Thursday, 29 December 2011

Dear SEBI. Can We Short Please?

The catalyst that turns fantasies into realities came in the form of this SEBI order for OneLife Capital Advisors (covered here). 

SEBI (Indian market watchdog) barred this company, several others and the merchant bankers to these initial public issues from accessing the securities markets. SEBI accused them of diverting IPO proceeds, performing shoddy due diligence and aiding promoters to prop up prices post-listing.

Unsurprisingly, in the beginning of the end scene, OCAP IN is down 15% as of this writing. A pummelling, rightly deserved. The end would be interesting. HaLin rued their inability to initiate Shorts on such cases, in the previous post.  

The Shorts are common whipping lads when markets and companies come under fire. The chorus against Shorts is inversely related to (1) market levels/stock prices, and (2) the acceleration of the fall from grace. Shorts are blamed for disrupting markets, for acting on misplaced rumours, for cornering poor and genteel companies looking to create employment in a socially responsible manner, and for generally being Evil. 

Few derive satisfaction from seeing others go bust and the Shorts aren't St. Good Guys at all times. But in certain instances, measured corrective forces in markets (provisions for single-stock shorts, for example) are a necessary counter-weight to the (sometimes questionable) actions of companies and issuers. A Long-only market character leads to a one-sided world, loaded in favour of companies. Frauds, historical and prospective, find a fertile setting to grow unabated in such an environment. 

Shorts impose a certain discipline on company managements, inducing them to contemplate the ill-effects of their actions, if exposed. Since the effect would directly be experienced by insiders through a drop in value of ESOPs/insider holdings, the Short-brigade bring some semblance of sanity to markets (its another matter that the Shorts themselves go insane occasionally!).  

The purging exercise brought about by the Shorts is a case of Darwinian survival of the fittest in business. By shorting dodgy companies into extinction, Shorts ensure that capital eventually finds its way to places where it is most welcome. (Social fallouts of capital re-allocation, a touchy subject, is left for another day)

The SEBI has a fine balancing act. If it raises minimum qualifying criteria, there's a risk of keeping public markets off-limits for fledgling companies reliant on capital for growth. This would impel them to seek capital from private sources, which come with their associated pros and cons. Relaxing qualifying criteria would attract shady companies. It is a tough problem which is, like so many things in life, without a black or white framework for a solution.

It is in such situations that Shorts serve a useful purpose. 

Is the SEBI listening?    

Wednesday, 21 December 2011

Over-priced Anomalies In Bear Markets

One of the alluring things about investing is the prospect of rare sightings of anomalies. In a torrid market, typically, the universe of value Longs tends to expand relative to bull times. The opposite - an anomalous over-pricing in certain pockets - is rarer.

One such example is OneLife Capital Advisors Ltd (Bloomberg: OCAP IN; "OCAL" or "Company"), a recently listed Indian company engaged in providing financial intermediary services, an aspiring equity broking franchise and portfolio management services company. 

'Aspiring' is the operative word, as OCAL was incorporated in 2007 and commenced business in September 2009. As the Company admitted, there is little to look at in their limited operating history. Nevertheless, market participants enthusiastically bought into the Company's prospective story. Overall IPO was subscribed 1.53x, with retail participation at 2.5x allotted portion and Institutional interest at 1.02x.  

Investment Banking franchise dynamics
People are an investment banking franchise's key source of competitive advantage. Superior deal sourcing, well-entrenched network of corporate relationships and deal history help differentiate one player from another in this competitive industry. Moat can also be derived by specialising in niche pockets (e.g., debt restructuring/resolution, mezzanine financing). A generalist investment banking franchise with limited history of operations, promoter pedigree and key employees (there were 11 employees as of the IPO filing) competes from a rather weak position. OCAL has all the ingredients of this eclectic combination.

Broking franchise dynamics
Broking is a fiercely competitive business, bearing a natural correlation with the capital markets. Except for instances where a broker serves an underpopulated segment in the market, pricing power is low and players compete fiercely in a race to the bottom of the price pyramid. Other means of building a moat is timely and best execution, low slippages, pre-trade investment research, post-trade execution services and attractive terms on margin funding. 

Revenues are primarily a function of volumes. As a result, waning volumes in a weak/sideways moving market has a negative impact on business. Well-entrenched incumbents tend to buy growth or rely on ancillary activities to drive revenues. A new, small-sized entrant would run into a gladiatorial arena full of competitors. OCAL is in such a position.

Portfolio Management Services dynamics   
This is a typical hedge fund structure, with respect to fees, that is. Performance-wise, there isn't much to be said about this group as a whole, in both absolute or relative terms. 

Revenues can form a good annuity stream (upfront yearly management fee) with optionality driven by Carry (a cut of profits). Recurring revenues are contingent on assets under management, which encourages management to embark on asset-gathering exhibitions to support revenue growth, sometimes to the detriment of investment performance.  
Differentiation is largely a function of investment performance than fee structures. Long history of superior performance under (hopefully) the same investment manager lends much credibility and strong competitive positioning. OCAL neither has the track record nor the personnel to guide this operation. A majority of its recent IPO proceeds (~35%) was earmarked for this venture, which hitherto contributed nothing to its topline. Attracting the right talent for this venture would not only prove difficult, given its history, it would also entail a large capital outlay; which will likely keep expenses on a rapid growth trajectory relative to revenues. It is difficult to envision OCAL achieving sustainable profitability, let alone cash flow, in the medium-term, given the scheme of affairs.

With this background, it is insightful to glance at a quick comparison, contrasting OCAL with a competitor, Brescon Corporate Advisors Ltd (Bloomberg: BFS IN). BFS IN is an investment banking franchise specialising in debt syndication, restructuring and resolution services. It is also involved in real estate and private equity financing.

OCAP IN has doubled since listing in mid-October.

An all-in bet on a perfect future
My interactions with the lead manager to the issue were illuminating. OCAL's current investment banking mandates = $95 mm (have to rely on the weight of words of the management). The revenue stream is a fraction of this value and payments are received based on achievement of milestones.

Working with a rather liberal 50% p.a. growth rate in mandates over the next 3 years and a 5% fee arrangement (typical, 1%-2%), the mandates would translate into revenues of ~$15 mm, which would accrue to OCAL over a period.  

Moving on to Portfolio Management Services. $2.5 mm is the initial funding received from IPO proceeds. Let's assume Management manages to grow assets under management (alliteration unintended) to $200 mm over the next few years and can charge 3% of AUM as fixed-management fee (typical, 1.5-2.5%). This would translate into revenues of $6 mm. 

Equity broking is a function of volumes. The largest company, Religare Enterprises managed volumes of $800 mm / day in 2010-11. Assuming OCAL manages 10% of this and using an average brokerage rate, this business would add ~$10 mm to OCAL's revenues. One of the ways of running a low-cost brokerage operation is to focus solely on execution, without adding ancillaries such as research (which add to costs). It was unclear, from my interactions, whether OCAL intended to take this route. 

Summing the three revenue streams up, one arrives at around $30 mm (cumulative, over a 3-year period). The largest integrated financial intermediaries currently trade at a Market value / revenue of ~2x, which is the multiple OCAL is discounting based on its prevailing market value. We haven't even touched upon profitability...

Parting thoughts
For a company with minuscule revenue, limited history and anything-but-upbeat business prospects, the stock enjoys good short-term momentum trading interests (daily traded value = $8 mm)The run enjoyed by companies like OCAL is a characteristic generally commonplace in bull markets. 

Market participants are expecting a stupendous show from OCAP IN over the next few years. With a drop in trading volumes and slowing investment banking mandates, the environment has been tough for players like BFS IN and indeed, for many players in the financial intermediation services industry. A situation that is likely to persist over the near-term. Another possibility behind the strong stock performance 2 months post-listing could be a take-over attempt by a larger rival, which appears remote.

These are the sort of occasions when one misses the ability to initiate a short.

Disclosure: No position

Disclaimer: This is not meant to be an invitation to indulge in speculative activity. Please consult your adviser, and more importantly, your judgement, before making investment decisions.   


Friday, 16 December 2011

The Bungee Jumping Indian Rupee

Of the many interesting events occupying market participants' attention in India in recent times, few have been more riveting than the rapid slide of the INR, which has depreciated > 20% against the US$, since the end of July 2011. 

The pace of depreciation appears to have caught policy makers and market participants by surprise. Hedge funds focused on India, who did a reasonably good job of arresting capital erosion until July, saw their returns plunging into the red, thanks largely to the INR's free fall. An economy on the fringes of diverging negatively from historical growth rates and a political climate dominated by corruption issues and policy flip-flopping aren't doing much to assuage negative sentiment either. 

If one traces India's macroeconomic developments over the past few years, the INR's fall-off-the-cliff show would be seen as a delayed reaction to realities. What is surprising is the lateness of the reaction, not the event itself.

In simple terms, if country A purchased more than what they sold to country B, A would stare at a trade deficit and B would enjoy a surplus. If this process continued over time, A's cumulative deficit would grow, mirrored by B's cumulative surpluses. A would have to continually rely on external capital to continue with the status quo. B, with its accumulated capital over the years, might agree to lend to A, so both continue to trade happily...

A's persistent borrowing to finance the deficit would lead to increasing indebtedness. Beyond a point, its financial health might begin to cause B some concern who, worried about repayment, might curtail lending. At this point, much-needed capital dries up and as confidence in A's financial well-being erodes progressively, investors would begin pulling out capital, leading to depreciation in A's home currency. 

To prevent continued depreciation and lend support to its currency, A could (1) utilise foreign currency reserves and/or (2) borrow. (2) is not a good option in situations similar to those in the above paragraphs (would lead to further erosion of investor confidence). Many countries through history have resorted to (1), and then (2); before complete erosion in confidence led to obliteration.   

Worsening Trade Balance...
Working off this (highly) simplified example, we turn to India's Trade situation. 

Source: RBI

The flat INR helped buoy imports, which grew 25% p.a., over the past 7 years. Exports, during the same period, grew 21% p.a. The progressive deterioration in trade balance necessitates a counter-weight through inflows of capital. Unlike its Asian peers, India does not enjoy surpluses on its current account, thereby exposing it to the vagaries of capital flows.

...funded by Capital inflows, so far

Source: RBI

Source: RBI

In the past, India has been somewhat heavily reliant on foreign portfolio flows, followed by credit, to fund the current account deficit. In 2008-09 when net portfolio investment was negative and credit dried up following the credit crunch, India had to dip into its foreign currency reserves to make good the shortfall. Part of the hypothesis behind the INR's prospective weakness is centred around this possibility. 

For the first 6 months of the current fiscal, net capital inflows were $40 billion, with FDI contributing over 50%, followed by External Commercial Borrowings (ECB). The more volatile foreign portfolio investment has been negligible this year, largely a reflection of the global macro environment, flight-to-safety and eventually, flight-to-cash.

The influx of longer-term FDI capital is a welcome development. In this backdrop, the recent backlash on FDI in multi-brand retail comes at an inopportune moment. Superimposed on a political environment characterised by credibility deficit triggered by corruption issues and frequent policy flip-flops, tapping the ECB route for funding seems the path of least action, going forward.     

INR History: An artificially high level?

India snapshot (source: RBI)

The growth in M3 - a money supply measure - over the long-run has been an important carrier of information on inflation (evidence from around the world: hereherehere)Over time, inflation chips away at the purchasing power of currency. Given the divergence in India's true inflation and those in developed market economies, the INR should have trended down over the years. While it wiggled up and down, the INR stayed flat over Dec-03 - Jun-11, even as money supply and credit expanded strongly.

Viewed in this context, a combination of foreign portfolio capital flight due to jittery global markets and persistently high inflation, have finally managed to trigger a long-overdue correction in the INR. 

External Debt situation
India's current total external debt = $316 billion. $68.5 billion of this amount is short-term, making up 43% of residual maturity (historical levels). Foreign currency reserves cover ~8 months of imports. Assuming that the maturing short-term debt is fully rolled over and the trade deficit at the end of fiscal '11-12 = $150 billion, India's incremental capital requirement through Mar-12 is likely to range between $20-30 billion. With external debt at < 20% of GDP and debt service coverage ratio at 4.5x, solvency is not a central issue. Refinancing could largely be contingent on the EU situation. Any deterioration on that front could put some pressure on debt roll-overs, by way of availability of refinance and/or cost. In the worst scenario, India's foreign reserves should be able to cover the maturing short-term debt comfortably. 

What could support the INR?
Broad factors:

  • Interest rate hikes
  • Foreign capital inflows 
  • EU debt resolution
  • RBI intervention

The strong pace of economic growth over the years has stoked inflationary pressures, which is persistently above the RBI's comfort zone. Prioritising inflation combating over growth, the RBI embarked on a rate-tightening regime over 2010-11. This interest-rate stance has been one of the factors supporting the INR, so far. As the world dipped into recession and interest rates headed towards the zero bound, investors hungry for yield found succour in high-interest rate markets such as India. 

Economic growth and investment activity are exhibiting signs of slow down, while industry and consumer expectation surveys paint a gloomy picture. The continuing issues in the EU is likely to persist into 2012. In this backdrop, rate hikes by RBI, going forward, appear low probability. If anything, should economic growth slow down, a reversal of RBI's interest-rate stance is highly likely, which would reduce the INR's allure. -1.

Given the negative real interest rates and political gridlocks repeatedly scuttling policy initiatives, the prospect of foreign portfolio investors returning to India with gusto appears grim. ECB seems the most likely route to be tapped, weakening INR notwithstanding. -2.

The evolving EU situation could have interesting repercussions for the INR. In the best case, a complete resolution that infuses a sense of bonhomie among investors could see capital flows into India, which would be positive for the INR. This, it must be admitted, is very low probability. The only other plausible options seem; (1) band-aiding of the EU continues, which would be neutral to the INR, due to investor risk aversion, or, (2) The extreme scenario: A Euro breakdown. This would mean curtains for the INR. -3

Enter RBI?
There's a growing chorus of voices urging intervention from the RBI to stem depreciation. The RBI's few attempts so far hasn't had the intended effect on market participants. Unlike its Asian peers, which may recycle trade surpluses to support their currencies, India's deficit situation reduces its room for manoeuvre. The RBI has voiced its intention of resorting to Open Market Operations and tapping other levers should push come to shove (jigging the Cash Reserve Ratio/Statutory Liquidity Reserve). 

Parting comments
A turn in RBI's hard interest-rate stance seems likely, going forward. Continued reliance on foreign currency borrowings appears to be the most likely outcome. In the best case (low probability), the INR is likely to wiggle sideways, while progressively introducing hurdles in the form of domestic and global macro issues (higher probability) quickly weakens the case for a long INR.