It is one day after Ramalinga Raju shocked the entire world with a five page document which has blowed the lid on perhaps the biggest corporate scam in India's history. It was absolutely shocking and staggering and all are trying to figure out over the last twenty-four hours what impact it could have across the board on many things like IT services, FII sentiment. It is not just one company which has perpetrated a fraud and could be much bigger.
Ruchir Sharma, Head-EM, Morgan Stanley Investment Management, expects some de-rating of Indian companies due to the Satyam fraud. “The Satyam fraud might dent India's image in the global scenario. India's premium on corporate governance versus other emerging markets might decline. However, the de-rating of Indian companies will be limited on account of the diversity of Indian markets. The market reaction post the Satyam fraud depicted the diversity of Indian markets. Everybody has learnt a lesson on quality of management, and corporate governance.”
There should be no price for a company with questionable earnings quality, he stated. “Management quality needs to be one of the key criteria for investors. Qualitative assessment of management is important for investors. The Satyam scam could drive many other companies with corporate governance issues to come clean. We see a lot of management restating fair value of companies.”
According to Sharma, investors have no idea of the fair value for Satyam. “The performance of Infosys versus Satyam yesterday outlined the new investment regime.”
Here is a verbatim transcript of the exclusive interview with Ruchir Sharma on CNBC-TV18. Also watch the accompanying video.
Q: What was your first impression when you saw that letter? What went through your mind?
A: I am here on a visit and nothing could make it more eventful. It was obviously like a shocker as far as I was concerned. But I think that the stock market action yesterday to me was really very interesting and was a defining day for the Indian stock market yesterday because if you looked at the relative performance differential between different stocks yesterday, it was a telling story that any stock with a whiff of corporate governance as an issue got hammered and some stocks in the Indian market which are known to be pretty high on their management quality and corporate governance standards outperformed significantly.
So I think it is a defining day, it was a very clear message to corporate India that this is what matters a lot and in the bull market of the past four-five years. I think that everyone had taken these things for granted and the standards have been relaxed way too much but the regime has changed and in this sort of an environment there is no way that any slight doubt is going to be tolerated by investors.
Q: Do you think that kind of reaction is warranted because we had an episode of this when the first technology bubble sort of burst and many scams got unearthed and we saw a huge derating on some of those momentum stocks? For the last four-five years corporate governance has been spoken about but has not been as centre stage for the stock market as it turned out to be yesterday. You’re calling this as a defining moment but do you think that kind of a reaction is warranted or justifiable?
A: I think so because quality of earnings is the key in this environment because earnings are declining across the world, across companies. So you want to have some certainty about the quality of earnings. The people and investors deserve to pay a premium for companies and earnings where they can trust especially because the entire market has been derated – all global equities have been derated. So when things are going cheap across the board, you might as well end up paying a relative premium for stocks where you can trust the quality of earnings versus other stocks where you don’t really know what the underlying earnings are. I think that this is justified and what happened yesterday is also a defining day because to me it at some level shows the diversity of the Indian market.
In any other emerging market if an event like this happened, the reaction would have been even more severe just because in many other key markets, whether it is Russia or Brazil, there are not more than about 20 odd stocks for investors to buy but in the Indian stock market, the diversity yesterday really showed as well. That there are many other stocks that you can still buy in the Indian stock market where the earnings quality is reasonably high.
Q: But are you saying that now more than ever if an investor is looking at an Indian basket of stocks and he has even a shadow of a doubt about the quality of earnings of a particular company, he would just give it the pass and look at something else?
A: That’s the lesson to be learnt from this episode because you probably know that even in the case of Satyam for a long period of time the research analysts would keep putting out these research reports and how its trading at 30-40% discount to Infosys – it has got to be cheap and they were a whole bunch of value investors trying to chase this stock over the past few weeks as well even as the issue was coming to the fore but the key takeaway from this is that for any stock or company where earnings quality is questionable, there is no price for it. There is no real valuation for it. So that’s the message from the market place which is pretty clear and this is an enduring message and not something which is a one-day event.
Q: It is interesting because you have been investing in India for a very long time and you have never owned that stock. Is it because of precisely these issues or something that you had, an inkling that all that you see is not quite fair that prevented you from buying this stock?
A: It is just having been around this block a while and having invested in emerging markets for 15 years now one lesson that we have learnt the hard way is to pay a lot attention to management quality. So it is a lesson we first learnt in the Asian crisis that topline growth is not always translated into bottomline growth but that was due to different reasons.
Corporate governance is one of the issues and that’s a lesson which has remained with us and it has come to fore repeatedly. What just happens to people is that their investment horizons tend to be short-term. So if some stock like offers instant appeal, they are wiling to overlook a lot of standards but as far as our investment philosophy is concerned and that’s the reason why we are still in business after having done this for a while is to pay a lot attention to investment criteria such as management quality.
One of the first rules of investing which I keep telling our portfolio managers to is that the first rule of investing is not to lose money. That’s the first rule and then you have got to keep out of such stocks where you think that the event one-day could be binary. So this whole thing about cracking performance etc, it has got to be much more long-term in nature and that’s what it shows up that anyone who was overweight this stock yesterday would have lost a significant deal of performance and which should have wiped out a lot of their long-term track records. So that’s the key message here that you got to have a long-term horizon and you got to be a lot of attention to manage quality as part of the investment philosophy.
Q: What specifically made you vary about this because management quality is a very broad kind of term, you have had several meetings with Ramalinga Raju and his team, yet you never took that call to buy into that company, was there a specific set of reported earnings or was it just the face of the promoter what made you vary that I am not buying into this company at all?
A: I hate to say this but management quality is a very touchy feel. It is one of those qualitative criteria where you interact with the management like one sort of criteria that we have is that unless we meet the management we don’t buy the stock. So even though we are not private equity investors, we are long only investors in the public space but we have to meet the management.
So when you meet the management it is for you to make a qualitative assessment that is what we are paid for, to make a qualitative assessment about what really the management quality is. For some reason we never got that comfort level with this company for the many years that we have been in India and in the IT space, we only own one or two stocks. So I think that is just got to do with that comfort level or sometimes we might go wrong with that qualitative assessment and there have been some instances in the 1990 where we went wrong with that especially.
But you learn this overtime, it is a completely qualitative game because as you know this company got many Corporate Governance Awards, Entrepreneur of the Year kind of awards etc. I think that is the other game which I find is pointless. It has played by all of us, played by the investors, by the media to give these awards etc but a lot of it has just done on some very plain vanilla metrics but true investing is a lot about meeting managements and making qualitative assessments about companies. I think that is just a quality assessment we had about this stock like we have about other stocks.
We literally have a black list with us of some companies which we will never invest in and this is across emerging markets and this is where institutional memory helps that if you have done this thing for fifteen-twenty years, you just know that there are some managements where the DNA does not change and there are some cases in India as such. These managements will always reemerge and be part of the next wave whether it is commodities in one boom or technology in another boom or got to do with some other things in the 90s in the capex boom. So it always keeps reemerging but the DNA remains the same. Once you don’t trust someone’s DNA, you just don’t believe the business model that they put into place.
Q: Do they ask you questions though – these promoters of large companies - because you are an influential investor, surely they must be wanting to have themselves in your books. For example, did Ramalinga Raju ever bring up that question with you that why have you never bought into Satyam?
A: Managements do bring this issue with us. I think that they bring it up less in bull markets because in bull markets there are a whole bunch of investors chasing the story but in bear markets they do. The last three-four years this issue was not brought up but I remember in 2000-2001 this issue had come up for us. We often end up getting into trouble also at times because of this like we have a very strict Chinese wall with the other parts of the firm and often these sort of questions come up that managements will complain that these people don’t even own our stock, why should we give you the business. So those kinds of pressures exist as far as this is concerned. Yes managements do bring this issue up but I would say much more in a bear market where they need investors rather than a bull market where everyone is chasing the same story.
Q: Where do you think is the end game for this saga? You don’t own Satyam but if you did, as an investor what would you think now that at Rs 40 I own the stock where is this story going to end up, is it going to zero, is somebody going to buy it out, what is your assessment?
A: I have no idea about what the fair value is because we have a bit of a pure investment philosophy maybe too purest which is that for a company with questionable fundamentals there is no price. So I don’t know what the fair value for this company is and particularly the risk here is that it is all about intellectual property rights (IPRs), there is no underlying asset apart from just the brand value and the intellectual property rights that they have. So there is no real underlying asset unlike some other infrastructure company etc where you can possibly offload that. So I don’t know about what fair value is.
Q: You won’t ascribe any value to the 50,000 employees?
A: I am sure there is value to that but I am saying that I don’t know how to assess that. That is my point which is because we just take this purest kind of view.
In terms of where the saga plays out, I think that let us not get a bit too much carried away by what happen in one day. Yes the market fell a lot but globally markets have started to weaken again after the year-end and early January rally. I think that is what causing some sort of issues. So the market sold off a lot yesterday. But as they say to me the more interesting story in the Indian stock market yesterday was the relative performance differential and I think that is here to stay in terms of companies with questionable corporate governance.
I think this is the message to many companies. Meeting some companies in India in the few days that I have been here and the thing is clear that if you are willing to sort out these balance sheet issues, no matter how much hit you take, you will end up getting a higher premium by the market.
Q: Yesterday interestingly Satyam collapsed 75% but Infosys was up. How do you think this will play out for some of the large companies both in terms accessing business and stock market performance?
A: As I said I think the rules of the games are going back to what they were in 2001-2002. At that point in time a lot more attention was paid to such factors - such as management quality, consistency of earnings, transparency so I think the game is going back to that.
Stock market function in what I call regimes; there are some rules which apply in certain periods of time and then the regime shifts and the rules which apply are different. So the regime of the past three-four years was about momentum, about being agnostic to valuations, about ideas, concepts and stories so that regime came to an end last year and we are still figuring out what the new regime is.
Why I say it’s a defining days that a day like yesterday tells you about what the regime is coming up to and it was already in the word. If you look at the relative performance of stock for the past few months you would see that the higher quality stocks were commanding a premium anyway within the sectors. But I think that what happened yesterday was like the defining day that – listen this is going to be major part of the new regime which is going to be in place for the next few months and maybe years.
Q: How will it work out in your eyes? Do you think within a sector there will be huge variation between PE multiples or valuations between ‘A’ type of stocks and ‘B’ type of stocks or do you think certain sectors where the quality of earnings is bit suspect like a lot of people do not believe real estate earnings in India. Do you think entire sectors might get derated because the visibility of cash flows and quality of earnings might be a bit suspect?
A: As I said that the process has already been in motion, it’s already happened so there are some sectors where you can take that sort of view but more than that within sectors the spreads will begin to widen out in terms of relative valuations in fact in the US that’s already happened. In the US the relative performance differential between stocks is currently at the highest level in post-war history which is that the high quality stocks are trading at a huge premium and the so called low quality distress stocks are trading at a massive discount. So that spread is already at a historical high and I think something similar is likely to happen or is already being happening but just been taken to a different level in India over the next few months.
Q: You have studied Indian companies for many years now. What do you think happens from here? Do you think people who are, probably not cooking their books but probably dressing up their earnings a little bit, do they now say I don’t want to walk this path – the scare is out in the open, I need to make disclosures over the next couple of quarters – clean up my books without sending a confessional like Ramalinga Raju? Do you expect companies to behave like that? Can you see more disclosures over the next couple of quarters?
A: The earnings results of this quarter will be possibly a watershed event for many of the companies and they are going to take that path because if they don’t take it, investors are just going to question it more and more. They are going to take the approach which is that they would want to be in this game, we want to be valued fairly. So, we might as well go out because today for example if a company in a troubled sector reports an earnings growth of 10-20% - no one believes that anyway. So one might as well go out there and say fairly as to what the true value of the company is – clean the slate and get on with it.
I don’t want to speak here about exactly but there are a couple of companies, large companies that I have spoken to in the past few days which are willing to take that approach. Like to say that even before this episode happened which is that they realized that these issues are there and they realized that there is no point playing this P&L game and one might as well sort of just present the assets the way they are. So this process as I said was already in motion and it is just that this is the final straw.
Q: You have actually spoken to management who are going to do this in the current quarter?
A: Managements like - they will not tell me that listen we were cooking our books. But I think managements who understand that this game of the last three-four years of targeting marketcap by trying to show a lot of profits, by having a very high level of receivables which are not translating into cash flow that game is up. I think that management get that - is my point.
So they are likely to see a lot of managements out there who are going to come out and in their own way restate it. As you said without anything as draconian as this because I do not think any other company in India at the largecap level is playing the game that this company did at least we hope not. But I think that management get this game that this business of showing of meeting some quarterly target which they had set sometime back and doing whatever it takes to meet that that game is up because analysts and investors aren’t going to believe those numbers anyway.
Q: What do you think this does to global investor sentiment because yesterday we did see some FII selling - might have been knee-jerk - but for people who are investing in various emerging markets like you do, does India go down a notch in their eyes?
A: Yes I think that some of that might happen because the Indian market historically - if you look at the past ten-fifteen years - has typically treated at about 20-25% premium to other emerging markets and that premium was a lot because India’s return on equity was about 30% higher on average compared to other emerging markets. That was the statement that the managements here can deliver superior earnings growth and I think some of that is obviously going to be questioned.
Having said that I don’t want to overreact to this because as I said that there are enough stocks in India - which is a very important point here - where the quality of earnings is pretty good and the market is very diverse. There is no other emerging market that I know of where you can still find roughly about 100 companies where the marketcap is still close to a billion dollars or above. There is no other emerging market like that.
So I think that is a very important point, there is enough diversity and even yesterday there were some largecap stocks which were up a bit or down marginally. So I think that is the relative strength of India, which always stands out and I think that it again was shown in the market yesterday.
Q: So you don’t see any significant derating of India as such on a secular basis over a period of time because of this?
A: There might be some but as I said I don’t see a material derating because the diversity still stands out as far as the stock market is concerned. There is no other market where I can find 100 stocks with a market cap of more than a billion. There is no emerging market like that.
Q: What happens to IT services as a sector in which you have some exposure – you own Infosys in your fund? Do you think that might be impacted where some of the clients sitting back in the US say I don’t know what kind of companies I am working with or is that an irrational fear?
A: I think that’s a bit of an irrational fear but the problem currently is very hard to disaggregate as to what's going on because as the IT companies themselves will tell you that demand is slowing extremely sharply and even yesterday as I said that when the Indian market fell yesterday by about 7% - the Chinese market yesterday, the H-shares listed in Hong Kong were down 5%. The US fell 3%, the Futures were already down. It is very hard these days to disaggregate as to how much of this is because of this event and how much due to any other event. But it is fair to say that there will be some derating of Indian companies because of this but the derating will be reasonable limited just because of the diversity of the market and same in the IT space as well that the stocks which went up yesterday were basically going up because there was this mood in the market that the business of Satyam will be transferred to some of these other companies. That’s my point about the diversity of this market.