Kenneth Andrade: Look at firms that shrink balance sheets

He has worked in the Indian mutual fund industry for more than 15 years. He picks tomorrow’s blue-chip stocks from today’s numerous mid-cap companies.

Investment philosophy: He hitched his fund wagon to the theme of consumption and food inflation more than two years ago and his top picks too have remained the same over that period.

Other interests: Stays in Mumbai and is slightly partial to Toto’s, that classic of a pub in the queen of the Mumbai suburbs, Bandra.

What is your outlook for 2012?

The environment now is very challenging and I don’t expect it to change in 2012 either. Obviously, the smaller companies will face a number of challenges both in the near term and in building their businesses over a period of time.

The cost of capital is going to be a challenge for the end of this year and also the beginning of next year. Base rates today are at about 11 percent in the banking system. So your cost of capital to be in operation is anywhere between 13-15 percent.

That’s a very high cost to pay to be in business. Profitability is next to nothing. 

How can an investor take advantage of this choppy environment, and do any thematic plays come to mind?

In an environment like this, markets usually consolidate. Either companies acquire additional assets or companies acquire customers. Let’s assume there’s an industry of 10 companies. Five won’t survive. The other five will double. They will take all the customers. That’s a big opportunity to tap. You have to identify the five companies who will survive! Look at cement. Ambuja, ACC and Ultratech had 60 percent of the market share in 2000. Currently they have 30 percent and all of them are debt free. All the other companies have huge amounts of debt. These guys will go back to 60 percent.

Some more examples please...

I don’t think one should look at companies from a capitalisation point of view. One should look at where the business is. If you want a large cap company in the FMCG space you only have three or four companies to choose from. There’s no number six or seven. But the entire business is dominated by smaller players. By capitalisation they are small. India’s largest retail company is a mid-cap company. That doesn’t mean it is a small company.

Where do mid-cap companies come from? 

Let me give you an example. Education is a multi-billion dollar opportunity in India. The problem is that it is so fragmented. So we need one entrepreneur to only consolidate the business. From that we will get one of India’s largest companies. None of these guys will invent this space. They will only have a service offering that will consolidate the market share.

How important is it to consider scaling up as a factor for midcap companies?

We look at a fragmented space and look at one company that can scale up the space. That’s our approach. Take sugar and it is Shree Renuka Sugars. It’s a Rs. 85,000 crore industry, but you have around 360 companies in that industry. You have private sector mills then you have around 400-500 co-operative mills that are there. One guy has to come in and consolidate that entire space.

What special challenges to portfolio construction do you see in this difficult environment?

In constructing a portfolio we have two choices on how to buy. You either buy on valuation risk or you buy on solvency risk. We prefer to go with valuation risk because we don’t want our companies to die on us. Every company which is stress-free on its balance sheet is very expensive. The price earnings multiple of our portfolio is extremely high. What we have stayed away from is not to buy companies that have too much of debt. That is going to be our approach for 2012.

I think any company that can monetise its assets, i.e. put its assets into operation and can service its debt, will come out on top. The other option and opportunity is to take the assets that are there on their books and sell them in the market and reduce the cost of their balance sheet. Look at companies who are reducing the size of their balance sheets. They are the ones to buy. One parameter that I will be closely looking for, in the next financial year i.e. 2013 is any company which is going into 2013-14 with a smaller balance sheet. I think those kind of companies are going to come out on top.

In your view, is the idea of strategic consolidation relevant to financial services as well?

Today, everyone is worried about how the banks are going to manage the delinquencies in the banking system. Let’s look at 2013. If corporate India maintains the current debt-equity ratio, their banks will refuse to fund incremental stress. They’ll only lend to guys who are financially disciplined. And financially disciplined guys are people who reduce their balance sheet. It’s all about availability of capital or liquidity for the next round of growth. The guys who are completely leveraged will not get the money. This is how the equity business has behaved in the last three years; this is how the lenders will behave in the next three years because the lenders will become extremely risk averse. That’s probably my only parameter to watch in 2012-13.

You will grow, not because the sector is growing, but because you are gaining market share. The growth will not come because of incremental profitability. The cost of acquired market share will show in your margins. And in the next cycle you will show profitability.

Source: http://ibnlive.in.com/news/andrade-look-at-firms-that-shrink-balance-sheets/221614-55.html

Neighbours are not financial wizards

Love thy neighbour is a common adage, but most people extend it to include financial decisions as well. For instance, a sustained rise or a sudden fall in the stock market is often observed due to frenzied buying in bubbles and selling in crashes.

In fact, as a recent study by Ameriprise Financial India shows, Indian investor even used this ‘follow the neighbour’ formula for purchasing insurance, gold and other financial instruments as well.

There are strong preferences for certain products in specific cities. No wonder, every city has its preference for certain instruments. Mutual funds and gold are preferred by Delhi, stocks are favoured by Mumbai, Chennai wants real estate and Bangalore is into debt. The survey was done between the age group of 28-45 and with an average annual household income in excess of Rs 12 lakh.

TWO DIFFERENT FAMILIES: YOU AND YOUR NEIGHBOURS

• Goals, time horizon will differ
• Risk-taking ability will differ
• Financial commitments will differ
• Age group may differ
• They share successes, not failures
• ...then, why follow them?

However, following the investment decisions of one's neighbour or friends or even relatives is not the best strategy. The culture of collaboration does not work while making financial decision for your family. There are a host of other reasons that should be considered while making investment decisions.

Your reason to save or invest may not be the same as your neighbour's. The other family may be investing for their child's school education, while you need it for higher education — clearly, the amounts required would be vastly different. For them, a 10-year debt instrument may work, whereas since the requirement is much more, you may have to opt for equity.

More importantly, your monthly outgo may be completely different. As financial planner Suresh Sadagopan says, individuals should count their priorities before copying. "When you have commitments, having cash in hand is important. And you have to account for it. But many don't," he says. Do not invest because somebody else is investing and he/she thinks you are missing out on something big.

Your neighbourhood uncle at 50 may be looking to earn 8.5 per cent on a 10-year NHAI bond, because it means a nice little safe corpus at the age of 60, when he retires. For you, at 30, it makes little sense. If the stock market falls further, there may be a good opportunity to enter and stay invested for the next 20 years.

Conversely, if you are 50, it makes more sense to stay away from high-risk, high-return products, because capital erosion is the last thing you want. Going with the good old bank fixed deposits or post office deposits may keep the corpus safe with steady returns.

Random investment is something that one should be wary of. The Ameriprise study talks about most individuals investing through real estate, insurance, gold and so on. But, none of these investors know if the asset class suits their profile.

However, you need to match your requirements to an asset class before investing. "For instance, real estate and start-ups could work wonders for some individuals, while it may end up being disastrous for others," explains Bimal Gandhi, chairman of Ameriprise Financial India. Therefore, do not pick a scheme just because good friends have done so.

Most important: It is unlikely that many will discuss their investment failures with you. Most will tell you about their successes. Certified financial planner Anil Rego says individuals see how their friend(s) have made money in an asset class/scheme. And then invest. "But, they fail to understand that this may or may not be the right time to enter that scheme. A classic example is gold and many are more than willing to enter gold now just because many have gained from it in the past year," he explains.

Source: http://www.business-standard.com/india/news/neighboursnot-financial-wizards/462019/

Go for corporate bonds, not gilts, in 2012

Government securities may yet see prices dip, as their supply over the next few months is expected to be high. Corporate bonds, especially those from top-rated companies, may deliver better gains.

For most of 2011, interest rates were on the rise, whetting the appetite of investors for debt investments. With rate cuts expected after March, what's the outlook for the bond market?

Interest rate outlook

The RBI has clearly indicated that it will stop raising interest rates. So markets are now betting on policy rates coming down. The recent moderation in inflation and slowing economic growth have supported this view.

The markets are expecting the RBI to cut repo rates by 50 to 75 basis points over the next 12 months. The cuts are expected to begin after July but we think the cuts may not be as steep as in 2008-09 when rates fell by 4.25 percentage points over six months.

This is because India's troubles with inflation, the key metric that the apex bank is watching, may not yet be over.

First, although food and primary inflation have abated recently, manufacturing inflation has not. Pending increases in coal prices and electricity tariffs may also feed into manufacturing inflation.

Second, though global commodity prices have cooled off recently, rupee weakness has offset much of this correction for Indian importers.

Third, crude oil prices, a key inflation driver, have not corrected by much. Any oil price hikes post-election may further fuel inflation.

Time not right for gilts

Based on the expectation of rate cuts, benchmark 10-year gilt yields that hit a high of 9 per cent in November have cooled to 8.26 per cent now. But this may not be an opportune time to enter gilts for two reasons.

One, the supply of gilts is likely to rise over the next three months owing to a slippage in the fiscal deficit targets. This may pressure gilt prices and push up yields.

Debt markets early in 2011 cheered the lower borrowings announced by the government. But a fall in small saving inflows and lower disinvestment income has already led to government hiking its borrowing target by close to Rs 92,872 crore for this fiscal (a good 22 per cent more than the budgeted market borrowings).

Two, banks are today heavily invested in government bonds as the credit off-take continues to be subdued. If demand for credit increases in coming months, banks may reduce gilt investments, also pressuring prices.

These factors suggest that this may not be a good entry point into long-term gilts.

The only liquid avenue available for retail investors interested in government securities is through gilt mutual funds.

Returns on these have been quite volatile. Ten-year gilt yields have swung from 5.2 to 9.4 per cent in the last five years. In addition, because of their longer-term investments, these funds register higher capital gains or losses on their NAV based on whether interest rates fall or rise. The average returns on gilt funds over the last five years have been 6.6 per cent. Timing your entry well is quite important while investing in gilt funds.

Investors seeking safety, however, can instead get exposure to top-rated quasi government entities through some ongoing bond issues. For instance, upcoming tax free bonds of Indian Railway Finance Corporation, HUDCO and infrastructure bonds of REC, PFC and IDFC can be considered.

Interest rates on such bonds are linked to government security yields. Interest rates of close to 8 per cent for tax-free bonds are attractive for investors in the high-tax bracket.

Corporate debt better

While long-term gilts don't appear attractive now, bonds from top-rated corporates do. From here, top-rated corporate bonds may outperform gilts for two reasons.

One, as Ritesh Jain, Head of Fixed-Income at Canara Robeco says, the balance sheets of top-rated corporates are in much better shape than the government. While the government is on a borrowing spree, top Indian companies have been cutting back on their investment plans, reducing debt on their balance sheets and hoarding cash.

Any issuances by them are, therefore, likely to be quickly picked up by institutional buyers.

Two, thanks to the same cautious mood, the supply of paper from them is also not likely to be high. In fact, this appears to be the reason why since March 2011, yields on AAA rated corporate bonds have not risen as much as government security yields.

Focus on the short-term, play it safe

Agreed, corporate bonds now appear a better bet than gilts. But should investors buy short-term (1-3 years), medium-term (3-5 years) or long-term options (5 years-plus)?

Those considering these options would essentially have to take the mutual fund route, which offers all three kinds of products. The short and medium-term funds appear better bets today.

Flat yield curve

While interest rates are expected to moderate from current levels (See accompanying story on Interest rate outlook), the fall in policy rates this time around may not be as steep as in 2008-09.

Gilt and long-term income funds, which bet on 5-year-plus instruments, usually make the most capital gains from a fall in interest rates. Shorter-term funds benefit more from interest rate accruals.

This suggests that moderate falls in interest rates would make for limited gains on bond and gilt mutual funds. Investors, therefore, can continue to look at short-term bond funds.

The other big reason why short and medium-term funds appear good options is the flat yield curve. Essentially, short-term bonds (1-2 years) today offer much the same yields as long-term bonds.

Under normal circumstances the yields on short-term bonds should be lower than long-term investments, as one takes the additional risk of interest rate volatility in the long term.

This suggests potential for yields at the shorter end to come down (and bond prices go up) once the rate cuts are effected.

Dhawal Dalal, Head, Fixed-Income, DSP Blackrock Mutual Fund, suggests investing in either short-term debt funds or the dynamic bond funds to play this trend in 2012. Dynamic bond funds have flexibility to increase or decrease duration based on the prevailing interest rates.

Look beyond returns

Fund managers, however, also warn it is best to play it safe when it comes to corporate bonds.

AAA bond investments are the preferred choice. While AAA- rated bond yields may decline to close the gap with gilts, bonds that enjoy lower ratings may not see an equivalent dip in yields.

In fact, bond issues from NBFCs with credit ratings ranging from AA+ to AA-, which offered high yields last year, are now trading lower than their par value.

Highlighting the riskiness of these bonds, Canara Robeco's Ritesh Jain says, “Slowing investment activity, deteriorating currency, lack of clarity in Euro Zone and high cost of debt will continue to put pressure on sub-prime corporate balance sheets. Hence the chances of credit downgrades increase.”

This suggests that while choosing a debt fund too, investors shouldn't merely look at the returns. Portfolio risk is a key factor. Under normal circumstances, the risky portfolio may give good returns as interest receipts flow in, masking the risk.

But during periods of crisis, where corporates are facing the risk of falling interest coverage and debt refinancing woes, these funds may take a hit.

Dalal points out that given the open ended-nature of DSP's debt funds, investors can exit anytime. This means the investments have to be liquid to meet the demands of investors. Therefore, they predominantly invest in banks' certificate of deposits and AAA bonds.

Source: http://www.thehindubusinessline.com/features/investment-world/article2801356.ece?ref=wl_companies

SEBI wants AMCs to launch pension products.

Market regulator Securities and Exchange Board of India today said fund houses should launch pension products, so that retirement money can be brought into the capital market.

Noting that retirement and pension money is not coming to the market, Sebi Chairman U K Sinha wondered why asset management companies (AMCs) are not launching funds aimed at attracting pension money.

"Retirement and pension money is not coming into the market. It is legally possible that retirement money can be invested in the markets ... why are AMCs not able to launch pension funds?" Sinha said at India Investment Conference here.

"We are passing through very difficult times. Margins and volumes and flow of fresh money are coming down. What you do in such a situation? We need to start taking measures," Sinha said, adding that level of participation in the markets by households is very low.

In future, Sinha said, Sebi will be regulating alternative investments. "Currently we are looking at regulations on distributors and investor advisers."

About 50 per cent of mutual fund business is done through distributors who are not regulated at all, he said.

On the proposed new IPO norms, Sinha said, "We are looking at a review of the entire IPO process, as to who would participate, and in what manner and how to reduce the timelines."

Replying to query on insider trading norms, Sinha said, "We will take strict action against market manipulators."

Source: http://articles.economictimes.indiatimes.com/2012-01-13/news/30623887_1_pension-funds-pension-money-pension-products