Infrastructure .... is this the next scam to come out?

Infrastructure and IT were two sectors that were shunned by investors ten years ago primarily because the companies in these two sectors could easily fudge the numbers. Since then these two sectors have given the most fabulous returns to investors. Companies have grown at a terrific pace to attain unbelievably mammoth size, propelling growth all around. The Satyam fraud has opened a Pandora's box for the IT sector. Many more scams will get unearthed if the authorities were to look deeply.

Gossip in financial circles in Hyderabad suggests that the numbers in Maytas too may have been fudged by a huge margin. The reported turnover and net profit for the year ended March 2008 were Rs.18,739 million and Rs. 907 million. The grapevine has it that the actual numbers are far lower than this. We do not have a way to find out, but after Satyam, anything is possible. While here it may be a case of bogus turnover and profits, there is another scam of a different kind that may be lurking.

Most EPC contracts provide for a Mobilization Advance of 10-15%, which is paid at the time of the award of the contract. Look at the size of the contracts that are awarded these days - anywhere from a few hundred crores to a few thousand crores. The mobilization advance itself is a sizable amount. Many cash strapped contractors will now do anything to bid for new contracts at the lowest possible levels to win the contracts and lay their hands on the mobilization advance. By doing that they can defer their problems to a future point in time in the hope things will improve. This will be detrimental to the good quality players because they lose out on the opportunities.

Accounting irregularities are quite easy to manage for infrastructure companies. Cash transactions form a substantial part when compared with IT companies. Turnovers can easily be shown and so also profitability. Here again, our advice is to look for companies whose cash flow management has been superior to others. Look for companies that have low debt, normal receivables and a long history of integrity. None of these are difficult to check for the keen eye.

With Maytas too under close scrutiny, there is a good possibility of some scam being unearthed there too, which could play spoilsport for the entire sector. Unfortunately, there aren't any Infosys and TCS calibre companies here (other than L&T).

Vivek Bhargava

Q3 numbers .... bad numbers discounted ... good ones will be seen with suspicion ...

Other than a few companies, most groups and companies have always been looked at with suspicion. The numbers aren't going to be great for a lot of companies, especially in the manufacturing sector. The liquidity crunch during the last quarter would have impacted the business for most companies. The early birds generally come out with decent numbers. The problem is with the bad set of numbers that invariably get postponed to the last days of the month. The good ones will be seen with suspicion - from the point of view of both - genuineness and sustainability. The market may react positively to bad numbers if they are not as bad as expected!!

The Obama stimulus package is getting diluted with difference in views on how it should be structured. Economists do not favour tax cuts as there is no guarantee that these will result in creation of demand. They are more in favour of increased spending in infrastructure to meet the shortfall in consumer spending. The counter view to this has been that infrastructure spending will not help those who have lost jobs. All this is likely to delay the announcement as well as structure of the package. The uncertainty has led to a reversal of the rally in commodity prices.

Meanwhile, the problems for the banking sector are not over. Bank of America needed a substantial bailout package. Two more US Banks have failed last week. The auto industry will again run out of money in a month or so. Oil, after a brief spurt to $47 levels, has again tanked to $36 levels. The global scenario is expected to remain gloomy for most of this year. In India, Satyam episode has shaken the faith of investors. Elections are now a few months away. Once we enter a quiet period there, the Government's ability to support markets, through stimulus packages, will be doubtful.

On the positive side, inflation has come down. Interest rates have been brought down too. Liquidity has eased considerably. However we do not believe that this will help in a quick revival. The biggest uncertainty for the markets and the industry will be the elections. Whatever forecasts are available as of now, do not make a pretty picture. The two large parties seem to have little chance of getting more than 60% of the required majority on their own. So we are likely to have another khichri government (which may be weaker than the present one), and that can be a scary thing for the markets.

The best case scenario for the markets is to linger sideways. And the worst case scenario is testing the previous lows and possibly creating new lows. Given the weak global scenario, the second one is quite likely over the next three to four months.

Vivek Bhargava

Satyam fraud terminates the rally .... Hyderabad companies lose credibility ...

The markets, which seemed to be coasting along nicely, were brought to an abrupt and steep decline after Satyam news came out. The rally would have otherwise gone along for another week or two, but now there is no chance of it sustaining. Bear markets have this amazing feature of new developments that bring about abrupt and steep ends to bear market rallies. We had been talking about 10th January 2009 earlier and were even thinking that the rally might last a little longer than that, but it was not to be so.

The markets now have a fundamental problem that goes to the heart of valuations. Can we trust the earnings of companies, especially those that don't have a history beyond the previous bull market. Frauds are invetiable whenever the market foolishly (or sometimes through deliberate manipulation) values companies at ridiculous levels. The dotcom bubble was a fraud by the analyst / fund management community on the investors. Several corporates also were party to it. These are the hazards of investing in equity markets. Fortunately we have something called a BEAR MARKET which purges the system. We believe that is exactly what is going to happen over the next 12-24 months. The bear market may end in the next 8-10 months, but it will take much longer for investors to trust companies.

Hyderabad companies have taken another hit on their credibility. Other than a few companies, Andhra Pradesh has not produced comapnies that could grow over long periods of time to become large enterprises. There are likely to many more frauds / failures on the cards over the next four quarters as cash becomes tight and the business environment becomes tougher. Hyderabad companies will have to work that much harder to overcome this stigma.

The crash of the financial industry is to do with the greed of the financial intermediaries. It is not a coincidence that the whole financial system is crashing down together across the world. The biggest culprits are the governments and central banks that have tried to use monetary policies that provided short term fixes and postponed the problems by every few years. What is happening is no different now. Pushing interest rates down to below inflation levels has created a scenario of negative real rates of return driving investors to take risks. The financial intermediaries have pounced on this opportunity and played around with investor money. The demand always is always to reduce interest rates and make credit easily available. No one wants to talk about reduction in prices, which are the real cause of the problem. Instead of allowing things to cool off on their own, the governments across the world have only been dropping interest rates and providing higher and higher money supply, thereby sowing the seeds for a bigger problem every time. The situation is the same all over the world.

The markets will bottom out as the increase in liquidity starts showing effect in a year or two and then we will have another bull run by 2012!!

Vivek Bhargava

Satyam Fraud .. unbelivable ... but not entirely surprising ...

Here is an excerpt from our 15 December 2008 commentary. We never expected Satyam to be the first one on our list.

"Every bull market has its share of fraud companies. They somehow declare fantastic results and manage to give the most spectacular returns on the way up. Investors typically chase them on the downturn because they appear to be cheap. These are the ones that do most damage to our portfolios. Fortunately, the bear market filters them out and you have a clean lot at the end of the bear market. Give another four quarters and you will know the difference between the good and bad. Till then stick to companies that are old with proven track record and have size and liquidity. "

It's quite normal for frauds to come out when the market stops supplying companies with easy cash. While there we always doubted the integrity of Satyam, even we are shocked at Ramalinga Raju's disclosures about the fraud in Satyam. He says the cash was never there. What does this mean?

We don't know, but here is what might have been done.

Entries were being passed to show fictitious revenues. To show receipts against these bogus billings, fictitious bank accounts were opened in the 'books' of the Company. Entries must have been passed to show that money was received from bogus clients and parked in these fictitious bank accounts. To ensure that auditors don't question these things, several documents would have been forged - bank statements, documents required from autorised dealers as paperwork for overseas remittances. Regulators don't get wind of these things because they were not even involved. It's unlikely that anyone is relating the data in the Annual Report to the data with the Authorised Dealers.


Perfect paper work would ensure that the auditors don't get wind of all this. The directors have no way of knowing all this. After all they are there only at Board Meetings and have to rely on the information given to them. Even in their wildest dreams they could never have imagined such a big fraud was going on under their nose. We can't blame the Directors or senior management team because the financial matters are based on the documents made available to them. Someone who has gone to a fraud of this extent would easily have fudged all the papers to the Board as well. When the auditors also haven't got a whiff of this fraud, how can one expect directors (who are not party to this) to have any idea about this.

Old timers in the market will remember similar frauds - Fairgrowth Financial Services Limited, Bangalore, which had been issuing bogus Letters of Credit and had been forging all the related paperwork.

This fraud may have gone on for more than a decade. The 1998-2000 period was a fatastic period for these companies. By merely selling a small fraction of their stake they could raise plenty of cash to make the balance sheets healthy and growing. As IT industry started losing fancy, the currency dwindled and it became more and more difficult to cover up the fraud. Many companies would have done this of the last four years - in the name of infrastructure, mining, etc. Whenever the market starts valuing companies beyond reasonable fair value, it makes fraud a viable business proposition.

There are only two criteria that can separate the good companies from the bad:
- how much tax are they paying?
- how much dividend are they paying?

Any company that pays a good amount of tax and has a good payout ratio, especially when the stock markets are down, is definitely generating good cash flows and deserves a premium valuation.

SATYAM FRAUD HAS CHANGED THE WAY INVESTORS WILL LOOK AT COMPANIES.

INVESTORS WILL NOW ASSUME THEY ARE GUILTY UNLESS THEY ARE PROVEN NOT-GUILTY.

Vivek Bhargava

A good start to the new year .... commodities will lead the way ...

The markets are gaining momentum especially with the strong gains in commodity prices. We will look at some of these things in greater detail over the next week or two, but here are some of the reasons that WILL provide a good rally in commodity prices and therefore a good jump in all the related commodity stocks:

• stimulus packages, especially the Obama package, which is quite substantial in size at around $800 billion
• likely weakness of the US dollar, because of too much supply expectations
• an extremely sharp fall in just 6 months that erased 3-4 year of gains almost without a decent and protracted bounce back
• near zero returns from debt markets again driving investors to seek opportunities to increase their returns
• human urge to do something all the time to make money

So, with a weak dollar expectation and with virtually no returns and safety of capital from debt investments, coupled with low risk after a steep fall in commodity prices and the possbility of good returns investors WILL flock to commodities markets as the stimulus package raises positive expectations. The commodity bulls will not let go the potent combination of these factors to ensure a good pull back in prices of most commodities.

We had recommended the commodity theme on 29th November 2008 and had again reviewed it on 15h Dec 2008 saying that there is a lot of steam left in the commodity stocks. The substantial jump in commodity prices since the last week of December suggest that we will see a good rally in the commodity stocks over the next two months to get closer to their 200 day averages.

The rally will peak out as the rise in commodities at some stage starts raising questions about the revival of demand and talks of recession resume. It will still be a bear market rally, but the duration is now likely to be longer seeking a higher target than before. It will pay to TRADE in stocks that lost the most in October fall and have a long history and still have a long way to recovery. We still do not advise a buy and forget strategy at this point of time.

WISHING YOU ALL THE BEST FOR A HAPPY AND PROSPEROUS 2009. IT IS BOUND TO BE A LOT BETTER IF YOU PLAY IT SMARTER.

Vivek Bhargava