For starters, the data is clearly improving. Inflation is now at a manageable sub 7%. GDP estimates are being revised upwards. Trade deficit and foreign reserves are under control. There is a stable, business friendly government in place. If all this doesn’t completely explain the rally, it explains a goodly portion of it.
With valuation and business quality as our guideposts, we have picked outstanding companies at good prices. Although the wholesale bargains of mid 2013 are no longer available, our portfolio companies largely remain fairly valued. We hold healthy cash balances and remain net buyers, with a slight shift in focus towards special situations. These situations often involve companies going through significant issues, and selling at fire-sale prices. Some of these wounds are self-inflicted and result from an adventurous management embroiled in a scandal.
To be sure, regardless whether one thinks of corporate scandals as investing opportunities or not, there is nothing more damaging than buying a company with scandalous management before the scandal breaks. Our formula for avoiding such accidents is simply to err on the side of caution. We hold the management to a high enough standard that even unwarranted blemishes often tie our hands. Along the way, we sometimes miss great opportunities. We are okay with that trade off.
However, after the management is caught with their pants down, the situation deserves more attention. As the news comes out, momentum traders are the first to cut and run; followed by money managers who can’t afford an egg-on-their-face (most can’t). Then there are those savvy foreign investors who knowingly partnered with the wrong guy, thinking: “if he can seduce us, he can surely put the government in trance”. By the time the dust settles, the stock sells off by 30-40% or more. Sell-side suspends coverage, so portfolio managers who rely on sell-side to do their work (many do) either abandon the stock or have no interest in buying it.
For investors willing to put in the research hours, special situations can be extremely lucrative. The price to value gap is an obvious draw but more importantly, the gains are largely idiosyncratic. These are pure alpha plays with little market correlation. Of course, not every scandal presents an investible situation. A few key pieces need to fall in place for a situation to be special.
Firstly, one must be able to value the company in order to know the price to value gap. That, in itself, is often an insurmountable hurdle when the company is in such flux. We take the easy way out, and only consider companies that maintain most of their pre-crisis economics. Diverse customer base, leading market share, secured financing, etc., are all tremendously helpful here.
Secondly, for us to get paid, the business needs to remain a going concern. Orderly liquidation, especially in the case of industrial companies, is an oxymoron even in developed economies. So we want the resolution to be quick, painless and somehow sympathetic to equity holders’ interests. Take, for example, the case of Bhushan Steel. Possessing more than 5 million tons in capacity, it’s amongst the largest steel producers in the country. It’s also amongst the most indebted, with close to $6 bn in borrowings. While the debt was always going to be a problem, the straw that maimed the camel was a corruption scandal involving Bhushan’s top commander, Neeraj Singhal. Allegedly, Mr. Singhal’s idea of debt restructuring was to simply bribe a bank official. He was caught in the act, quite literally. The stock promptly dropped 75%, wiping out close to $2bn in equity value. It’s not very difficult to get a handle on the bare-bones NAV for this company and by our estimates, the stock is trading at a hefty discount. However, it’s uncertain whether shareholders can make money holding the stock. Liquidation will certainly be disorderly and restructuring will require severe sacrifice from equity holders, especially the minority kind.
Our final criterion for investing in corporate scandals is a favorable change of control. The recent drama surrounding DLF, a large real estate developer, is a good case in point. The company went public in 2007 with a hugely successful IPO, which is now the center-point of the drama. Although DLF was never a poster-child for good corporate governance, and carried substantial debt, it never got into serious trouble. The company is by and large cash flow positive and holds high quality real estate that can easily be encumbered. The drama happened when SEBI dinged them for poor disclosures on their IPO documents. The company and its executives are now barred from raising any money from the public equity or debt markets for a period of three years. A slowing real estate market was already forcing DLF’s hand and the company was busy offloading non-core assets to pay off the lenders. But the SEBI ruling just made its life exponentially more difficult. DLF has close to 60mm sq. ft. of real estate under construction and badly needs money to fund that development. The stock is down 35% since the news broke and currently sells at substantial discount to the NAV. The company remains cash flow positive and there’s a good chance that it can sell some high quality real estate assets to lower the debt burden. However, we just don’t trust the current management to do right by the minority shareholders. Unless there is a meaningful change at the top, our hands will remain tied, at least at the prevailing price.
One wonders the, whether special situations, mired in so much uncertainty, could ever be worth investing in. Yes, but rarely. A great one we found earlier this year was MCX.
MCX is India’s largest commodity exchange. It has close to 85% market share of all commodity trading done in India with individual market share of 90%+ in gold, silver and crude, the most actively traded commodities. It was promoted by Financial Technologies (FTIL), which is also owned NSEL, the now defunct spot exchange.
In general, financial exchanges are great businesses. Historically, the jurisdiction converges onto one or two dominant exchanges, as it should, owing to exceptional network effects. Exchanges also tend to be excellent long-term value compounders with an impenetrable moat, as long as an honest and able management runs them. Therein lies the rub.
In mid 2013, it was discovered that NSEL was illegally facilitating lending arrangements between a few brokers and a large number of lenders who were promised 12-14% return on “commodity arbitrage trades”. To the regulator’s dismay, the short side of these trades often involved naked futures positions with phony warehouse receipts as the collateral. If push came to shove, the shorts would not deliver. Once the activity was discovered and clamped down, the whole scheme unraveled and the borrowers defaulted. Top management was found to be complicit in this scheme and was jailed. FTIL, the parent company, was also found to be hand in glove. Every business owned by FTIL, including MCX, bore the brunt of FTIL’s reputational damage. SEBI subsequently banned FTIL from owning any exchange and ordered the liquidation of its stake in MCX. A couple of other items, such as introduction of commodity transaction tax and import duty on gold, threw enough fuel to the fire that the stock lost about 80% of its value.
We followed the situation for a few quarters (perhaps waiting too long) before finally buying MCX in the middle of 2014. The business is easy to understand and retained its entire pre-crisis market share albeit in a shrunken market. It’s debt free and has no contingent liability due of its parent’s missteps. In fact, SEBI forced FTIL to shed their entire stake, which was sold to reputable and honest shareholders. This has been a good position for us so far, but the stock is still trading at a substantial discount to its own valuation, and the valuation of comparable global exchanges.
During sustained bull markets, we expect our allocation in special situations to increase. We will write more on this in our forthcoming letters.