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 $

Competition

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.

Capture.PNG
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

Conclusion

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.