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Diamonds In The Dust

Crushing Risk Is The Key To Generating Higher Returns In India

You need to minimize four types of risks if you want to generate steady and healthy investment returns in the Indian stock market:


Accounting risk: Whilst you all now know how prominent public and private sector banks in India fudged their bad-debt figures for years until the RBI's Asset Quality Review in 2015 forced them to come clean, the same problem still exists with several housing finance companies. The accounts of a leading cement manufacturer don't stack up. Neither does the annual report of a high-flying retailer make sense—ditto with a prominent petrochemical company and a prominent pharma company. The majority of the companies in the BSE500 have annual reports that don't pass scrutiny. Using twelve forensic accounting ratios and a financial model which contains time-series data on 1,300 of India's largest listed companies, they seek to identify that 20% of the Indian stock market whose books are believable. The next chapter of the book focuses on this subject in more detail.


Revenue risk: At around US$2100, India's per capita income is still meagre (nearly half the level of Sri Lanka's, less than one-fifth of Malaysia's and about one-fourth of Thailand's). As a result, beyond the essentials of life—FMCG products, medicines, basic apparel and basic financial services products—most other products in India are luxury items for most Indians. As a result, even for small cars or entry-level two-wheelers, demand in India fluctuates wildly. For example, suppose you consider the sales volumes reported by Maruti Suzuki. In that case, you see that the company typically experiences six to seven years of solid demand growth (growth well above 15% per annum—for example, 15.2% CAGR in volumes over FY 2004–11) followed by three to four years of famine (growth well below 5% per annum—example, 0.4% CAGR in volumes over FY 2011–15). Whilst its cross-cycle average growth tends to be around 12%, the stock price volatility reflects the volatility of Maruti's top-line growth. In contrast, a company selling essential products, like Asian Paints or Marico, tends to see steady revenue growth—between 10% and 20% per annum—pretty much every year. Investing in companies selling essential products in India, therefore, reduces risk.


Profit risk: As the cost of capital is still pretty high for India, it is rare to find Indian companies that spend heavily on genuine R&D.
Understandably, the Indian economy is characterized by rapid imitation—one company spots a niche (say, gold loan finance), and within a decade, it has dozens of imitators. This rapid entry of new companies into a business squeezes the profitability of the first mover and thus creates risk for its shareholders. To reduce such risk, they look for sectors where, over extended periods, one or two companies cumulatively account for 80% of the sector's profit pie. Such monopolies have lower volatility in their profit margin.


Liquidity risk: Liquidity measures how easily an asset or security (like stocks) can be bought or sold in its markets. Liquidity is usually measured in terms of a stock's average daily traded volume (ADV). The higher the ADV, the easier it is to buy or sell the stock without materially impacting its price. Unfortunately, India is one of the least liquid of the world's top eight stock markets, mainly because promoters own more than half of the shares outstanding in the Indian market. As a result, beyond the top thirty or so stocks in India, liquidity drops rapidly. By the time you are in the lower reaches of the BSE100, the ADV tends to fall to as low as Rs 10 crore per day. Such low liquidity creates stock-price gyrations as investors go through election-induced euphoria cycles and accounting fraud-induced panic. Tilting the portfolio towards liquid stocks reduces this risk.

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