Wednesday, Jan 15, 2020

By Apoorva Choubey and Ajay Ramanathan

MUMBAI - An active credit default swap market could help Indian companies and banks address the country's corporate debt problem, which has arisen due to rising bad debt and risk-aversion of lenders, believes Joel Litman, chief executive officer of Cambridge-based Valens Research. 

Currently, India's credit default swap market is not vibrant and lacks infrastructure as well as participation. 

Besides offering a hedge to debt investments, credit default swaps reduce the reliance of investors on credit rating agencies and allow better price discovery for debt instruments, Litman told Cogencis at the sidelines of the CFA Society India's 10th investment conference last week.

"Even in the case of the Lehman crisis, every CDS contract around the world paid off, and there were CDS contracts on top of CDS' if you will, and they also paid off," Litman said. "So there is proof that even in the worst scenario, CDS contracts are viable," he said.

Valens Research provides research and financial statements of over 8,000 corporates using Uniform Financial Accounting and Reporting Standards, which gives them an edge over those using the distorted and inefficient format of Generally Accepted Accounting Principles or International Financial Reporting Standards, which most companies use to report financials.

On an average, stocks which have been recommended as a "conviction long" by Valens Research have outperformed the S&P 500 by 11% annually. 

The company's clients include the top 200-250 asset managers across the world by way of corpus.

Until India is stuck with credit ratings agencies to rely on, the bad debt problem could continue because investors, even institutional ones, won't get a world view on the debt and will hence remain in the dark, he said.

A classic example of over-reliance on credit ratings agencies is the collapse of Infrastructure Leasing and Financial Services in September 2018, when investors waited for downgrades to pare holdings. 

The lack of a CDS market also means that the downside will be huge when the stress surfaces, even in the Indian equity market because it's closely linked to credit, Litman said.

While the bad debt problem is a concern, a repeat of the Asian financial crisis of 1997 is unlikely, he said.

"After that you've seen a regulatory clean up across most markets that maybe India still needs a bit more of," he said.

At the core of Litman and his team's research is the ideology that one cannot become a great equity investor unless one is a good credit analyst, which echoes the views of some marquee equity investors such as Benjamin Graham.

The credit profiles of the 400 biggest non-financial companies in India look quite good, based on financials under the uniform accounting methods, Litman said.

What's more, corporate earnings power in India has seen a 40% increase over the past 18-24 months, according to Valens Research.

The return on investment capital, under the uniform accounting method has risen to 7% from 5% a couple of years ago, he said.

To top it off, analysis under the uniform accounting standards show that the price-to-earnings multiple for top 400 non-financial companies in India is around 23 times, which is at an 11-year low.

In this context of strong corporate earnings power and credit profile, the relatively attractive valuations of Indian stocks make Litman bullish on Indian equities.

Litman also believes that investors shouldn't be bothered if high valuations of leading companies are accompanied by strong growth in earnings. This holds true for some blue-chip Indian stocks as well as the US' FAANG--Apple, Amazon, Netflix and Google--stocks, he said.

While buying stocks, one should also focus on the environmental, social and governance parameters too, he said.

However, Litman believes governance is more than just putting "silly" rules in place such as splitting of chief executive officer and chairman roles or having a specific number of independents on a company's board of directors.

Regulators should instead put rules in place that ensure that directors or top management of a company is paid less in base salary but instead hold hefty stock options, which will ensure that they want the company to do well, Litman said.

He is bullish on global growth and emerging markets as a segment, and believes that the ongoing geopolitical tensions aren't that big of a risk as they are limited and aren't as bad as those seen in the past 100 years. End

Edited by Arshad Hussain

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