By: Punam Sharma
Thank you for the box of chocolates you sent me. I’m regularly walking and doing my morning exercise and practicing restraint as far as chocolates go. I know you’ll say that I’m currently in great health, but good habits will ensure that this continues.
I’ve been reading the news lately when it struck me that I must write to you. I remember the concerns you and your clients went through during the financial crisis of 2008 with the sudden rise in borrowing costs and companies showing high stress on their ability to repay money they had borrowed. I recall how my friends rushed in to exit their FMPs even at the cost of high exit loads. It was hilarious seeing the blood rush from their faces whenever they held up the newspaper. The reason I brought this up is because even though today doesn’t feel like those times of stress, I see some signs around me that suggest that you must exercise caution with respect to whom you lend money to in your business. In the news and from my friends running businesses and corporations, I hear that there has been a substantial slow down in business activity. I read a news piece where Crisil had stated that annual default rate in corporate India has touched a 10 year high and is much higher than the stressful year of 2008-09. Now that is alarming! Being a keen follower of financial and economic news it seems to me that given the global and local conditions our RBI will not be able to display the policy aggression it showed in 2008-09. All these conditions suggest that it is far more prudent to take on interest rate risk which means relying that interest rates may not rise anymore given economic conditions rather than taking on credit risk while lending which means relying on heavily indebted borrowers to keep their promises
Let me tell you what you should watch out for when you lend to a business. These are a few principles that have helped me make prudent investment decisions in my life. Watch out for companies that show weak financials because this impacts their ability to service their borrowings.
1. Watch their debt/ EBDITA ratio: It will tell you which companies can repay comfortably from their business operations and which companies are likely to show stress. Companies that have taken on debt that is greater than 5 times their yearly operating earnings (EBDITA), I would consider them as posing high risk in their ability to honor their commitments to their borrowers.
2. Also watch for Debt/Equity ratios of companies since companies showing a high ratio are susceptible to stumble when the business cycle turns adverse. I look at companies where this ratio stands greater than 1.25 and have serious questions on their ability to weather adverse economic conditions. Always remember Ben Graham’s definition of investment being an operation which on thorough analysis promises safety of principal and an adequate return; note his emphasis on thorough analysis, note his emphasis on safety of principal and note his emphasis on adequate return not high return. All investment that don’t subscribe to this tenet must be described as speculative he says.
3. Watch out for companies that belong to promoters or groups that are financially weak.
My experience over many business cycles shows that though a standalone business may show strength, a weak parentage is likely to deteriorate their credit standing in the future. This seems to be a corporate version of the phrase “It runs in the family”. So watch out for parents when you lend; don’t look at the children alone.
4. Watch out for companies having direct or indirect exposure to real estate.
Real estate and people who have lent money against real estate remain exposed to volatile prices and uncertainty of demand. In case the real estate market experiences a meaningful decline, companies exposed to this sector will experience stress on servicing debt.
I see around me people taking on credit related risk without making an attempt to understand the workings of the companies to which they lend. I suggest you be extremely cautious of taking on such risks and if you do, make sure you’re adequately paid to take on risk. Most investors take on a Heads I win a little, Tails I lose a lot stance in such matters. If you ever encounter someone offering you a higher return for funds borrowed, chances are he’s taking higher business risk or his business doesn’t have the market standing to command funds cheap. This is the time to take on interest rate risk. I would rather rely on interest rates moving down rather than relying on the kindness of my borrowers in case adversity strikes.
You may say that all these things may not occur and you may not be wrong on that one. However as you know, in finance as in life if something hasn’t occurred so far, it doesn’t mean that it will never occur as the events of 2008 have made amply clear. As a man of finance you must display prudent investment habits; it’s far more profitable to side step risk than try to jump over it. I may never fall on ill health, but I must continue my exercise regime to protect against it.