In my previous column, I gave a technical explanation of why I thought the cost of equity of the largest Indian companies is a bit over 15% rather than the sub-13% assumed by most of my peers. When I presented this view to our client base, our overseas clients did not have trouble accepting such a view but most of our domestic clients simply could not reconcile themselves to a 15% + cost of equity figure. They came up with various arguments to justify a much lower cost of equity figure for India.
It soon dawned on me that a technical debate on cost of equity is futile since you can prove anything you like with numbers. Hence, I will now turn to qualitative factors to justify my “15%+” position.
Whilst it is fashionable these days to denigrate the Capital Asset Pricing Model, it is hard to beat the underlying simplicity of the theory which says that for it be worthwhile for you to invest in equities, you need a premium over the risk free rate of return, usually measured in our country by the yield on the ten year Government bond (currently around 7.4%). So, if I believe that the cost of equity is 15%+ in India, I am in effect saying that equities have to deliver a 100% premium over the Government bond rate. Why am I saying this?
1. We have a judicial system which has major flaws in it, flaws which are highlighted not just by tragic national disasters such as the gassing of 15,000 civilians in Bhopal in 1984 but also by more personal miscarriages of justice such as the long drawn out cases around the deaths of Jessica Lal in Delhi and Ruchika Girhotra in Chandigarh. If because of the failings of the legal system, those in power can kill people and get away with it, they can take your and my investments and abuse it with much greater impunity. That should raise the return you need to be tempted to invest in equities.
2. We have a political establishment which long ago lost the trust of the people but which is now losing its grip on vast swathes of territory in the heart of India. With most of India’s coal, iron-ore, manganese and bauxite sitting in this belt, if you are an investor in a Power, Infrastructure or Metals/Mining company with significant investments in Naxal-affected zones, your cost of equity cannot be south of 15% given that your investment is de facto at the mercy of an insurgent group which has our Government on the run.
3. We have dozens of industry regulators in operation but most of these regulators are incapable of providing clean, competitive, level playing fields in the sectors that they monitor. Instead they are focused either on handing out favours (at a price) to specific companies or fighting turf wars with each other. The distorted playing field that such regulation produces pushes up the risks facing even large listed companies dramatically and hence pushes up cost of equity. Those who doubt this might want to have a look at how the recent 3G auctions has redrawn the telecoms landscape in the favour of certain companies and against some of their rivals.
4. Finally, all of us are operating in a global financial system which is being roiled by repeated bouts of investor panic to which Governments and central banks don’t seem to have any meaningful solution other than printing money to buy Government bonds and then pumping that printed money into the economy. It’s a world where one day the euro is strong enough to be deemed a reserve currency one day and then the next day its very existence is in question. It’s world when the global consulting giant, Acccenture’s stock price can be $41 one minute and then one penny a few minutes later.
Now, if in spite of all this, you are happy to invest in equities for a mere 13% return (i.e. a return only 2% points higher than the rate that a typical Indian corporate pays for its borrowings), then you are likely to be Indian corporates’ best friend. You will be invited by these corporates to their dinner parties and invited to participate in their IPOs and QIPs.
If on the other hand, you are one of these people who need a higher rate of return before you part with your cash, you might have fewer friends in the corporate world but you are likely to have higher investment returns.