Published on: 8 Feb, 2019

As the same problems which ravaged India’s banking system now spread into its money & bond markets, we highlight the need for investors to strengthen their forensic accounting firepower. With over 60 years of experience of analysing the accounts of India’s leading companies, Marcellus’ research team (now stuffed with CAs and CFAs) is of the view that over 70% of India’s listed entities publish accounts which don’t make sense.         

“The definition of insanity is doing the same thing over and over again, but expecting different results.”Albert Einstein

“For all practical purposes, board members are nominated by the managers, with limited or no input from the external shareholders. This tilts the balance of power in favour of the insiders or managers, who could choose to ignore the shareholders. However, there are other participants in the governance system, who could play an important role in correcting this imbalance. They are the information intermediaries, called ‘gatekeepers’, who ensure that only the right information about the corporation reaches the gates of the external investors, particularly shareholders.
The gatekeepers in the financial market include credit rating agencies that evaluate a company’s creditworthiness, external auditors who provide independent assurance that the company’s financial condition is portrayed fairly, and securities analysts who assess its business prospects…
It is these gatekeepers who failed in the case of Infrastructure Leasing & Financial Services (IL& FS)…During the financial year 2017-18, its operating profit rose to Rs 7,267.3 crore. However, debt increased at a much faster pace to Rs 91,091.3 crore. As a result, interest outgo touched Rs 7,922.8 crore during 2017-18. By 2018, the company was not even making enough profit to take care of its interest expense. Hence the default happened.
While the board’s failure is apparent, the gatekeepers whose vigilance could have averted the crisis also failed in the case of IL&FS.” – Economic Times, 1st November 2018 (Source: https://economictimes.indiatimes.com/markets/stocks/news/ilfs-mess-how-gatekeeper-rating-agencies-auditors-analysts-let-you-down/articleshow/66457372.cms )

The stress in the banking system has spilled over
Through 2013-17 as we watched the stress in the banking system build-up (with stressed assets ultimately rising beyond 15% of total banking system assets implying that most of the banks were bust in all but name), many of us kept asking ourselves “how long before this problem spills over into the rest of the financial system?”

The beauty of a complex financial system is that it often refuses to follow the simple models that we build in our heads. So, rather than the problems of the banking system spilling over to the rest of the financial system, we ended up with a broad-based financial boom in 2017.

As liquidity flooded into the financial system post-demonetisation, not only did the stockmarket soar (the Nifty rose by 29% that year) but the three month Commercial Paper (CP) rate move towards 6% in July 2017 (from as high as 12% in September 2013).

The 2017 boom in financial markets made the issues in the banking system look like an isolated problem. More importantly, the healthy run that stock and bond markets enjoyed between 2014-2017 gave two successive RBI Governors, Raghu Rajan and Urjit Patel, the political space to squeeze errant promoters who had defaulted on their bank loans. To their credit, both Governors gradually squeezed the flow of credit from Public Sector Banks (PSBs) to promoters who were proven experts in gaming the banking system. In 2017 these promoters ran to the money market to raise funds – using CPs and Non-convertible debentures (NCDs) these promoters borrowed from India’s mutual fund industry which is ill-equipped to deal with premier league schemers.

Then, over the last 18 months, as liquidity conditions normalised, the cost of issuing CPs and NCDs steadily rose – the three month CP rate is now approaching 8% in India. As a result, the final source of liquidity for many influential promoters was drying out. These people then lobbied New Delhi that the restrictions that the RBI had imposed on PSBs should be removed in the broader national interest of stimulating economic growth. We don’t need to elaborate what happened next at the RBI.

However, if we look beyond the drama at the RBI, what is more alarming is the ongoing challenge facing India’s money & bond markets. Basically, the same set of factors that laid to waste much of the banking system is now rippling through our CP and NCD markets. In these markets the providers of credit are mutual funds and corporate Treasuries. Our extensive interactions with many of these market participants over the last three years has left us convinced that they are even less capable than our banks of dealing with India’s premier league schemers.

So why did this happen…
At one level it is not hard to see what is happening in India. The same rickety market infrastructure of conflicted auditors and equally conflicted credit rating agencies which did not work in America 10-20 years ago is letting India down. No sane person – in India or elsewhere – can expect an auditor or a credit rating agency to collect its fees from the company but work in the interests of shareholders/bondholders.

What exacerbates the problem in India is the slowness of the legal system to deliver justice to lenders or shareholders who are shortchanged by the promoters/managements. So until we create a system in which the market does not have to depend on the numbers/ratings produced by conflicted parties, we will continue to see Indian lenders being taken the cleaners regardless of how good the NCLT process is. In fact the shorter the tenor of the debt instrument, the lower the relevance of the NCLT process. It is worth noting that America’s famed bankruptcy process could not help bond investors from the being cleaned out in the wake of Bear Stearns and Lehman going bust.

…and what can we do about it
As investors in India grapple with the issues rippling through the money market and the bond market, it is clear that the auditing and rating process needs an overhaul. Issuers should pay for their audits and their ratings but they should not be able to have any influence over their auditor or credit rater. Whilst the reflex reaction of regulators will be to say “we will appoint the auditor/rater”, a better way to do it would be to allocate auditors and raters using an online lottery system!

Leaving aside structural fixes and until such time when the legal system dispenses justice more swiftly, investors in India’s financial markets need to double up on their forensic accounting skills and steer clear of companies whose accounts don’t make sense. At Marcellus, every single analyst and fund manager has a Indian Chartered Accountancy and/or a Chartered Financial Analyst (AIMR, USA) qualification. Between us we have over six decades of experience of studying the accounts of most of India’s leading companies and our view is that 70% of listed entities in India have accounts which do not make sense. It is relatively easy for us to steer clear of these firms given the amount of diligence we bring to bear on them. However, if the entire financial system begins to steer clear of these firms, India’s capex and job creation machinery will freeze. It is in this context that we reiterate that who wins the forthcoming elections has little relevance either for the financial markets or for the economy.

If you want to read our other published material, please visit https://marcellus.in/blog/

Saurabh Mukherjea is the author of “The Unusual Billionaires” and “Coffee Can Investing: the Low Risk Route to Stupendous Wealth”.

Note: the above material is neither investment research, nor investment advice. Marcellus does not seek payment for or business from this email in any shape or form. Marcellus Investment Managers is regulated by the Securities and Exchange Board of India as a provider of Portfolio Management Services and as an Investment Advisor.

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