Mind of a Flawed Entrepreneur - Sanjeev Pandiya

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About a decade back, I left a leading finance company to join a large manufacturing corporate that had just bankrupted itself trying to digest what was then India's largest acquisition ever. The company was already defaulting on loans, even though its business was then generating decent ROCE. Manmohan Singh's “liquidity crunch” (of 1996) had left a huge hole in the company's means of finance, which had to be covered by asset sales and inter-corporate deposits (ICDs).

In one of my first discussions with the CEO, I was struck by how the company refused to see where it stood, and retained a false optimism that “something would change”. With operating margins at a comfortable 22 per cent on sales, the company was still defaulting on loans because at the margin, it was paying up to 27-32 per cent on its ICD portfolio. Yet, top management believed they would pull through.

I once said rhetorically, that if this company was a mutual fund, the top management would be sacked. A mutual fund manager cannot argue when stock prices fall, that the fund will pull through. He is not allowed to carry losses on his portfolio, arguing that they are long term investments and hence these losses are temporary in nature. When he takes a decision to invest, he has to 'mark-to-market' his portfolio and value his portfolio net of his losses.

Why are we so forgiving of corporate India? Is it simply because the CA institute does not want to (or have the intellectual wherewithal to) revalue corporate balance sheets, that CEOs are able to ignore the markets, pretend that they have made long term investments and get away with bad asset investments, a luxury denied to our mutual fund managers.

But finally all this money ends up in the hands of corporate India. Shouldn't good companies at least voluntarily disclose their estimate of net asset value based on estimated cash flows discounted at the cost of capital? Put it on your website even if you can't carry it in your annual report. It will sensitise CEOs to a whole range of issues that they tend to ignore. I will mention just a few.

When interest rates go up, the value of any cash flow will fall, so as we all know, bond prices fall. All that has changed is the 'discount factor'. I hope everyone understands why, otherwise don't bother with the rest of my article. When short-term interest rates are higher than long-term rates (as happened recently with call rates at 20 per cent and bank lending rates at 9.5 per cent), it is a signal that long rates too will harden. This process is triggered by central banks (like our RBI) to signal tighter money, so please slow down capex, especially long-term capex.

The knee-jerk corporate reaction is to rush further money into long-term assets. They divert working capital into long-term assets, further squeezing themselves dry. Then they go around desperately looking for short-term money, any money, paying through their nose to tide over a self-made liquidity crisis.

If only CEOs were a little more market-sensitive…what is the market trying to tell you under such situations? If short-term rates are high, then the cost of working capital will rise above the cost of long-term debt. At such times, the company should be liquidating long-term assets to stay liquid. Just now, which company do you see around you, that is doing anything remotely resembling this?

We are at the peak of the capex cycle. One by one, corporate India tries to wriggle out to find some arbitrage, like ECBs. And a good regulator like the RBI will follow through and plug each of these loopholes as they find them. Why won't CEOs listen?

Moreover, working capital financing gets renegotiated with every rollover. All the more reason to reduce your requirements but the majority of companies are doing the exact opposite. The typical argument given is the old one: growth is more important than cost.

My counter-question is: In a mad rush (also called bull market, a.k.a. boom cycle) the survivors are going to be those who know when (and how) to hold back. Retail investors know this feeling fully well…in a bull market, the surviving bulls are those who know when not to buy. At one point in a general bull market, the bull who says "growth at any cost" is the person who will be dead.

Across corporate India, you now have companies faced with the same predicament as retail investors. During the boom cycle, they have gone and committed capex. Now the debt market (and in some cases, commodity prices) is telling them that they cannot invest. The companies that don't listen are the ones who will be dead. If you aren't watching, you (as an investor in those companies) will be dead yourself.

I have often berated the media for triggering market volatility for the wrong reasons. The answer I get from editors is that the media is as much a part of society as investors or any other community, and hence prone to the same irrationalities. But this time, I was surprised to see wide publicity given to the ECB capping by the RBI, yet not a whisper on the markets. I cannot think of a more direct cause of general market bearishness than this announcement, yet nobody seemed to get it.

We seem to understand housing collapses, dollar movements, carry trades and whatnot, but nobody went through the list of pending ECBs and the pipeline to bring out a list of short-sells. Sectorally speaking, you would have found the entire list being made up of long-cycle sectors, which includes the current investor favourite, infrastructure.

Isn't it common-sensical to invest where the return (or opportunity cost) is higher? Then why do corporates invest in long-term assets when short-term rates are higher than long-term rates?

Ah, this very rational question above made you stop, didn't it? Let me explain why…..the word you are looking for is momentum. Humans will keep doing what got them success in the past, long after it stops getting them any further success any more. Like that coyote in the comics, who keeps running long after the ground has disappeared from under him, corporate India will suddenly look down from where they are and find that they are running on air, i.e., without working capital. Then the slide will start…! CEOs will go into denial and CFOs will go around whispering "but I told you so…". The ones who raise their voices will of course, no longer be CFO. CEOs will go into denial looking for hope (and their next CFO). They will look for ways to "pull through". Choose your sector/ companies and look for these clear behavioural cues to pick out the 10- baggers of the next boom cycle.

In fact, if you are intelligent and know any sector well, pick out 3-5 companies of any sector and ask the questions above. Put down your answers at both stages: the first stage is the start of the down cycle, which is just now, I think. At the bottom, look for the companies that are doing nothing, versus those that are in action mode, investing their limited cash at a time when the crowd has gone home.

For the last year and a half, I have been sitting with a quarter of my net worth in the bank. Yes, I have chosen to feel foolish, not buying real estate while it was trebling, or (not) buying DLF/ Omaxe while it was fashionable to do so.

For the last laugh, watch this space……!!!