Investment lessons from Adani stocks crash

The Adani Group corporate house in Ahmedabad. The Hindenburg report made many 'allegations' against the group, which triggered a fall in the prices of stocks of its listed companies.
The Adani Group corporate house in Ahmedabad. The Hindenburg report made many 'allegations' against the group, which triggered a fall in the prices of stocks of its listed companies.

Summary

  • Post the Hindenburg report, fundamental changes have kicked in. Retail investors will struggle to gauge its impact
  • What goes up fast, can come down faster. Given the low free-float and low liquidity, there weren’t enough buyers of Adani Group stocks when the sentiment turned

On 25 January, at around 8.15 am India time, US-based Hindenburg Research put out a tweet, talking about a negative report on the Adani Group that it had published. The report concluded by saying: “After extensive research, we have taken a short position in Adani Group companies through US-traded bonds and non-Indian-traded derivative instruments."

The report made many “allegations" against the group, which triggered a fall in the price of their listed stocks. The Adani Group said that the claims are baseless and published a 413-page rebuttal.

The Hindenburg report was published just two days before 27 January, the day the follow-on public offer (FPO) of 20,000 crore of Adani Enterprises was ready to hit the market. The situation, which is still evolving and is yet to settle down, has left many investors confused about whether they should invest in these stocks or not. Many influencers have linked buying Adani Group stocks to patriotism and said that it is our duty as Indians to buy these stocks.

So, how should retail investors go about this? In this piece, we explore this question in detail. Here are some investment lessons that emerge from the fall in prices of the Adani Group stocks.

Beware of storytelling

In a recent piece on the Adani Group, the valuation guru, Aswath Damodaran, said that the Indian stock market has “a bias towards bullish momentum over its bearish counterpart".

Over the years, nobody has understood this better than the stock market gurus, mutual fund managers and other experts. Basically, anyone whose income is dependent on more and more people buying listed stocks, directly as well as indirectly. Of course, in a way, such individuals are feeding into the internal mental need of current and prospective investors, who need to be told over and over again that they have made the right decision of investing in stocks. Stock market gurus provide that internal validation by being bullish all the time.

Now, this understanding has also seeped into the financial influencers trying to sell courseware in an era of cheap smartphone and very cheap internet. One of the narratives that the influencers put out was that given the low free float in the Adani Group stocks, the likelihood of anyone selling was low, and hence, the price of these stocks would only go up. QED.

A low free float indicates that the company has a very concentrated ownership and hence, these stocks are not available for buying or selling in the stock market, implying low liquidity.

Take the case of Adani Enterprises. As of 31 December, the promoter and the promoter group owned 72.6% of the company. The argument offered by influencers was that the promoters definitely won’t sell.

The Life Insurance Corporation (LIC) of India owned 4.2% of the company. Other insurance companies owned 4.3%. LIC and the other insurance companies invest for the long-term, and hence, they were unlikely to sell.

While these figures presented here are as of 31 December, the story was similar in December 2021 as well—the promoters owned 74.9% of the firm; LIC owned 3.1% and other insurance companies 3.2%.

So, given the low free-float and the unlikelihood of existing large investors selling, anyone wanting to buy the stock, would have to offer a higher price than the prevailing market price in order to cajole existing investors to sell. This dynamic would keep pushing up the market price of the stock.

What the storytellers didn’t say was that the dynamic that worked when prices were going up, would also work on the way down. And that’s what happened. After Hindenburg Research put out its report and the sentiment turned, investors who were desperate to sell out, were ready to accept significantly lower prices. Given the low free-float and low liquidity, there weren’t enough buyers of the stock (like there weren’t enough sellers when the price was on its way up). So, what went up fast, came down even faster.

Simplest reason

The human mind seeks order. And to achieve that, stories are told. In this case, many conspiracy theories have been offered. One question that has repeatedly been asked: why did Hindenburg Research publish the report just when Adani Enterprises’ FPO was about to hit the market?

Many investors and influencers have projected this as an economic attack on India. In a world seeking explanations, this theory has been bought as well. But it is worth keeping the Occam’s Razor in mind here, which states that the simplest possible explanation is usually the right one.

In this case, it is worth remembering that Hindenburg Research is a short-seller and, like any other short-seller, it is also looking for the maximum bang for its buck. And what better opportunity to do that than put out the report just before the FPO of the company is about to start. For a short-seller, it was brilliant timing.

A short-seller is a kind of an investor who first borrows stocks or bonds and then sells it, in the hope that the price of the financial security will fall. When the price falls, the short-seller buys back what they had sold at a lower price and, in the process, makes a profit.

Of course, the short-sellers run the risk of the price of the financial security going up instead of going down and thus ending up with losses. Thus, the risk that any short-seller takes on the trade is extremely high, given that at least theoretically there is no upper limit to how high the price of a stock or a bond that has been short-sold can go. On the flip side, if the price falls, it cannot fall below zero. Hence, while the possible profits that can be made are limited, the possible losses can be infinite. So, the short-seller has a huge skin-in-the-game here and is unlikely to be frivolous.

High P-E ratio

It is worth remembering that the stock price of Adani Enterprises was falling even before the Hindenburg report was published. On 20 December, the stock closed at 4,165. By 24 January, the stock price had fallen by more than 17% to 3,442, in a period when the Nifty 50 stock market index fell 1.5%.

So, clearly, the existing investors were already having doubts about the high price of the stock. A simple reason was its very high valuation. As Damodaran puts it: “The price to earnings (P-E) ratio for the stock has gone from a modest 15 times earnings in the 2016-21 time period to 214 times earnings in the most recent two years." This meant that the stock price was worth 214 times the earnings per share of the company, which is extremely high.

Typically, when prices are so high, investors are banking on bumper future profits. Nonetheless, as Damodran says, Adani Enterprises is an “infrastructure company, and the irrational exuberance that animates pricing in tech or software usually has little play in this sector." In fact, as on 10 February, as per the BSE, the P-E ratio of the company was 191.

Don’t link patriotism

Many influencers have nudged their followers to show their patriotism by buying Adani Group stocks. Now, here’s the thing. If, as an investor, you feel that the investing case for any of the Adani stocks is strong, then please go ahead and buy them.

Nonetheless, it’s worth remembering that there are 50 stocks in the Nifty 50 index, including Adani Enterprises and Adani Ports and Special Economic Zone. And as an investor you won’t be any less patriotic if you bought any of the 48 other stocks than you would be if you bought the Adani stocks.

Don’t short-sell

Short-selling the Adani Group stocks is currently a very risky strategy because of the huge volatility in the price of its stocks. There have been days when the price of the stock, after having fallen dramatically, has gone up dramatically. This can blow out a short-seller, unless the timing is perfect. This is primarily because of the low free float of the stock. Even a small change in demand or supply of the stock, can drive up its price quickly in one direction.

Hence, it is worth remembering something that Charlie Munger, the vice-chairman of Berkshire Hathaway, had said about the electric carmaker Tesla, when the price of the stock had a very volatile week. Munger was asked what he thought about the ups and downs of Tesla’s stock price. “My thoughts are two," Munger said: “I would never buy (Tesla), and I would never sell it short."

Impact on fundamentals

Typically, the fundamentals of a company impact its market price. So, if the earnings of a company are expected to go up, the investors do not wait for the earnings to go up—they buy the stock in the expectation of the earnings going up and, in the process, drive up its price. The stock market discounts for possibilities. But this is something that we already know. The vice-versa can also turn out to be true. Sometimes, the market price of a stock impacts its fundamentals and that’s something which is currently happening to the Adani Group stocks.

Take the case of France’s TotalEnergies, which had a partnership going with the Adani Group to produce green hydrogen. The company has put this participation on hold. Its CEO, Patrick Pouyanne, told reporters in Paris last Wednesday: “It was announced, nothing was signed. It doesn’t exist." He added: “Mr Adani has other things to deal with now; it’s just good sense to pause things". At the same time, Pouyanne insisted that there would be no impact on Total’s venture with Adani to sell natural gas.

Then there is the case of the Adani Group deciding to prepay $1.1 billion it had borrowed against shares. On this, the Financial Times reported that the lenders, which included Barclays, Citigroup and Deutsche Bank, had requested the Adani Group to “top up the amount of stock pledged against the loan after shares of…(their) listed companies fell sharply". The Adani Group decided to repay the loan completely instead of topping it up. When money is borrowed against shares of a company as a collateral, and the value of those shares falls, the lenders tend to ask for extra collateral, as they did in this case.

A day after $1.1 billion was prepaid, Adani Ports and Special Economic Zone said it was considering repaying about 5,000 crore of loans. The firm also said that it would roughly halve its capital expenditure in 2023-24 in comparison to the current financial year.

Further, a Bloomberg news report points out that the Adani Group’s “traders are offering to sell several coal shipments from Australia and Indonesia at discounts of about 4% relative to Asia’s price benchmarks."

Closer to home, MR Kumar, the chairman of LIC, has said: “Our investor team has already sought clarifications from the Adanis… We are soon going to call them to meet us and explain."

Further, a Reuters report points out that the stock market regulator, the Securities and Exchange Board of India, “is investigating Adani Group’s links to some of the investors in the conglomerate’s aborted $2.5 billion ( 20,000 crore) share sale."

To conclude, there have been quite a few of these fundamental changes happening because of the fall in the value of the Adani Group stocks, post the report put out by Hindenburg Research, things that were unlikely to have happened otherwise.

For individual investors it is next to impossible to figure out how many more of such changes will happen and what their exact impact will be on the price of the Adani Group stocks. These are the unknown unknowns. Hence, it might just make sense to sit this one out and wait for greater clarity to evolve. At the end of the day, it is a question of properly investing your hard-earned money, and there is nothing that can be possibly more important than that.

Vivek Kaul is the author of Bad Money.

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