The cleansing of the Indian stock market, which started with Satyam going bust in January 2009, continued with a lot of powerful people visiting the Tihar Jail in 2011. As a result, throughout 2011, Indian companies whose core competitive advantage is connectivity to the political apparatus, underperformed heavily. Ambit’s index of 75 politically connected companies (the ‘connected 75’) underperformed the BSE 100 by 23 per cent in CY11.
Now, however, with FII capital returning to India and with the usual ‘dash for trash’ which characterises the early stage of bull markets in India, some investors believe that it is safe once again to invest in connected companies. After all, YTD in CY12, the connected 75 have outperformed the BSE 100 by 15 per cent.
But I don’t agree. In fact, I believe that the structural changes that are taking place in India make life increasingly difficult for the connected companies.
The fragmented nature of power in India: Political power in India has become fragmented with different Cabinet ministers establishing their own power centres, with the state governments (now, increasingly run by regional parties) becoming more powerful and with various regulators (CERC, TRAI, SEBI), watchdogs (CVC, CAG, Competition Commission) and courts becoming more assertive.
Hence, a decade ago, if I were a mining tycoon, I could pay my respects at a single address in New Delhi and get things done. Now, to achieve the same end result, I will have to pay my respects to at least two senior ministers in New Delhi, a couple of watchdogs and the state governments in whose territories I operate. Such a process is more time-consuming, more expensive and entails greater reputational risk. In effect, the old ‘under-the-table’ model of co-operation between politicians and promoters is broken and investors should be wary of companies who claim that it is not.
Managerial competence: With one or two exceptions, I am yet to meet connected companies which are managed competently. If I were a top-flight executive in the power industry, would I really want to report to someone who has no idea (and probably no interest) in how a power plant operates? By and large, connected companies tend to be badly managed. In terms of share price performance, topline and bottomline growth, the connected 75 have underperformed the BSE 500 by 15 per cent, 7 per cent and 12 per cent respectively (on a CAGR basis) over the past two years.
Accounting issues: This is a corollary of the previous issue – when a connected company’s financial performance sags, creative accounting techniques are usually brought into play to shore up the wrecked accounts. Unsurprisingly, a majority of our connected 75 companies are in the bottom half of our forensic accounting model for the BSE 500 companies.
Shareholders’ rights: Even if you do hold the view that political connectivity can be turned into a sustained competitive advantage, that still leaves open two very important questions regarding corporate ethics:
1. Will companies, who are unethical in their pursuit of profits, become ethical when it comes to giving shareholders a fair deal? I am yet to see such a company in India.
2. Will companies, who are unethical in their pursuit of profits, become victims of other equally unethical companies? To my mind, the 2G investigation clearly shows how such dynamics could play on a sector-wide scale.
A ‘new India’ story: The ‘India story’ has now changed quite fundamentally. It is no longer driven by the Centre, no longer driven by macroeconomic thrust and no longer driven by crony capitalism. The new (to my mind ‘improved’) India story is driven by reform at the state-specific level, prudent management at the corporate level and aspirations of a better life at the individual level.
The era of connected companies generating sustained shareholder returns is over. As we enter an economic recovery in India, investors need to find ways to avoid such companies if they are to reap the full benefits of this recovery. I continue to believe that investing in ‘good and clean’ companies across the cycle is a reliable way for institutional investors to beat the broader market (which might NOT be as discerning about political connectivity as it should be). Listed below is the quarter by quarter outperformance of Ambit’s ‘good & clean’ portfolio on a free float market cap weighted basis:
Mid-March 2011 to mid-June 2011: 380 bps.
Mid-June 2011 to mid-Oct 2011: 500 bps.
Mid-Oct 2011 to current: 90 bps.
On a separate note, I am becoming increasingly convinced that the 8-10 per cent growth rates that India saw in the noughties are unlikely to return on any systematic basis as a considerable part of that growth was due to heavy investments in the crony capitalist-dominated sectors such as mining, power, infrastructure, telecom and real estate. With the informal contracts which drove this growth having broken down, regardless of how much reform happens at the Centre, the ‘gold rush’ years are probably behind us. The ‘new normal’ of GDP growth around 7 per cent and structurally high interest rates will test the mettle of even the best-managed companies in India.