Steel Rally : Sleep with one eye open

This article appeared in the Grey Swan, a substack that I am contributor to

Metals are internationally priced commodities and India is a price-taker

There is no training, classroom or otherwise, that can prepare for trading the last third of a move, whether it’s the end of a bull market or the end of a bear market. – Paul Tudor Jones

Dear Readers, as we approach 2022, steel sector stocks are prominent in many of our portfolios. A question on the minds of many of us will be – where are we with regards to the Steel cycle?

The Grey Metal

The Industrial Revolution changed the world. Mankind broke free of its bonds to the soil, and began building giant structures like skyscrapers and bridges. The huge growth in population that followed also drove much growth in demand for steel. Steel is the grey metal that supports concrete, which is the foundation of our civilization. The services built on concrete are what we often call ‘growth in the economy’. Steel can be described in general terms as iron with most of the carbon removed, to make it tougher and more ductile.

The steel sector is very cyclical.

Steel demand follows industrial production and industrial production follows economic activity, as such, it is no surprise that many steel companies do well during economic expansions and real estate booms. The cycle of course is also dependent on seasonal changes as well as commodity movements.

FY 2021, A Golden Year for Steel Companies

2021 was a breakout year for the steel sector. Demand for commodities heated up as China controlled the virus and saw an expansion in industrial activity. Existing capacities of both steel and iron ore manufacturers struggled to keep up with the demand, a mismatch exacerbated by supply chain issues and increasing raw material costs.

The price of steel and iron ore skyrocketed, leading to supernormal realizations for steel and mineral companies that had benefited from the consolidation in the industry during the past few years. Naturally, the NIFTY METAL Index, half of whose constituents are Iron & Steel manufacturers, has massively outperformed the index.

Source: TradingView

Raw Materials for Steel Production: Is the ground shifting?

Steelmaking is the process of applying heat and a reducing agent to iron ore, in order to produce the metal, usually in bar or slab form. Steel can be produced either through an Electric arc furnace or through “basic oxygen” processes. These processes produce steel suitable for a range of purposes.

November saw a massive short buildup in steel stocks in spite of a spectacular set of results.

Indian steel demand had stopped accelerating in H2’21 when compared with April 21. Was this a case of selling the news?

Let’s examine what changed recently :

  • Iron ore requirement, which accounts for 15-20% of the cost of production of steel, is entirely met from domestic sources. Iron ore prices have halved in the last six months, owing partly to large scale production facilities coming online (Arcellor Mittal-Nippon Steel JV 20MT pellet plant is online, Tata Steel’s projected expansion of 6MT plant), due to the Chinese ’embargo’ on Australian iron ore.
  • Prices of Coking Coal, the other key input, continue to remain elevated, trading at $400USD/tonne (FOB), up about 4x from the FY20 lows of $100USD/tonne. Unlike Iron Ore, Coking coal is mostly imported by domestic steel players and prices have stayed firm globally.
  • Other inputs like Nickel, Molybdenum and Zinc has mimicked the rise in steel demand and are trading anywhere between 2x-4x since last year April.

The key question then is whether consumers of steel will be willing to continue buying at high prices when raw material prices fall, or will there be pressure on steel manufacturers to reduce prices.

Another ponderable is that given heavy consolidation in the steel industry through 2015-2020, a cartelized co-opetition dynamic may emerge – wherein the prominent players decide to sustain prices in rational competition. This dynamic further depends on the future policy of the Indian government on export caps and duties.

Changing nature of competition and demand…

Apart from raw materials, the demand dynamics of the industry seems to be altering:

  • Chinese demand is crashing and set to crash further as CY21 continues to unwind. More than being a key market for Indian Iron Ore exports, China is an international price setter for steel.
  • Indian demand has softened on the back of the monsoon season, and weak auto sales.
  • The only geographic spot where HRC steel prices have not softened is in the USMCA region, where HRC (hot-rolled coil) continues to trade at an eye-popping price of 2000USD/mt. In contrast, the ASEAN region trades at a benign 800-900USD/mt.
  • On the other hand, the steel bulls and OG steel industry captains believe that this cycle is different from those before (ergo, this time its different!) as demand is driven by a global shift to clean power and the associated demand for steel in clean power structures, instrumentation and tooling.

The competition is also shaping up in new ways:

  • Nippon Steel has restarted all the blast furnaces that were under banking last year
  • Arcelor Mittal and its Nippon Steel joint venture has been expanding their production in Western Hemisphere (Calvert is fully operational)
  • POSCO is profitably expanding on the back of competitive cost structure, undercutting Indian supply in South East Asian markets (Read, the blue line: Notice how the lone Korean player and the average Russian player has lower total cost than the average Indian player)

What does it mean for Indian players?

The Auto industry, one of the largest consumers of flat steel products – had its worst festive season in a decade as growth remains sluggish (~9% QoQ) and the post-covid recovery lagged expectations. Additionally, higher port inventory numbers and newer downstream facilities point to slowing revenues.

The dip in domestic steel production in China was earlier a piece of good news as it provided a ready market for Indian exporters to benefit from; but now with Chinese demand is also dipping, a major market is now turning unremunerative.

Exports have been slowing down this year. As per Joint Plant Committee Report, in the month of October 21, finished steel exports were down by 22% on a month over month basis.

On the plus side commentary from JSW, Tata Steel has been positive about maintaining EBIDTA going forward but as it goes with such things, take it with a pinch of salt.

It is important to consider the direction of future government policy. CREDAI, a confederation of real estate developers in India has raised alarm on rising steel prices and sought government intervention. Real Estate and Auto are key downstream industries and make a significant contribution to employment and GDP in India. Sustained high steel prices are not in their interest. Protecting their interests will weigh on future Government decisions.Subscribe

Actionable Insights

What is the likely direction of the steel rally? Are we early in a super-cycle? What must an investor in the grey metal do, as she is faced with conflicting evidence?

Luckily for steel, we have historical precedents in past boom-bust cycles. In 97–’98, the Asian financial crisis reduced global demand for steel products. Metal and mineral exporters such as Russia and Brazil turned to the US where industrial and construction activity was still thriving to dump their extra capacity.

Even though US demand of basic materials was strong, metal prices dropped 25% from this new flood of foreign supply, sending metal & mining stocks down by over 20%.

It is likely a similar scenario may play out with new POSCO and other large player capacities coming online and a change in the stance of Chinese policy, if it involves dumping of excess output into geographies like India.

Share prices move on the expectation of change in underlying fundamentals – positive or negative. If an investor in the steel sector has to profit going forward, an improvement in any or all of these three should be present: Revenue growth, Margin expansion or Sentiment improvement.

  • Revenue growth may not be a source of supply anymore. South-East Asian region has gone on a wait-and-watch mode, as China realigns its growth bearings. Indian steelmakers are undercut by other steelmakers as prices tumble. For instance, hot-rolled coil export offers to Vietnam (by Indian steelmakers) were undercut by Russian steel mills by about $50-55/tonne on a CFR (cost and freight) basis.
  • While domestic consumption revved up last year on the back of government-led CAPEX, the market doesn’t anticipate an acceleration in it.
  • Auto Industry, which is the main consumer of flat steel products, and was expected to show up earlier this year, is still posting sluggish growth.
  • As global supply chain issues get resolved and new global capacities come online, a cooling down of the exports market also implies little to no margin expansion till H2’FY23.
  • That leaves behind sentiments, as the sole driver of prices. Put in other words, any buyer here is expecting the momentum to continue. Evidence abounds that points to momentum investors steadily exiting the steel sectors.

So dear reader, do form your own inferences. While you do so, we leave you finally with the below summary of drivers.

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An adventure in Indian Pharma : A comprehensive guide for the new investor

Summary: Globally the Pharmaceutical and Life Sciences sector has shown resilience in the market meltdown. In India too the Pharma Index has broken past multi-year resistance and is poised to reach new highs. What is driving the sectoral bull run ? What are the unknowns and risks for an investor new to the sector ? I answer these questions and also give a framework for investing in Pharma companies.

Pharmaceuticals : Unique risks

The most important note for a new investor to Pharma is that the sector has unique characteristics:

  • Regulated : Like banking, Pharma is a heavily regulated industry with compliance requirements that are unique to each geography. However, regulations in Pharma are a greater source of risk than banking because the costs of non-compliance do not just include fines but involve enforcement actions by regulators like the USFDA and the UK based MHRA such as blanket bans on production facilities. These enforcement actions can create serious balance sheet risks by rating production facilities producing multiple approved drugs as non-compliant and putting all production and exports from the facilities indefinitely on hold.
  • Product to Market lifecycle : There is no sector where the length of time and costs involved to bring a New Chemical Entity (NCE) to actual market are as prohibitive as Pharma. The time can run into decades with average costs of up to $500 million. For contrast, defense equipment manufacturers also have decades of product development (Say for a fighter jet like the Rafale) but can rely on support of local governments and foreign markets. For pharmaceutical companies there are no guarantees, backstops, forward orders or support from authorities. Regulators can at any stage in the lengthy process derail an investment in a drug as unsuitable or unsafe and lead to a costly write off. This is particularly true of Indian companies with markets abroad. The marketplace may also change in the interim long period, or new competing therapies may become available. This causes financial risks in the form R&D sunk costs (which can be as much as 15% of a company’s topline), opportunity costs and also balance sheet risks.
  • Value Chain : Because most complex formulations require a prescription the pharma value chain is complicated by many stakeholders – such as groups of buyers, pharmacy chains, marketing field force, doctors and even chemical ingredient and intermediary manufacturers in China. Any consolidation in any section of the value chain can increase or decrease bargaining power and change the margins for the drug formulation manufacturer. Often the developer of the drug is not the manufacturer (where manufacturing is contract based or outsourced by the drug owner) and often the marketing company (which could be a different pharma company altogether) could be different from the company that produces or owns the drug. These factors introduce new and unknown risks. A drug that seemed viable at discovery may become economically unviable due to changes in the value chain.

Given the above unique characteristics that drive unique risks and their complex interactions, and in full honesty to my readers : Pharma is a sector best invested in via a sector specific mutual fund led by fund managers with deep experience in tracking the sector and their individual companies

Pharmaceuticals: Unique Rewards

Just as the sector has unique risks, it offers unique rewards to those direct investors who may choose to persevere recklessly to master its complexities.

Global play: Like IT and Auto parts, the Indian Pharma sector is a major exporter to developed countries (and underdeveloped continents as well). But unknown to many it is much more integrated into the global industry than IT and embedded much higher in the value chain, all the way to owning marketing of its own branded generics formulations (the point of maximum returns). Coupled with foreign exchange realizations, this gives it access to good margins and market size.

Barriers to Entry: Although most Indian Pharma companies do not produce IP protected formulations but produce generics versions of drugs that have come off patent, jumping through the many hoops of regulatory approvals, quality inspections and negotiating with the value chain partners gives them a strong barrier to entry. Competencies take years to build and so the barriers to entry in Pharmaceutical formulations are much higher than Pharmaceutical ingredients, which in turn is higher than those in specialty and bulk chemicals (such as those used in pesticides). To illustrate, if a producer of specialty chemicals chose to enter into pharma – it would need to meet myriad quality and regulatory requirements and find alliance partners in the target country

Non-cyclicity: Most listed companies in India have a cylical business, with peaks and troughs in demand through time. IT services, auto and believe it or not, financial services are cyclical as well. Pharma is one of the few spaces where you can park money without a fear of broader Industry seeing a lull in demand. This is especially true of chronic therapy portfolios like diabetes and heart disease. Non-cyclical industries in general command higher multiples and can prove to be rewarding long-term investments.

Pharmaceuticals: Every company is different

Naturally, pharma companies must reflect the specializations and unique complexities of the underlying diseases or conditions they try to address. While this is true of all sectors, in Pharma the variance between company profiles is much broader than sectors offering more commoditized products or services.

In general, companies vary by;

  • Product portfolio –
    • Value chain product – drug formulations, active pharma ingredients (APIs) or downstream chemical intermediaries
    • Complexity – drugs can be complex like injectables, radio pharmaceuticals and respiratory inhalers or simple like over-the-counter cough syrups or pain medication
    • Chronic or Acute – chronic therapies like diabetes and cardiovascular disease or acute like pain management and anti-infective drugs
  • Geographies served – India-focused, US-focused, EU-focused, Africa, Latin America, Japan – you name it, Indian companies are everywhere. The geographical strategies adopted by Indian companies may vary broadly. For example, small cap Marksans Pharma (NSE: MARKSANS) focuses entirely on US/UK/Australian geographies with no Indian presence; while similar sized companies like Jenburkt Pharma or RPG Life Sciences are focused on the domestic Indian markets. Companies like Caplin Point Laboratories (NSE: CAPLINPOINT) focus on the South American market for most of its revenues. The fortunes of these companies will naturally follow the idiosyncrasies of the particular focus geography (which is also why, larger companies that are geographically diversified often make safer investments).
  • Size of operations – in general big pharma is very different in scale, portfolio quality and quantity from small pharma companies. For example Big Pharma companies can afford to have an experimental Biologics portfolio and larger R&D outlays, in part because they are more certain of market access and success due to scale and experience. An example is Sun Pharma’s research wing – SPARC, which focuses on drug discovery. If successful, the drugs are developed and marketed by Sun Pharma (which keeps the profits and shares the royalties with SPARC).

Apart from the above, the pharma companies in India can be organized by tiers. Generally market cap is a good proxy for the quality of product portfolios in this industry.

Rule of Thumb: Large cap pharma companies can be reliably assumed to have more NDAs (new drug applications) filed and approved in India and abroad than Mid or Small cap companies. They will also have more complex and diversified portfolios.

If we were to arrange the companies into tiers, they would look as shown below –

Tier 1 companies – the Lamborghinis: Sun Pharma, Biocon, Lupin, Aurobindo Pharma, Dr Reddys Labs, Cipla

Tier 2 companies – the BMWs: Glenmark, Jubilant Life Sciences, Torrent Pharma, Abbott (Indian subsidiary), AstraZeneca (Indian subsidiary)

Tier 3 companies – the Hondas: Natco Pharma, Alembic Pharma, Shilpa Medicare, Caplin Point Labs

Tier 4 companies – the Fiats: Laurus Labs, Neuland Labs, Albert David, Jenburkt Pharma

Tier 5 companies – the Golfcarts: Lincoln Pharma, Anuh Pharma, Sakar Healthcare, Tyche Industries

You don’t want to ride this

What happened to Pharma these past few years ?

Debt piled up when the Pharma Index peaked in 2015

In the Trump Era, regulatory actions and Value Chain consolidation eroded the profitability of generics drugs in the USA. Competition among generic players also intensified and due to locked capital investments – balance sheets of big Indian pharma companies took a hit as debt from new investments piled up with no pay back in sight. Many of these investments had to be written off (e.g. recent Dr Reddys Q420 results) or sold to raise cash (e.g Jubilant contemplating sale of its portfolios and demerger of some entities).

The Pharma Index peaked in 2015 and has been in a downtrend ever since .. until recently

Due to decline in prices from value chain consolidation, competition and increased regulatory actions, Indian Pharma companies responded with changes to their strategy :

  • Focused away from regulated markets (US, EU) to unregulated / less regulated markets (South America, Africa, Russia and CIS states)
  • Increased their India portfolio and exposure
  • De-bottlenecking of existing capacities to save on operational costs
  • Rationalize portfolio of drugs to focus on scale and margin protection

Anticipating increased regulatory action and reducing margins, one strategy of Indian Pharma companies has been moving from basic generics formulations into advanced formulations (injectables, gelatin dosages, inhalers, complex drugs etc.). The other strategy has been to increase exposure to the domestic Indian market.

As recently as February 2020, Dr Reddy’s – which is listed on NYSE – bought Wockhardt’s South Asia plant and product portfolio. Andhra based Natco Pharma even began to explore getting into adjacent industries like agrochemicals to protect its margins.

Since the top in 2015, Indian Pharma companies have been on the defensive – then the Pandemic happened.

Change in Fortunes

The surge in global demand for the anti-malarial drug Hydroxychloroquine (better known as HCQ), Azithromycin and Paracetamol have put Indian Pharma companies in spotlight once again. This short term driver has also led to temporary regulatory forbearance from the USFDA for other, unrelated drug applications that were in pipeline.

Further, Value Chain disruptions from China, which is a major producer of bulk drugs/intermediaries and APIs – raw materials for Indian and global pharmaceutical formulations companies, will drive longer-term trends. Near-sourcing of drug production by US / EU regulated markets or a shift to alternatives like India and Vietnam will happen in the coming years.

However, in terms of scale, experience, sophistication and access to global markets – no country comes close to India. There is no competition.

Well poised – Indian companies have a 35.8% share of the US generics market

To summarize, the euphoria in the Pharma counters is not entirely speculative and is driven by the following factors:

Short term drivers –

  • Temporary regulatory forbearance from the USFDA
  • Demand for HCQ and Azithromycin
  • No impact of lockdowns as Pharma is an essential industry – the market likes certainty of earnings

Long term drivers –

  • Increased market share of downstream API, bulk drugs and generics formulation (shift from China)
  • Increased spending on Healthcare (hence higher multiples to Pharma companies)
  • Strategic shift: More optimized portfolios, costs and diversification of portfolios undertaken since 2015 put pharma companies on a good footing
  • Price erosion in simpler generics to continue, however opportunities in complex generics and new therapies such as Biologics may lead to higher possible returns

The Beginning Pharma Investor: A Framework

Now that we have listed out the drivers of the bull run, I define a framework to minimize yours risks of investing in Pharma companies.

FactorDescriptionMetrics (check for)
Strength of Balance SheetPharma is a capital intensive business and unique risks give rise to balance sheet riskAltman Z Score > 3
Capital AllocationDue to the constantly changing risk and reward landscape, capital allocation is a critical skill in pharma and also a barometer of management quality in picking the right opportunities and avoiding the pitfalls. ROCE or Return on Capital Employed can be studied through the cycle (from 2014 to 2020)3-year average ROCE > 10%
6-year average ROCE > 15%
Mutual Fund HoldingQuality pharma companies with growth potential will be held by foreign or domestic mutual funds Institutions hold > 5% of public shares
R&DQuality pharma companies will spend on R&D as they look to develop more complex APIs or formulations that lead to more sustained margins5-year average R&D as a % of sales > 3%
ValuationGiven the uncertain cashflows and active deal books in pharma, EV/EBIDTA informs us of the relative valuation or acquisition multiple for the pharma company better the P/E or other metricsEV/EBIDTA < 25
Portfolio QualityGreater chronic portfolio v/s acute leads to less competition and more sustained pricing power10% or more of sales is in Chronic drugs or APIs
Evaluate each company on this scorecard

Apart from the other quantitative metrics one should also evaluate qualitative metrics:

  • Trend of regulatory actions in the past-5 years: Have regulators frequently handed out bans and enforcement actions over quality of production processes and data? Has there been an improvement in compliance since 2015? Old habits die hard and this is an important barometer of a Quality Conscious management.
  • Diversification: In an uncertain industry, the more legs to stand on the higher the staying power of the company and safer your investment. Questions we must ask during the investment process –
    • How embedded is the company across the pharmaceutical value chain – APIs, contract research, marketing teams, foreign production facilities, alliances ?
    • How much do raw material risks impact the company’s profits ? A formulations company that produces its own active pharmaceutical ingredients has a unique cost and stability advantage in post-coronavirus world.
    • Others like Biocon or Dr Reddys Labs do well by focusing on formulations and procuring their raw materials. They have diversification benefits by geographical presence and value chain activities (such as Biocon’s contract research and manufacturing divisions in Syngene, or DRLs growing Rest of World and Indian portfolio)

Conclusion: In sum, pharmaceutical companies are the leaders of the current bear market rally and the rally may have just stretched its long legs. While investing in Pharma seems lucrative it is important to understand the risks and rewards and study the unique profile of each company to see how it is placed for growth in a changing world. For further discussion, happy to take your questions. Please leave a comment or DM me on twitter.

Liquidity is the vaccine: What different Markets tell us about the economic impact of the Coronavirus

Summary: There is speculation that the Coronavirus pandemic will lead to a global recession. Indeed the bearish price action in commodity and stock markets indicates that there is trouble ahead for the global economy.

The sharp sell-off should be seen as the markets adjusting to the exponential reality of a pandemic past its containment. The structure of modern asset markets is such that in the short to medium term, liquidity inflows and outflow drive asset prices. Fundamentals matter less in the short to medium term. In the long term fundamentals do cause mean reversion to economic reality but going by data from past flu pandemics such as H1N1 – a vaccine will likely be ready in the long-term or the pandemic will resolve.

The current correction in asset markets can therefore be seen as a pullback in the liquidity driven structural bull market that started in 2009 and not a bear market indicative of a looming global recession. The chain of quantitative easing announcements by central banks across the world (“the liquidity vaccine”) has in fact made higher stock valuations more viable in the long run.

Remember the H1N1 flu was declared a pandemic in 2009 – but the markets kept rallying due to a deluge of Central Bank Liquidity in late 2008.

Let us study reactions in different markets to see the role of liquidity –

Commodity Markets: Crashing commodity prices are one of the indicators of recession. Crude oil prices have crashed, other essential commodity prices such as Steel, Sugar and Soybean have also crashed. However these corrections are not entirely due to market forces but due to cartel price cuts in case of Oil and long unwinding.

Long unwinding happens when funds (such as hedge funds) that were net long on sugar futures, for instance, have liquidated their positions competitively to cause sugar prices to cascade down.

In case of rare supply constrained commodities like Arabica Coffee however, the coronavirus pandemic has actually led to a rise in its global price. This is because Funds were not long on arabica beans – so the prices were determined by demand and supply and not speculation.

Stock Markets: Stock Indexes hit historical lows with consecutive circuit breakers last seen only in 2008. However a lot of panic selling was triggered by the exponential spread of the virus in the US and should be seen as a “pricing in” of sudden bad news.

The markets are an amazing discounting machine but they are not perfect in their reading of the future (i.e semi-efficient). A viral pandemic that is now post containment in parts of Europe and threatens to cripple the world’s largest economy had therefore to be suddenly priced in with the news of deaths in NYC, the financial center of the world.

How did the markets react? A historic crash in the S&P due to sudden unwinding of ETF long positions and also due to the cascading effect of stop losses being triggered due to algorithmic selling. Again – Liquidity driven.

However after last week, the pricing in and discounting of most of the bad news should be behind us. In fact the CBOE Volatility Index or VIX is a reliable indicator of peak pessimism and a market bottom and the VIX was close to 2008 levels towards the end of last week. A bottom may be formed in the week ending 20 March. The highly leveraged banking and financial sector that led to the 2008 recession is also largely intact and the top US bank are reporting good numbers – ruling out a repeat of a systemic financial crisis.

Bond Markets: With the crashing stock markets, the flight to safe havens produced a sharp rise in the 20+ Year U.S. Treasury Bonds. However the spike did not last long and has since been selling off since the global stock market rally on Friday the 13th, supporting the idea that money is moving back into stock markets.

Indian Markets: In India – where there is no liquid alternative to US Treasuries (GSecs are not very liquid and are not traded by retail investors), the flight to safety therefore saw flight of money to marquee FMCG stocks like Nestle that trade at extremely high valuations. But like the US Treasuries – their prices corrected during the late pullback rally on Friday the 13th, as money moved back from safety into quality stocks available at historically low valuations. The crash has been largely driven by FPI and FII selling – foreign money withdrawing from Indian markets – however domestic investors have been net buyers in this crisis.

The Indian NIFTY Index is still 500 points from hitting the lows of demonetization of the rupee and may find support next week and make a bottom. Demonetization was a deflationary event but currently the Indian economy is better placed with inflationary global environment, historically low Oil prices (as a net crude importer) and a low dependence on global trade. In fact, Indian exports have a low base and can grow double digits just by gaining market share even if global trade grows in low single digits due to the coronavirus (“base effect”). These past few years have also seen structural reforms such as corporate tax and income tax cuts giving a boost to corporate earnings and domestic consumption.

The biggest risk for Indian Markets finding support at demonetization levels remains the Coronavirus spreading beyond containment – an incident that may not yet have been priced in.

Conclusion: Central bank fueled liquidity is the foundation of modern market structure. Central banks must use this “dry powder” of quantitative easing sparingly. Black swan events like the coronavirus force their hand to support the economy of G-8 nations that is not backed by real economic growth.

Unlike 2008, the banking and financial system is also largely intact ruling out a credit and systemic financial crisis, which is a larger existential threat to leveraged economies than a temporary GDP based slowdown caused by the coronavirus.

The modern economy, like the stock market is addicted to “easy money” and has received its flu-shot, perhaps the strongest since 2008. A sustained bear market triggered due to the coronavirus may therefore be ruled out.


Avanti Feeds: Is the story over?

This post is not BUY/SELL/HOLD advice but a statement of my personal views and opinion. I am invested in AF and my views are biased. Please consult a SEBI registered adviser.

Recency bias is powerful. I purchased Avanti Feeds back in July 2018, after what I thought was a significant correction in price of a mid cap stock that had been the darling of the bull run.

I was always interested in the shrimp business and had been tracking it for some time. I had missed out and my buying decision had to do with the fear of missing out again.

Time and the sobriety that comes with reflection proved some of my initial theories wrong-

  • Non-Cyclicity: I believed firmly that it was more of an FMCG business than a cyclical business. In this view I was alone. My thought was shrimp had become a food staple globally and with limited quality suppliers, and together with its non-seasonality – it could not be cyclical
  • Temporary not structural slowdown: An unusually long winter in the US and reversion to mean in soy prices seemed factors that would ease with time and the market was overreacting

As the price has since languished, I have had a lot of chance to question my assumptions. I am sharing some of my notes on the business and revised beliefs.

The significance of Farm Gate Prices

Cyclicity is introduced by Farm Gate prices: Farm Gate prices are the key incentive in this business. Shrimp farming in India is still discretionary and farmers weigh the risk / reward of seeding a shrimp harvest based on the prices they would get by selling the harvest to wholesalers or packagers. So what factors impact farm gate prices and make them cyclical?

  • Demand/supply – Like any raw material prices are determined by end user demand and available supply. Shrimp is cultivated everywhere from Ecuador to Saudi Arabia to Vietnam and consumed everywhere from China to EU to the USA.
  • Discretionary factors – Flooding, disease, import duties, raw material prices etc

In 2017 for instance, due to muted demand in the US and spike in raw material prices, the farm gate prices fell so low that farmers could not break even on their operating costs. The operating costs consist of the following –

  • Buying larvae – Shrimp larvae must be purchased
  • Feeds – Shrimp need a healthy and customized diet of protein and carbohydrates composed of soy meal, wheat and fish-meal. The prices fluctuate as soy meal is a volatile commodity and its price is not allowed to be hedged by feed suppliers, who must then pass on any increase in price. Shrimp also require different types of feed as per their stage of growth.
  • Electricity and antibiotics – Pumps and medicine to keep shrimp ponds oxygenated and healthy. Also refrigeration costs if applicable
  • Opportunity cost – growing some substitute crop

However farm gate prices have been slowly recovering and they look somewhat like this: Indian prices – 8 $, Indonesian – 12 $, Argentine/Equador – 6 $


In terms of quality and price, Argentinian and Equadorian shrimp are particularly competitive due to higher perceived quality and lower prices but there are caps on the metric tons of shrimp they can produce. Thailand used to be a major player but their shrimp culture has been suffering due to disease and their leadership has since been ceded to India and Vietnam.

China is not a major net exporter as it is a larger consumer of shrimp. Saudi Arabia and Mexico are the new players on the scene to watch out for. However in terms of scale – only Indonesia, Thailand and Vietnam offer real threats to Indian dominance in exports that is amplified due to limited local consumption (unlike South East Asia, where shrimp is a staple diet).

Where does Avanti Feeds fit into the Shrimp story?

Although there have been a lot many IPOs, Avanti Feeds remains a proxy to Indian shrimp story, which in turn depends on Farm Gate prices. Shrimp feed is highly customized and critical to the success of shrimp produce.

Shrimp feed therefore has qualities of a specialized commodity that must be customized to stage of shrimp growth and geographical needs.

Avanti has close to 48% market share in this space. Avanti is also established in other parts of the shrimp culture value chain – from hatcheries to processing.

It has been directionally focused on Shrimp processing and exports in the past few years in tie ups with large MNCs (Red Lobster/Thai Union) and with a focus to capture the quality trace-ability requirements of the EU and US such as SIMP better than its competitors.

Souce: Tijori Finance

However there are as many threats to AF as there are opportunities.

Medium term threats

  • MNCs like Cargill, CP, Godrej Agrovet etc. stall or erode Avanti’s market leadership in feed
  • Farm gate prices fail to become viable in 2020

Long term threats

  • Indian market fails to keep up with SE Asian growth in exports
  • Disease destroys Indian shrimp culture like EMS did to Thailand
  • US market stops expanding
  • US duties on shrimp are increased
  • EU ban on Indian shrimp
  • Chinese market captured by Vietnam

What could go right? (triggers for price)

  • Farm gate prices increase steadily through FY2020, leading to pricing power for feeds
  • Record monsoon cools of Soy prices like in 2017 (unlikely due to minimum support prices)
  • Packaging: Avanti Feeds captures 50% or more of Thai Union/Red Lobster packaging from India
  • Increased quality and scrutiny by importers puts other unorganized and smaller feed players plus processors out of business
  • Dollar, EUR furthers strengthens against INR
  • Ample cash with Avanti Feeds is deployed to increase capacities or extend credit to farmers hence protecting market share

Strengths and Advantages

  • ROIC highest in industry
  • Leadership in most Indian states on east coast (west coast needs improvement)
  • Excess cash to invest in capacities, fence out competition and cut prices if required
  • Latent pricing power in its customized feeds business, relationships with farmers, distributors and also in its wide geographical plus vertical integration
  • Management is nimble and a focused capital allocater – for instance they won’t pay dividends if they see a better use of the cash. They have deployed it strategically in the past and the same can be expect going forward


As long as farm gate prices are on the upswing and shrimp culture in India does not contract, Avanti will remain the ideal play on Indian aquaculture.

My Presentation on Edelweiss Financial Services – Bangalore Investor Group

I had the privilege to present on Edelweiss Financial Services today at the Bangalore Investor Group (BIG), a community that traces its origins to the ValuePickr forum.

The presentation includes valuations based on conservative and fair value scenarios (Slide 17). All disclaimers on Slide 2 apply.

Valuation on slide 27 is uploaded here:

Google spreadsheet

Valuation methodologies may vary and if you find an error in my numbers, please point it out or comment on the sheet.

Disclaimer: This is a hobby effort and not investment advice.

Data Science can’t crack the Stock Market

Data science is eating jobs, so why can’t algos (e.g. RenTech) “consistently” beat returns the same way as programs can beat high ELO rated players at chess?

The markets are more poker than chess, like life itself – where luck plays a defining role. Algos can break down factor-based investing and even use retail sentiment indicators (such as ICICI Direct’s RIBI) to make bets.

A data scientist will break LUCK as “stacked probabilities” in strategies backed by back-testing. This lies at the heart of algorithmic trading.

Let’s take the Put Call Ratio or PCR. PCR over 1 is seen as a bearish indicator but also as a contrarian indicator. Can an algorithm bake in “contrarianism”?

What happens to valuation defying momentum returns in the grip of panic like the crash in FAANG stocks?

What about Trump’s ever changing stance on trade wars?

Business is war. War by nature is asymmetric and unpredictable. In 1942, Germany’s surrender was thought to be around the corner due to its failure to secure Russian oil fields. Germany ground on till 1945, partly due to innovations in equipment and in using synthetic fuel (Fischer-Tropsch process).

Companies similarly are an ever-changing, non-ergodic process, with new inventions, new information and predicting their moves can be like predicting the weather on mars.

So you can take the emotion out of the markets but can you ever take the market out of emotions?

Nevertheless, those who sell shovels for this new gold rush to extract Alpha out of Data will get incredibly rich in the process.

Short note on Q3 Results of Housing Finance Companies. Will they stage a comeback in 2019?

Q3 results suggest a bottom is in place for Housing Finance cos. Are they set for a comeback?

With 2021 DHFL bonds at 24% YTM, market is pricing a default. It was not a lack of business that crashed the stock price of the leading mortgage provider (450+ to 120) but issues with governance & worries about raising funding and viability as a going concern.

Q3 results of its close private sector competitor – Indiabulls housing also show slowdown in disbursement, once again, not from a lack of demand for mortgage loans – but concerns over ALM.

Sentiment may be bad but the true measure of housing loan demand is from a government financing company that does not have to worry about its failure to raise funds. Q3 results of LIC Housing Finance show a spectacular increase in mortgage AUM and a maintained yoy financial margin of 19%.

Possible Bottom

Further the sell-down of mortgage portfolios to public banks and securitization have helped private players de-risk and raise funds for the post-RERA leg of growth via affordable housing. With the Cobrapost sting, all bad news is in public. Good news is being ignored. Further, there is no palpable distress on the liability side (CP market) as seen in earnings presentations. These signs indicate a possible bottom.

The real estate cycle is said to be of 11-13 years. The property bubble peaked in 2012 but the bottom may be closer than we imagine. Think of affordable housing like small cap and leading indicators that will rally way before home inventories in the main cities start getting back-filled in 2024. We are already in 2019.

At less than 2 forward price to book, the market seems to think mortgage disbursement will keep slowing into the future and loan yields will not rise as fast as bond yields. For the investor these misunderstandings and cyclically depressed valuations may spell opportunity.

Q3 Results by Avenue Supermarts. End of the uptrend?

Poor Avenue Supermarts (DMart) Q3 numbers.

In two months, stock was up from 1150 to 1650 in anticipation of good results and other news related euphoria like the new e-commerce policy that restricts foreign e-tailers. But now with just 2% PAT growth valuations seem unreasonable. I previously wrote how the stock was overpriced at IPO.

Even the salvaging 33% growth in topline is not sustainable. Discount stores can’t keep mushrooming at historical rates and same-store sales cannot grow indefinitely by giving deep discounts and squeezing suppliers.

So if not for growth or earnings, what are shareholders paying a forward PE of 78 for? Peter Lynch said he judges retailers by same-store growth and inventory turns.

Share holders should keep an eye out for trouble in DMart – especially piling of inventories and rising working capital that may signal that growing sales by discounting is not working well enough to catch up with valuations.

On Charts:

Stock has broken below 20-day SMA, center line of the Bollinger Band, which suggests the short term uptrend since November may be coming to an end. It will break under RSI center line on Monday, 14-January, beginning a down trend.

Long term opportunities in the Bandhan Bank and Gruh Finance merger

Bandhan Bank merging with Gruh in a share swap deal, is a marriage of east and west. Bandhan Bank is a microlending powerhouse based out of Bengal, while Gruh is a Gujarat based home lending NBFC with HDFC bank pedigree.

The marriage has caused market participants severe indigestion, primarily over valuation concerns. It is a marriage of convenience (Bandhan’s management seeks to dilute its ownership to be in compliance and HDFC seeks to raise capital) but there are more than tactical concerns. So what are the potential long-term benefits that are being ignored?

First, Bandhan, whose motto is “aapka bhala, sabki bhalai” (i.e. for your good and everyone else’s) is a very aggressive and profit-centric bank with a deceiving “not-for-profit” facade.

Bandhan has maintained industry beating NIMs of 10%+. In its recent quarterly results the treasury operations have also scaled and generated 63 times (!) YoY profit growth, in part due to treasury riding positive yield curve movements in AFS and HTM portfolio. This is clearly not a management that let’s an opportunity pass and Gruh’s acquisition will not necessarily prove to be EPS negative (Gruh has lower NIIs but higher ROE than Bandhan)

Second, Bandhan Bank has grown its CASA deposits within just 3 years to an astounding 41%, which is similar to a veteran bank like HDFC! This growing deposit base will help in the future to fund Gruh’s liabilities for long-tenor home lending. No more borrowing for Gruh at premium from debt markets and bank facilities. Gruh’s industry beating home loan underwriting standards will now have the benefit of the Bandhan’s low cost funding. The merged entity will enjoy peerless expertise in both unsecured (primarily Microfinance lending of Bandhan) and secured (collateralized home-lending) loans.

Third, geographical and cross-market synergies have immense potential. East India has a huge and untapped home lending market that could be accessed quickly using Gruh’s underwriting processes. Bandhan is deeply entrenched in this geography, while it has more than a toehold in the West of India (94 branches) and it could use Gruh’s branch network to cross-sell its micro-banking products.

The rural and semi-urban portfolio of the merged entity would be 71%. Bandhan Bank would then cross-sell deposits, microloans and home loans to a bottom of the pyramid clientele.

Additionally, Gruh has a significant wholesale book with its developer/builder lending portfolio. This is an area where a primarily retail lending bank like Bandhan can struggle to build capabilities as has been demonstrated by the recent IL&FS provisioning and write off (gross NPAs have surged YoY in the recent Q3 results). Bandhan will now have capabilities of a full-fledged bank across retail and wholesale portfolios.

Valuation Risks remain and have been noted and priced in by the market. At current market capitalization, Bandhan and Gruh finance have a combined market cap of about 70k crores, which is much more than the expected pro-forma AUM of the merged entity (50k crore). For comparison, Ujjivan and Equitas both currently trade at par or discount to its AUM.

But is it a fair comparison? Ujjivan and Equitas are small finance banks and Bandhan is a full-fledged bank without the restrictions placed on SFBs, which lends to lower costs of lending. Besides, based on past history and its presence in under-penetrated markets, the growth and profitability expectations from Bandhan should be much higher. The market is a voting machine in the short term but a weighing machine in the long term. So let us wait and watch.

Do Indian NBFCs really need new ALM regulations?

The recent crisis in the commercial paper market had put the regulatory spot light on NBFC’s borrow-short, lend-long strategy.

NBFCs effectively leveraged from the low interest CP markets to fund home lending with much longer tenors.

Due to the risk in this popular strategy, the Reserve Bank of India is creating new frameworks and reporting standards to monitor asset-liability mismatches in NBFCs. But can this case of over-regulation be avoided?

Why not simply tailor and extend the NSFR reporting requirement under BASEL III to NBFCs?

The Net Stable Funding Ratio requirement is defined as Available Stable Funding / Required Stable Funding > 1, i.e. the available stable funding sources at the NBFC should always be sufficient to cover said requirement. The stability of different funding sources (such as commercial paper) can then be weighted by the regulator to ensure an ideal mix.

NSFR therefore can be a simple metric to monitor stability of liquidity available to NBFCs. Good financial regulation is meant to be light yet effective. You can read more about the NSFR here:

NSFR implementation will also save NBFCs the costs of finally transitioning to a deposit taking Small Bank, under the RBI’s Small Bank License, which is the usual end goal for many NBFCs.

Just food for thought.

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