The Hyderabad Connection
In August, 2008, I found myself on a flight to Hyderabad with our infrastructure analyst. On the flight, we went through the financial statements of the said infra company, but could not make any sense of the balance sheet. Why was the infra company making loans equivalent to almost its entire shareholders’ equity? And why did the annual report say that the infra company only had minority stakes in its power plants when the investor presentations clearly suggested otherwise?
On being asked these questions, the infra CFO said, “Look, this is the way things are in India. You need to get used to it.” In effect, he was trying to circumvent Accounting Standard 21 by using a clever structure, which allowed him to use his own balance sheet to flatter his own P&L.
When we published our ‘Sell’ note on the said infra company, we were threatened by the same CFO in Bollywood-style language. And next came the investors’ reaction. While some clients heeded our warnings and stayed away from the infra company, others said, “You have to accept these political connections… This company is a prime play on the ‘power deficit’ story in India.”
These investors were right. Throughout CY09 and the first quarter of CY10, the company’s stock trebled as it won more contracts and was given water and fuel linkages. And then came the scandals.
These were the defining national scandals of CY09 – CWG, Adarsh, 2G, etc. and they have had two salutary effects across a range of sectors. Firstly, they have deterred politicians from helping companies win contracts or access natural resources. Secondly, they have deterred investors from investing in companies, which are fronts for certain political godfathers. These findings are from two studies, performed over the past quarter by my colleagues.
The first study hinges our forensic accounting model, which ranks the BSE 500 companies according to the quality of their financial statements. I remember trying to use this forensic model to make stock calls in CY08, CY09 and CY10. But it was a fruitless exercise because investors would back companies, like the infra company highlighted above, which had hopeless accounting but strong political connections. These companies would, in turn, go on to outperform the broader market. However, as the corporate-politician nexus has sought cover over the past year or so, investors have swiftly gravitated towards companies, which have strong accounting quality.
So, if I break the BSE 500 into four quartiles, where quartile A has the strongest accounting quality (as per our forensic accounting model) and quartile D has the weakest, our analysis shows that over 1, 3 and 5 years, quartile A has outperformed B; this, in turn, has outperformed C, which has outperformed D. Whatever return metric is used – average returns from each quartile, median returns from each quartile, % of companies in a quartile reporting positive shareholder returns over 1/3/5 years – this pattern holds, suggesting that finally, share prices in India are being driven by fundamentals, rather than political connections.
Our second hinges around explicitly analysing the impact of political connections on shareholder returns. Within our universe of BSE500 stocks (excluding financial services stocks), we have classified the companies into ‘Strong/Medium/Low,’ based on the strength of their connectivity to political establishments over the past few years.
Out of this universe of 360 firms, our sector leads have classified 25 (7 per cent) of these firms as having ‘strong’ connectivity and another 50 (14 per cent) as having ‘medium’ connectivity. By default, therefore, the remaining 285 (79 per cent) firms are deemed to have ‘low’ connectivity.
The 75 stocks with ‘strong’ or ‘medium’ connectivity came from the following sectors: Power (13 per cent), Capital Goods, Infrastructure and Construction (44 per cent), Real Estate (17 per cent), Technology (16 per cent), Metals and Mining (5 per cent), Telecom (3 per cent) and Media (1 per cent).
In the previous bull run (the period ending 2008), the ‘strong connect’ stocks outperformed the market substantially. However, around 2008, this outperformance peaked. Then this outperformance gave way to underperformance, which has become especially meaningful during the past one year. Over the past one year, the cumulative outperformance since 2006 has not only waned and disappeared, but has now moved into negative territory. In particular, the ‘strong connect’ group has underperformed the market by 14 per cent in the past one year.
It is debatable whether the pattern which has been established over the past year – of investors avoiding well-connected firms in favour of fundamentally high quality firms – is here to stay or is it a temporary reaction to the fear created by the intensity of the 2G investigation. I believe that this pattern is a positive paradigm shift and marks a watershed in the evolution of the Indian stock market. Several investment implications arise from this positive paradigm shift:
Fundamentals will become a bigger focus in sectors such as Power, Realty, Construction, Technology, Mining, Real Estate, etc., as the market forces these companies to either shape up or ship out. It won’t be enough for these companies to have one or two powerful people sitting on their Boards and expect a premium valuation from investors due to the presence of these luminaries.
When the Indian market finally goes into a secular bull run, the kind of stocks which will deliver market-beating returns will be very different from the stocks which did well in the two previous bull runs (the one ending January, 2008, and the other brief blast from March, 2009-July, 2009). In particular, the high beta stocks, to the extent that they are ‘strong or medium connect’ companies with weak fundamentals, might not be able to outperform. In contrast, companies with clean accounting and solid franchises should be in high demand.
Investors’ ability to generate market-beating performance should now become more closely aligned to their skills of spotting fundamentally high quality companies (as opposed to their skill in knowing which company is connected to which grandee).