Level of Corporate Leverage in India is Worrying

So far I have put together quant reports for 76 companies and I will be adding another 25 to 35 over the next month or so. You can view them via www.maxkapital.com. 40% of the universe covered ex financials is dangerously over-leveraged. Some action has been taken to deleverage, but it is not enough.

I keep returning to leverage because it worries me deeply. As a long term investor, excessive leverage warns of inexperienced management, bad corporate governance or both. Thus over-leveraged entities do not belong in my core portfolio. In addition, leverage usually unwinds and when it does, more often than not, dilution (or worse) occurs when shares are trading well short of fair value. A company which has access to new credit (or equity) to replace expiring credit might survive; but continued access to credit markets must not be taken for granted; particularly in the present environment where it is clear that deleveraging will occur over several years. In addition, I personally expect an inflationary environment (despite offsetting deflationary pressures from deleveraging and excess capacity) because of the massive monetary stimulus injected into the market; early signs are indicating that the present economic cycle will run with high interest rates in India. On the one hand inflation is good for leveraged companies, because the real value of monies repaid to lenders is worth less than what was borrowed; but on the other hand, the higher interest causes more volatility in earnings. But to benefit from debt pay-down in an inflationary environment means creation and use of cash flow to pay-down debt – not refinancing it at higher rates. I have noticed that the highly levered companies tend to have a tendency towards irresponsible behavior; their balance sheets continue to expand – and in several cases, they are unable to even generate positive operating cash flows (some examples Unitech, DLF, Indian Oil).

On the other hand, I also seek to make short term money from mispriced risk. And leverage is so easily mispriced during recessions; it creates massive gain potential opportunities. But this is a high risk business – low quality often gives good short term returns, however, it is rare that they will deliver consistent safe and superior long term returns. In my view, the next recession will come from the next deleveraging cycle. When it occurs, the over-leveraged players will be devastated. It is however somewhat early to be looking for the next deleveraging cycle; US short term treasuries trading at near 0% yield is worrying but I still feel we have at least 18 months of growth before a potential phase of anguish. At this stage, the leverage trade is over, but growth premiums will still be paid by the market and several of the over-leveraged players have good growth prospects as we move into a cyclical upturn. But be warned, outperformance will cease well in advance of a visible downturn!

Of the 76 entities, 10 are financials; in financials one expects to see leveraged balance sheets for that is their business. Of the remaining 66, I have 26 highly leveraged entities; that is near 40% of the universe which is disappointingly high. I define a highly leveraged entity as one where the debt to debt plus equity ratio is in excess of 33%; i.e. a traditional gearing ratio of over 50%. In my view, such levels of leverage are unsafe and are indicative of very poor corporate governance; a stable and enduring capital structure is an important task - management should take active steps to ensure that shareholders interests are not compromised through excessive financial risk.

The highly leveraged companies include:

Bharat Petroleum, Balrampur Chini, Adani Enterprises, Aban Offshore, Gujarat NRE Coke, Glenmark, Essar Oil, Educomp, DLF, JP Associates, Jindal Steel, Indian Oil, India Hotels, Hindustan Petroleum, Hindalco, L&T, Powergrid, M&M, Lupin, Unitech, Tata Steel, Tata Power, Tata Motors, Tata Communications, Suzlon and Shree Renuka Sugar.

India Hotels leverage can be accepted as the market value of its property is well in excess of the carrying value on its balance sheet.

Powergrid and Tata Power are large utilities projects which tend to have income streams less influenced by cyclical factors. While I believe the companies are over-leveraged, the nature of their business does add an element of safety as a result of relatively stable and recurring income streams. In my view these remain quality stocks worth holding for the long term if purchased when dilution risks were fully priced.

Tata Steel & Hindalco have reasonable access to capital markets. In addition, I believe that the events which led to excessive leverage were good long term decisions. While I do believe they should have adopted safer capital structures, in my view these remain quality stocks worth holding for the long term if purchased when dilution risks were fully priced.

Balrampur Chini and Shree Renuka are partly covered by the staple nature of their product as demand for sugar does not vary significantly with the economic cycle. However, because agricultural commodity prices are very influenced by government policy, weather and area cultivated, their business is very cyclical in nature. I do not see these as high quality issues to be held for the long term.

L&T might be forgiven its sins as a result of strong backlogs providing strong earnings visibility; I would not accept it as an excuse for high leverage, unless the backlog comes from firm contracts with AAA rated companies and the cash flow generated from backlog is used to pay down debt. The backlog should only be considered if it gives comfort to the level of it being a safe and realizable off balance sheet asset. I like this company for what they have achieved; but I dislike it because of poor governance caused by a poor capital structure. I also dislike it for its poor capital allocation decision when it chased Satyam; this is an infrastructure company; they had no business chasing IT with shareholders money – that was poor governance too. As a result, I do not see this as a high quality issue to be held for the long term.

As for the rest, they belong in cyclical sectors and in my view have no business carrying the degree of leverage that they do.

Leveraged Balance Sheets Amongst Indian Entities

Indian entities have surprisingly reasonable capital structures. From over 50 companies I have studied, I am of the view that approximately 36% have a weak balance sheet and capital structure; the remaining 64% have sound capital structures. At least half of the so called weak balance sheets are not weak when you dig beneath the surface. In several instances the asset values carried in the balance sheet are very low; and the high quality of these assets with low carrying values, means that real leverage as measured in the context of market values of assets is actually far lower than the perceived degree of leverage when measured by way of the historic cost basis balance sheet.

Investing is all about risk, reward and time. Time arbitrage is very important; for example if the broad market focuses on a one year horizon, risk and reward expectations are priced with that term in mind. If you chose a slightly longer horizon, you can seek out opportunities where the perceived risk is high, while the real risk is lower.

One way of seeking out super normal gains is through risk taking. A better way; is to spend time in finding opportunities where the perceived risk is high while the actual risk is lower. In such situations, the perceived risk gets priced in the market value of a security; as confidence in lower real risk returns, super-normal gains can result. In this post I am looking at mispriced financial risk; that is the risk associated with the degree of leverage embedded in the capital structure of a corporation. This is a high risk strategy; remember that you are playing with highly levered company; you are already planning to benefit from leverage – do not get twice levered by leveraging your own investment through borrowing. If you use this strategy never add further leverage by borrowing to invest; instead use time arbitrage - take a longer term view, and wait patiently for results.

The information in this post is based on data presented on "The Quant Report". You can view the data by accessing http://www.maxkapital.com/ and then access "The Quant Report" via the link at the bottom of the page.

When the markets start falling, it is normally in response to an expected decline in future economic activity. At such times, it is important to keep in mind, that the expected decline in future economic activity is a short term phenomenon. The market looks forward and responds to expectations over the next six months. It does not price in the subsequent recovery. Such times create the best investing opportunities, if you use time arbitrage by taking a slightly longer term view than the market. You only get the opportunity to buy at fair and bear values during recessions because that is the time when risk gets priced and then over priced. Once a recovery is perceived, asset values rise rapidly to trade at premiums to fair values. The problem is that when you come to the market too early, you can suffer severe short term losses; and timing the market is a fools game; believe me no-one can do it. So instead of trying to time the market, use the opportunity wisely, start with maintaining your long term portfolio allocations to equity; allow slight under-weights (relative to your standard allocations) to develop as the market falls. Once the market trades at fair value; get back to normal weight-age. And as the market trades at a discount to fair value, start over-weighting equities with the aim of returning to standard allocation once the market is trading at an ever so slight premium to normal multiple based value. You can start getting confident of being close to a bottom only when the yield curve is steep (i.e. the short maturities {I use a 2 year bond yield} on government bonds is trading much lower than the longer term maturities {I use the 10 year bond yield}). This signals future recovery, just as an inverted yield curve indicates a decline in economic activity ahead.

But before the yield curve steepens, it will look most unusual, you will see a steep rise at the short end of the yield curve, with inversions as you move to longer maturities. At the same time, you will see the spread between AAA corporate bonds and the 10 year government bond widen well over long term averages and yes, you also see a rising spread between AAA versus AA and lower rated bonds. At this stage the absolute fear and confusion is very apparent, confidence is very low and chances are that risks have got mispriced and are loaded in favor of long term investors.

Now cross check data versus the market. At this stage, you should find broad markets trading at low multiples and at or near fair values. Defensive stocks and large caps will outperform (in that they will have lost less!) cyclical and small and mid cap companies. And leveraged companies will have valuations beaten down to or near bear values.

At this stage, perceived risk is normally high and fully priced. As the economy recovers, real risk (not perceived risk) measured over a longer term will be recognized. As money chases risk for higher rewards, the reversion to fair value will occur. And for the leveraged companies, since the reversion is taking place from bear values, the gains can be monumental.

The easy money from the risk trade is behind us for this economic cycle. Normally, when financial risk associated with highly levered companies is punished, no one is spared. The questions are simple – will this company be able to access the debt markets to maintain debt levels embedded in its capital structure? Will this company be able to pay interest due on its debt? Will the company be able to meet its debt repayment obligations if it cannot extend the debt maturity? Will it be able to continue payment of dividends? Will there be a massive dilution as a result of equity raised to pay-down debt? What is the company worth; will there be anything left over for shareholders after debt is paid? While the answers to this question are pursued, no one is spared and share values collapse; it is broad based. Then you will see dividend cuts, cost cutting and similar steps taken by companies to move towards repairing damaged balance sheets. Some confidence will return; more will follow as new debt is raised to extend debt maturity; and still more will follow as some dilution through new equity being raised occurs. As fear recedes, the leveraged players will be rewarded across the board and share prices will lift rapidly to fair value. At this stage, the yield curve will be steep but in the process of flattening and you will see corporate bond spreads narrow back to historic averages. You will also see the spread between AAA and AA and lower bonds normalize. This is where we are today.

What is left now is to look at real leverage as opposed to perceived leverage. Those with low real leverage with high perceived leverage will prosper while those with high real leverage may not. We are back a full circle to the point where asset values matter more than the historic cost of the assets! Perceived leverage is seen through the lens of historic cost financial statements. During periods of caution we look at gearing through the debt to debt plus equity ratio. Every company with a gearing of more than 30% is viewed as a risk with higher risk being attributed as gearing rises over 40%. And leverage gets punished. Real leverage often tells a different story. Suppose you bought a house for Rs 1 million 25 years ago. Suppose you have borrowed Rs 5 million against the value of the house. Your historic cost statements are going to call you highly over-leveraged with debt to debt plus equity of 500%. Now suppose the market value of the house now is Rs 50 million and you sell it to me. I borrow Rs 15 million to finance the purchase. My gearing is a more sensible 30%. Thus, for you, the prior owner, the real financial risk was not actually high because the real value of assets was far greater than book value. Sometimes it is not so simple; for example a monetized backlog can make leverage look very high, but strong earnings visibility backed by firm contracts together with management commitment to reduce debt means that the real leverage including the off-balance sheet backlog is lower compared with perceived leverage. The problem is several Indian entities behave as if they are the Federal Reserve - they will refuse to recognize financial risk and continue to expand their balance sheets with no commitment to returning to a sensible capital structure. I am being unfair here as I am sure the Federal Reserve will shrink their balance sheet when the appropriate time arrives; I am less sure about how members of corporate India might behave.

I have listed below companies which I believe are over-leveraged based on historic cost financial statements. I have broken them down into "Dogs" and "Feds", Dogs are stocks that I still like; perhaps because the financial risk is still priced, perhaps because the perceived financial risk is higher than real financial risk, maybe because of both. The "Feds" are stocks I would avoid; perhaps because the financial risk is no longer priced, perhaps because real financial risk is higher than perceived financial risk, maybe because of both.

Dogs: Hindalco, M&M, Tata Power, Tata Steel, Jindal Steel & Power, Powergrid, L&T, Gujarat NRE Coke, Suzlon, and Lupin.

Feds: Jaiprakash Associates, Reliance Communication, Tata Motors, Aban Offshore, Balrampur Chini, Shree Renuka Sugar, Educomp, Unitech and DLF.

Several of the Feds are still great short term opportunities because of money flow chasing a sector of intense investor interest or indeed money chasing earnings growth without regard to the dilution threat which typically emerges during recessions. I believe that these stocks will be available at cheaper prices than present during the next five years, but the wait might be long as the stocks could rise significantly before the fall.

The Dogs on the other hand are in my view decent long term opportunities if purchased at the correct entry price. The bold dogs are already reasonably valued (though not cheap), the italics are not very well valued at present, but they could present good opportunities on corrections.

But don't forget to review The Quant Reports for value within the vast number of Indian entities with strong balance sheets. Some of the best long term opportunities will arise amongst these well managed companies with safe capital structures. Not all are good buys at current level, but several are; the ones in bold are those I like. But with limited capital available for investment, I would give a higher priority to non public sector players. These companies include:

Axis Bank, A C C Ltd., Bharat Heavy Electricals Ltd., Bharti Airtel Ltd., Grasim Industries Ltd., H D F C Bank Ltd., Hero Honda Motors Ltd., Hindustan Unilever Ltd., Housing Development Finance Corpn. Ltd., I C I C I Bank Ltd., I T C Ltd., Infosys Technologies Ltd., Maruti Suzuki India Ltd., N T P C Ltd., Oil & Natural Gas Corpn. Ltd., Reliance Industries Ltd., Reliance Infrastructure Ltd., State Bank Of India, Sterlite Industries (India) Ltd., Sun Pharmaceutical Inds. Ltd., Tata Consultancy Services Ltd., ABB, Ambuja Cement, Cipla, GAIL, HCL, IDFC, NMDC, PNB, Ranbaxy, Rel Cap, SAIL, Sesa Goa, Siemens.

US Macro View

GDP

GDP at market prices in current prices reported on 1 July 2009 came in at $14,305.1 million. This compared with $ 14,546.7 million for the same quarter during 2008. The annual decrease is 1.7%. Comparing average CPI levels during the quarter for 2009 versus the same quarter in 2008, I observe a price decline of 0.2%. Thus there is no growth in economic activity in nominal terms or in real terms. Using 2008 as the base period, economic activity contracted 1.5% in real terms.

During the immediately prior quarter, GDP at market prices in current prices was $ 14,151.2 million; thus the most recent quarter shows a 1.1% improvement compared with the immediately prior quarter. Average CPI levels fell 0.6% comparing the most recent quarter with the immediately prior quarter. This economic activity improved 1.7% in real terms using the prior quarter as the base period.

In my view, it is clear that US has seen a significant contraction in economic activity. It is also clear that a recovery is occurring. Inflation, remains a very distant threat, but it must be pointed out CPI has inched upwards in each of the past five months. Elimination of deflation as a threat and a gradual return to health appears to be on the cards. Longer term, in my view rising commodity prices together with the massive creation of fiat money will bring inflationary pressures into the economy; I remain of the view that this threat will arise earlier than most expect – perhaps as early as mid 2010.

Interest Rates

Interest rates have remained at the low 0.12% level. The 10 year note has inched up to 3.39% by October. The yield curve remains very steep, rising rapidly from a two year maturity at 0.95% to 3.39% on the 10 year note. In my view, the yield curve should now start flattening as interest rates at the short end of the yield curve rise faster than those at the long end. The spread between the GS10 and the Aaa/Baa corporate bonds have narrowed but remain well ahead of historic spreads; this is indicative of continuing risk aversion. But it must be noted that the spread between Corporate Aaa and Corporate Baa bonds is now in line with historic norms; this is indicative of falling risk aversion. In fact risk capital is first chasing super normal returns from corporate debt markets and equities (including riskier classes such as emerging markets, cyclical stocks and mid/small caps). In my view, the next step will be further narrowing in the spread between GS10 and corporate bonds as the recovery takes hold. Personally, I would not like to be in corporate bonds once the recovery takes hold and the first indication of rate rises is priced by markets. It might not be as bad as I expect, because chances are that confidence in an enduring recovery will be weak and this will lend support to treasuries.

Observe that real interest rates are presently high. The 10 year is trading at a money rate of near 3.39%. Twelve month inflation based on CPI is running at negative 1.3%. Thus the real interest rate is 4.7% (Real Rate = (1+Money Rate %)/(1+ Expected Inflation Rate%) - 1. Historic real interest rates in US have run at 1.9% positive. Thus the fed should really be under no pressure to raise interest rates until inflation and inflation expectations rise. The spread between the 10 year TIPS and GS 10 indicates an inflation expectation of 2.06%. Using 2% as a long term inflation expectation, the real interest rate with the 10 year at 3.39% is 1.363%; this is low compared with the long term real interest rates. In my view, once actual inflation rises to 2%, the fed will begin raising rates to challenge higher inflation expectations; the GS10 by that time can be expected to rise to 3.9% to 4%.

Over the upcoming economic cycle, I expect to see higher real interest rates followed by rising money rates as long term inflation expectations start rising. I would not be surprised to see the money rate increase to 5.5% as inflation expectation of 3.5% rear its ugly head. I do expect forward inflation to be higher than the historic inflation rates of 2.5%; creation of fiat currency, a weakening $ and rising commodity prices will likely offset deflationary pressures from deleveraging to give a long term inflation rate of near 3.5%. As a result, I expect the long term yield associated with the GS10 to rise to 5.5% over several years. However, I expect this dance to be vigorous and volatile; there are likely to be further periods of deflation as deleveraging re-asserts during periods of low or regressive growth.

With an expectation of rising interest rates as the back drop, I would support investment in large caps which have better access to cheaper foreign debt compared with small and mid caps. In addition, rising interest rates can add much volatility to earnings; in these circumstances, it would make sense to avoid over-leveraged companies and target those with stronger balance sheets. During periods of rising interest rates and accelerating activity, I expect to see considerable dilution in over leveraged entities forced to return to responsible capital structures in the face of rising cost of debt. Corporate bond spreads are likely to shrink below historic norms as risk aversion disappears, but given that spreads are near historic norms, the shrinkage is unlikely to offset the higher cost of debt expected to arise in the upcoming year. The risk trade is over; large returns from investing in over-leveraged entities are past – the threat of dilution is no longer priced.

Do keep in mind that equities as an asset class can be expected to outperform bonds as interest rates rise. The force of history is compelling and as we revert to median levels of economic activity measured in real terms, equities are the class most likely to outperform. While valuations are no longer dirt cheap, The Quant Report is still indicating significant return potential for long term investors. However, it is equally clear that better prices will be available in the future. Yet, on a cycle basis there are returns to capture. The current markets are great for portfolio allocators; as markets rise, rebalance to raise liquidity levels in preparation for the next buying opportunity.

India Macro Outlook

GDP

GDP at market prices in current prices during the first quarter of fiscal 2010 came in at Rs 13,269.57 billion. This compared with Rs 12,354.27 billion for the same quarter during fiscal 2009. The annual increase is 7.4%. Comparing average CPI levels during Q1 2010 versus Q1 2009, I observe a price rise of 8.8%. Thus growth in economic activity while apparent in nominal terms; did not really exist in real terms. Using Q1 2009 as the base period, economic activity contracted 1.4% in real terms.

During the immediately prior quarter (Q4 FY 2009), GDP at market prices in current prices was 13,930.96 billion; a 4.98% decline compared with Q1 2010. Here nominal growth rates contracted quarter on quarter. Average CPI levels rose 0.3% comparing Q1 2010 versus Q2 2010. This economic activity declined 5.18% in real terms using the prior quarter as the base period.

In my view, it is clear that India has seen a significant contraction in economic activity. While the recession is viewed as an earnings recession in nominal terms, it is clear that real economic activity is running at a pace below where it was in the prior year.

Q2 2010 GDP estimates are expected on 30 November 2009. I am expecting quarter on quarter inflation to come in at 2.9%. Year on year inflation comparing CPI during Q2 2009 to Q2 2010 is expected to come in at 11%. I expect Q2 GDP at market prices in current prices to come in at Rs 13,866.7 billion; 4.5% over the prior quarter and 8.25% over the same quarter last year. Real economic activity compared with the same quarter last year is expected to be down 2.75% (using the same quarter last year as the base period), but compared to the immediately prior quarter (using the immediately prior quarter as the base period), it is expected to have improved 1.6%.

The Q3 GDP estimates can be expected to be stronger quarter on quarter because of seasonable factors, however, the year on year numbers face downside risks as a consequence of monsoon risk; late December we will know how bad or good the monsoon really was.

Interest Rates

Interest rates have remained at the low 3.25% level. However, an expectation of near future rate increases is getting firmly priced by the markets. During November the 10 year note has inched up to 7.28%. The yield curve remains fairly steep, rising rapidly from a one year maturity at 4.5% to a 3 year maturity at 6.5% and continuing to rise to 7.5% on the 9 year and then dipping to 7.28% on the 10 year note. In my view, the yield curve should now start flattening as interest rates at the short end of the yield curve rise faster than those at the long end. The spread on corporate bonds have narrowed towards historic norms. Liquidity is ample and risk aversion is contracting. As the recovery takes hold credit expansion can be expected.

What is interesting to note is that the 10 year note is now trading at over 7%. In the prior economic cycle, the 10 year note crossed 7% only in June 2006 by which time growth was robust. In June 2006, the RBI rate was at 5.5%. This indicates to me that the upcoming economic cycle will come with higher interest rates as the RBI battles to contain long term inflation levels at or near 6%.

Observe that real interest rates are presently very low. The 10 year is trading at a money rate of near 7.3%. Inflation based on CPI is running at 11.72%. Thus the real interest rate is 3.6% negative (Real Rate = (1+Money Rate%)/(1+ Expected Inflation Rate%) - 1. Historic real interest rates in India have run at 1.7% positive. For real interest rates to revert to historic levels, with 11.72% inflation, nominal interest rates would need to rise to 13.15%. I do believe that using 11.72% inflation as a long term expectation is not rational; high interest rates will tend to reduce inflation expectations. Using a 6% long term inflation expectation would mean nominal rates near 7.8%. All in all, I believe the long term interest rates will be within this range. However, as the RBI does battle with inflation during calendar 2010, we could see a rapid escalation in interest rates at both the short and long end of the yield curve. The pace of increase could be measured or accelerated depending on the rate of acceleration in economic growth.

With an expectation of rising interest rates as the back drop, I would support investment in large caps which have better access to cheaper foreign debt compared with small and mid caps. In addition, rising interest rates can add much volatility to earnings; in these circumstances, it would make sense to avoid over-leveraged companies and target those with stronger balance sheets. During periods of rising interest rates and accelerating activity, I expect to see considerable dilution in over leveraged entities forced to return to responsible capital structures in the face of rising cost of debt. Corporate bond spreads are likely to shrink below historic norms as risk aversion disappears, but given that spreads are near historic norms, the shrinkage is unlikely to offset the higher cost of debt expected to arise in the upcoming year. The risk trade is over; large returns from investing in over-leveraged entities are past – the threat of dilution is no longer priced.

Do keep in mind that equities as an asset class can be expected to outperform bonds as interest rates rise. The force of history is compelling and as we revert to median levels of economic activity measured in real terms, equities are the class most likely to outperform. While valuations are no longer dirt cheap, The Quant Report is still indicating significant return potential for long term investors.