Working with what we already know

Working with what we already know
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First Published: Mon, Dec 05 2011. 10 20 PM IST

Illustration by Shyamal Banerjee/Mint
Illustration by Shyamal Banerjee/Mint
Updated: Mon, Dec 05 2011. 10 20 PM IST
Investors are having a traumatic time. Stocks have been going up and down (mostly down) based on factors which have come out of the blue: The sovereign debt crisis in the Europe, the failure of the US congressional committee to cut deficit, the sudden depreciation of the rupee against the dollar or the political turmoil in India.
Illustration by Shyamal Banerjee/Mint
As investment professionals, we are often asked for our views on topics such as inflation and interest rates forecast for India, whether the crisis in Europe will blow over, or whether we will have another contagion as we saw in 2008.
It is important to realize that no investment professional is an astrologer and also that there are no definite answers to such questions. At best the so called “experts” can give their subjective judgement on what is expected to happen.
Given such uncertainties, a lot of people tend to go into a shell as far as equity investing is concerned and prefer bank deposits at such times. At the other extreme, there are some people who take outsize risks in the hope of making large profits.
A question naturally arises as to how does one go about investing in such uncertain times when we do not know the answer to a lot of questions. Luckily for us, there are a lot of things that we do know and which can guide us in our investments.
Beware of companies with a lot of debt: Even if there is a downturn in the overall economy, not all companies will suffer equally. Companies with a lot of debt on their balance sheets have to keep paying interest and principal on the loans. Hence, their staying capacity is limited and they face the maximum risk of downsizing or bankruptcy in a recession. They are also vulnerable to interest rate increases and rupee depreciation in case their borrowings are in foreign currency. On the other hand, cash-rich companies have staying capacity, can earn more interest income and can opportunistically make acquisitions in difficult times.
Companies in the global market are more vulnerable: Exporters and importers are affected by exchange rates. Exporters are affected by recessions in their export markets and, hence, these companies have more volatile businesses. The current depreciation in the rupee against the dollar, for example, will benefit exporters and harm importers. Domestic businesses on the other hand are more immune to foreign events.
Beware of large projects: If a company is in the process of doubling or tripling its existing capacity, it would be prone to a lot of risk in the current environment. Clearances may not come in time or funding may not be available delaying the project. Even if the project is completed (with or without cost/time overruns), there could be situations where the demand for the company’s products is not robust and profitability will get affected as the interest costs and depreciation for the new project will start hitting the profit and loss account.
Beware of the political economy: It is obvious that sectors where government policy, clearances and licences are critical to the business are more risky than other businesses. Hence, one has to be cautious while investing in sectors such as telecom, mining, infrastructure and real estate.
Beware of creative accounting: A lot of companies engage in accounting which is legally permissible but which is in the realm of creative accounting. Transactions such as sale and lease-back of assets, group company transactions and use of foreign-currency convertible bonds to hide the interest costs of foreign debt are practices which are examples of creative accounting. It is in bad times that the adverse impact of such practices comes to light and one should stay away from companies indulging in such practices.
Pessimism and panic create opportunities: Finally on a positive note, bearish market conditions bring down stock prices of most companies. For companies which are not fundamentally affected by the external events and which are not in the categories mentioned above, any significant fall in share prices creates opportunity to invest and create wealth in the long term.
Rajeev Thakkar is CEO, Parag Parikh Financial Advisory Services Ltd.
We welcome your comments at mintmoney@livemint.com
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First Published: Mon, Dec 05 2011. 10 20 PM IST