The fall in stock prices over Sep-October has finally dented investor confidence. For most of October, markets shifted to a 'sell on rise' market as opposed to 'buy on dips' seen for the most part of the past 4 years. Macro negatives like rising oil prices, softer rupee, high current account deficit and weak earnings momentum existed for some time. The immediate cause for turn-down in investor sentiment was a default by IL&FS (an 'AAA' rated company) on short-term loans and commercial paper (CP), which led to tightening of credit available to non-banking financial companies (NBFCs) and a consequent drop in their stock prices. NBFC stocks had been flag bearers of the stock market rally that started in 2013. Stock prices for many NBFCs doubled over the past 12-14 months. Now that prices have corrected between 15%-60%, investors are again looking for buying opportunities. The question is - do the current prices present 'value'.
Were the prices at the peak justified?
|L&T Finance Holding||47.85||63.85||157.1||0.07||0.57|
|L&T Finance Holding||2.6||3.58||6.46||0.08||0.34|
The tables above show stock price and EPS for a select set of NBFCs. Keep in mind many of these would have raised money at a premium to book value over the period (FY12-FY18) and therefore EPS figures would be inflated. Ideally, stock prices should be driven by return on equity -which would typically lag immediately after a capital raise, even as EPS rises. Ignoring this, and using EPS as a proxy, it is obvious that price rise over FY16-18 was way more than earnings growth. Earnings growth lagged stock price 'inflation' over FY12-FY16 - and even as earnings growth increased over FY16-FY18, stock price growth accelerated further. Clearly, markets were willing to pay substantially higher even though higher EPS growth rates were phenomena observed for only the immediate past 18-24 months. It's easy to argue that markets were running ahead of themselves. In fact, if one were to take the same rate of stock price growth over FY16-FY18 as witnessed in the prior 4 years, stock prices would be between 20% to 58% lower compared to actual prices at the end of Sep 2018 (except in the case of Chola Finance). It is undeniable that earnings accelerated over FY16-FY18. Nonetheless, to extrapolate lack of competition from large parts of banking sector and benign liquidity conditions over a long period going forward reflected naivety on part of the market. If one concedes that at peak, prices represented irrational exuberance, a drop from peak doesn't automatically make stocks 'cheap'.
Commercial paper - an important source of funding
One estimate of commercial paper (CP) raised by NBFCs and housing finance companies (HFC's) put the figure at 2.64 trillion - about 50% of the total market. Of this, mutual funds subscribe to almost 85% of issuances. As has happened, if investor aversion forces mutual funds to desist from investing in these CP's, NBFCs and HFC's would need to run down their balance sheet by about 10% - and that over a tight 90 day period. While some companies have the cash (JM Finance, for example, has brought back some of their CP's) to be able to tide over tighter liquidity, some with asset-liability mismatches will need to sell off assets or find other replacement for their liabilities.
Liquidity window - elusive
Unlike banks that have a portfolio of government securities that can be pledged with RBI to raise money, assets that NBFCs own are largely real-estate and consumer loans - assets that RBI cannot lend against directly. A special loan window for NBFCs is not easy to structure for RBI. Another option - that of directing banks to extend loans to NBFCs - at a time when mutual funds are selling out CPs would invite justified criticism given that banks have been hauled over coal for loose credit standards.
Selling down assets is probably the only viable option for cash trapped NBFCs and this would imply that growth rates will not only come down, but some may also actually have to shrink the balance sheet. Assuming a 10% de-growth would mean a very sharp decrease in valuations. This is without even assuming a reduction in net-interest margins - which is a possibility given the increase in cost of borrowing that seems inevitable. A higher interest regime also implies a lower P/E as cost of equity increases.
All this is without assuming any worsening of the macro environment or accounting shenanigans which invariably emerge when a credit cycle expansion draws towards its end and balance sheets shrink. Slower growth and lower valuations are a potent combination - forcing significantly lower stock prices.
Lessons for investors
Investors somehow need reminding that risks in businesses don't disappear and need to be priced. The lending business apparently has little in way of entry barrier - anyone with money seems able to get in and gain a share of the insatiable demand for credit. However, not all credit evaluation processes are same and not all companies can be valued as if they will exist in perpetuity. Additionally, growth rates substantially greater than economic growth essentially means higher penetration - with perhaps a reasonable expectation of poor credit profile of borrowers. To value such businesses as if they can maintain these growths without compromising either margins or credit quality is asking for the moon.
Implications include a possible slowdown in consumer credit and a consequent slowing of discretionary demand.
Additionally, role of credit rating agencies is again in question - if they blow the whistle after the horse has bolted, why do they exist? When investors are largely banks and mutual funds - both professional investor categories fully capable of carrying out their own credit risk analysis - why insist on paid advice that invariable misses deterioration in credit quality till after a crisis.
Lastly, the role of Board members needs careful examination. Yet again, Board members who should have provided oversight have failed miserably in their job of protecting interest of investors.
In the final analysis, for an investor it's important that risk be properly priced and dependence on external agencies with little skin in the game be minimised. To that extent, momentum investing - of which index investing is an example - will remain prone to high risks. In the current scenario, unless fallout of tighter credit is contained, second-order effects will inevitably arise which can drag down already anaemic corporate earnings growth. Prudence requires investing with extreme caution despite the apparent reset in stock prices.