Although the investible universe is still rich, the current momentum in equity prices for the broader market is driven by a little bit of reflexive buy.
By Rahul Bhasin
Equity prices are headed up, after taking out key resistance levels. The advance-decline in ratios and moving averages confirm it. Historically, it took 6-9 months for Fed-injected liquidity transmission into emerging markets, as the excess return erosion wave progressed through the American Asset risk stack. This time it has barely taken two months.
- Getting money to the SMEs: Banks have replaced the development finance institutions, but without the necessary skill sets
- Disastrous management: NDMA's institutional redundancy and the mismanagement of Covid-19 pandemic
- A state in crisis: Why Ministry of Home Affairs is a surprising pick to deal with Covid crisis
But, how has the value changed? Profitability, the efficiency of capital, growth and, then, risk-free rate and the risk premium?
The lockdown has hurt all businesses as their salaries and wages, rent, lease payments, licence payments and interest costs persisted, unlike their contribution. First, businesses that had low asset turnover ratios (infrastructure, airline, airports, hotels, restaurants, retail, hospitals, real estate) and/or facilitated social aggregation (marriage halls, clubs, concerts, sports, movie halls, fetes, salons, etc) will find their available equity and debt capital significantly impaired. Capital infusion would be needed to protect the franchise value.
Consolidation and market-share gains by leaders and cash-rich players are inevitable. Secondary derivative pain will be felt by media companies as advertising contracts, and by lenders to businesses where the equity capital can’t cover the short-term losses and where the borrowers have suffered a loss of livelihood. Tertiary pain will be felt because of loss of consumption due to job losses and supply-side disruptions in labour and logistics, suspension of capex, inventory spoilage and expiry, loss of export markets, forced government austerity and discontinuity in process industries.
Gainers were those catering to the digital technology stack and content for at-home media and entertainment, e-sports, gaming, etc, but sadly, the predominant part of the supply chain is from outside India. The telecom data pipes saw higher utilisation, and the under-owned pharmaceutical industry is unimpaired. Agriculture did better.
In order to restore enterprise value, capital will need to fund net-worth erosion of unabsorbed, the cumulative fixed cost associated external liabilities, and the restoration of working capital. The component of permanent value destruction will be compensated for by equity issuances, future retained earnings, incremental borrowing, lower taxes, M&A, etc. However, all will have friction, productivity and time-value costs. Additionally, social distancing norms will add to commute costs, lower utilisation and lower asset turns, resulting in a lower incremental return on capital employed.
The eternally ‘behind the curve’ RBI that has presided over continuous m3/m4 reduction (as a percentage of nominal GDP) for seven years has lowered the repo rate twice, albeit inadequately, to compensate for the wholesale demand destruction. But, the relevant metric for the equity market is the long-term sustainable risk-free rate. Sadly, the plebiscite-ruled polity has always believed that fiscal transfers of resources, they do not have, masked by accruing liabilities off the books, and gaming the true picture by following cash accounting, is a prudent policy.
Additionally, the creeping debt-GDP ratio makes it hard to believe that a meaningfully lower risk-free rate can be sustained.
Even dismissing the record VIX levels as an aberration, can we make a case for the soaring Nifty by ascribing it to a structurally lower risk premium? The barrage of often contradictory notifications by the governments at every level of the federal structure, and the proclivity of the courts to assign liabilities onto several, who were in no position to bear these, does not engender confidence.
The Indian state is quick to fix price caps on the pharmaceutical sector, which sells drugs in India at one-twentieth the price in the US, and on hospitals that, as an industry, generate barely single-digit return on the capital employed. Indian states regularly renege on PPA contracts.
The telecom industry has been treated like an ATM, and costs and fines imposed on the industry ensure low returns on capital employed. Fiscal rules are regularly changed to mop up super-normal gains that any part of the hydrocarbon value-chain might make at any point in the cycle, and, after they make investments, the access to free-market prices is denied. The sovereign delays virtually all its contractually-committed vendor-payments. Its hostile tax regime inhibits expanding supply chains into India.
The finance minister is able to label payment of due tax refunds as an incentive. In spite of the real estate industry being in the doldrums for a decade, no state has taken responsibility for delivering FSI-ready urban capacity to the industry. Our judiciary regularly stays economic activity. The crisis gave the government a fantastic opportunity to reform itself and cut down the attributable risk premium. Sadly, it hasn’t acted meaningfully—except for the long overdue and welcomed agricultural reforms. Current geopolitics increase the risk premium attributable.
The answer to this disconnect is in the detail. In BFSI, the HDFC twins, Kotak, the health insurers, the gold-loan companies will gain market share and benefit from operating leverage and lower cost of funding. The rationalised agri supply-chains will benefit the food companies. The need for social distancing will increase demand for personal vehicles and benefit the two-wheeler companies and the entry-car segment as well as the battery and tyre companies and the digital stack. Demand will rebound for durables which aid productivity in household chores.
Consumer-centric healthcare diagnostics, wearables and AI will benefit. Although the investible universe is still rich, one has to conclude that the current momentum in equity prices for the broader market is driven by a little bit of reflexive buy, with the dip mindset dominating structured value analysis.
Managing Partner, Baring Private Equity Partners (India) Pvt Ltd. Views are personal