound corporate governance make for attractive investments despite policy uncertainty.

While India is a good market for value investors, it is also infested with value traps. How should investors distinguish value picks from value traps

Eight out of 10 times, stocks are cheap for a reason. It is not uncommon to first see the P/E of a stock decline without any apparent reason and then see earnings plummet shortly after, leading to an increase in P/E again. Value investors should identify investments that are genuine value picks because they are being ignored or are misunderstood by the market.

The characteristic that is common to almost all value traps are poor corporate governance and poor capital allocation. Investors get drawn to cheap valuations and rosy business opportunities and get trapped. In the book, I have discussed the five-step framework that can help investors separate genuine values from value traps.

India is one of the biggest untapped opportunities and its stockmarket will be one of the biggest wealth creators in coming years. But only those who invest based on sound fundamental research will be able to take advantage of it.

With India becoming a favoured destination for long-term contract manufacturing and given its potential in chemical manufacturing, how should investors look at the sector

India has very strong skill sets and competitive advantage in process industries like chemical manufacturing, especially those involving complex processes and engineering. With the government's thrust on Make in India, the process manufacturing industry will likely witness strong growth.

Once an investor identifies a universe of companies with good corporate governance in this space, he should look at capital allocation and return on capital. Companies with locations close to ports, terminals, consumers and gas pipelines, as well as those with strong engineering and manufacturing capabilities, generate high returns. Within that set, one should look for companies that manufacture products for which the external market is large and growing. And finally, look for companies with strong balance sheets and relatively debt-free profiles.

How should investors be encouraged for savings to flow into financial instruments

Indias financial sector needs to deepen. Land and gold are unproductive savings whereas financial assets are productive. As Indians become wealthier, they are likely to turn towards financial savings to plan for things like children's education, marriage and retirement. Those who reduce exposure to land and gold and increase investments in financial instruments early will benefit tremendously those who come in later will bid up prices and valuations of financial assets.