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Trust Mr Market, Not The Credit Rating

Mr Market may be stupid but he is a lot smarter than credit rating agencies

The Irony of It All

Isn't it ironical? First, the typical Indian investor lost his shirt in the bull market of 1992 by buying stocks
at exorbitantly high prices. Then he lost his shirt again in the bull market of 1994 by buying new issues at
prices which were ten times or more than their current prices. Then he said to himself, "I've had enough of
stocks! Stocks are only for gamblers and speculators, not for me. From now on I'll invest my money only
in safe debt instruments like secured debentures and fixed deposits. There's this company, CRB Capital
Markets, which is offering very attractive returns (including upfront incentives). The company also enjoys
the patronage of the RBI. It's going to start a bank, you know. It's fixed deposits enjoy an investment
grade credit rating. So, that's where I'm going to put my money, so that I can sleep at night."

Well, you know what's happened to our friend? He lost his shirt again! And there are many more like him,
who have lost, or will lose, their shirts in the debt market just like they lost their shirts in the equity
market. You know why? Because they trusted the wrong people. They placed their faith in their brokers
or the merchant bankers touting unremarkable merchandise or, in the case of debt instruments, they
trusted the credit rating agencies.

Mr Market is Stupid . . .

The fact that Indian stockmarkets are quite inefficient means that frequently there are opportunities for the
thinking investor to act intelligently. There are times when the market values ACC at Rs 10,000 per share
(as happened in 1992) and then there are times when the market values the same company at Rs 1,100 per
share (as is happening now). Clearly, as far as stocks are concerned, Mr. Market is often stupid. However,
in the last couple of years, I have noticed that even though Mr Market may be frequently stupid as far as
stocks are concerned, he is not so stupid as far as fixed income securities such as bonds, debentures and
fixed deposits are concerned. In fact, I think often he is a lot smarter than the credit rating agencies. Here's
why:

. . . But a Lot Smarter than Credit Rating Agencies

It is the job of any credit rating agency to evaluate the risk of default in a credit instrument. The
assessment of this risk involves studying the economics of the borrower's business, the past record of it's
profitability, it's capital structure, the terms of the credit instrument being evaluated, the future outlook of
the industry and the company, the management factors, and many other factors. Once a rating is assigned
to a bond or a fixed deposit, it is subject to change. Therefore, if the industry prospects turn for the worse,
the rating agency might downgrade the bond or fixed deposit. Conversely, a bond or a fixed deposit may
be up-graded because of some favourable developments which, in the opinion of the rating agency, reduce
the probability of a default.

The decisions to assign ratings, as well as decisions to downgrade or upgrade credit instruments are not
taken by individuals but by committees. Often, I find that when due to some unfavourable development,
the probability of default has increased and a downgrading is warranted, the credit rating agency takes its
own sweet time in downgrading the instrument. But, Mr Market who does not need to take any decisions
in a committee environment, acts and quickly downgrades the stock of the company.

In other words, while the credit rating agency takes its time in downgrading a credit instrument, the

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borrower's stock price often crashes well before the instrument is downgraded. Because the company is
expected to be in financial trouble, the stockmarket reacts much more quickly by downgrading its stock
than credit rating agencies act by downgrading it's debentures or fixed deposits.

For example, recently ICRA downgraded the debentures issued by DCL Polyesters Ltd, DCM Ltd, JCT
Electronics Ltd, Montari Industries Ltd, Paam Pharmaceuticals Ltd, Parasrampuria Synthetics, SIEL Ltd,
The Waterbase Ltd and Western India Sugar and Industries Ltd. But, if you study the stock prices of these
companies, you will find that they crashed much before their debentures were downgraded.

ICRA also recently downgraded the fixed deposits issued by Bhuwalka Steel Industries Limited, DCM
Shriram Industries Limited and Samtel Color Ltd. Again, if you study the stock prices of these companies,
you will find that they crashed much before the debentures were downgraded.

The evidence from ICRA, as well as from CRISIL and CARE indicates that in general, the stock price is a
far better predictor of financial distress than credit ratings. I also found that information about financial
distress commonly available to the brokers in the inter-corporate deposit market is a lot more timely and
reliable than credit ratings because many borrowers become defaulters in the ICD market long before their
debt is downgraded by the credit rating agencies.

Something is obviously very wrong here. Either the credit rating agencies are not paying attention to what
the stockmarket is telling them, or they are not bothering to find out what is already known to the ICD
market or they are wasting their time in committee rooms debating whether or not to downgrade a credit
instrument.

But, What's an Investor to Do?

All of the above does not mean that credit ratings are thoroughly useless. What it does mean is that apart
from the credit rating and other things (see my article in Strategic Commentary) you should pay careful
attention to the stock price of companies in which you own debentures or fixed deposits. Often you will
find that the market is telling you something what the credit rating agency will tell you much later. So
much later, in fact, that it may be too late for you to do anything about it. Using information contained in
stock prices, however, there's a lot you can do to avoid losses. An example will explain what I mean.

Look for a Cushion

Assume the market price of a company's stock is Rs 150 per share. The company has 1 crore shares
outstanding, implying a total equity value of Rs 150 crores. Assume the company also has outstanding,
18% bonds (it's only debt) amounting to Rs 50 crores. Therefore market value of all the assets of the
company is Rs 200 crores. Assume further that this company's recent earnings before depreciation,
interest and taxes were Rs 36 crores and it's annual interest expense is Rs 9 crores. This translates into an
interest coverage ratio of 4 which is high enough for the debt of this company to be assigned an
investment grade credit rating.

Note that the safety of the bondholder of this company comes from two financial characteristics. The first
one, of course, is the interest-coverage ratio of 4 which indicates that even if this company's earnings
before interest, depreciation and taxes were to drop by 75%, it would still be able to service its debt. The
second criteria, however, is also critical but too often ignored. This is the stock equity cushion. Note that
the market value of all the assets of this company is Rs 200 crores while its debt is only Rs 50 crores. The
excess of Rs 150 crores is the stock equity cushion.

To see why the presence of ample stock equity cushion is critical, think of a situation where you have to
pledge your gold watch with a pawnbroker in order to raise a loan. The pawnbroker will make sure that
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the amount of the loan he gives you is a lot less than market value of your watch. If your watch is worth,
say, Rs 50,000, he is unlikely to give you a loan over Rs 25,000. The same principle works in corporate
debt. When you buy or hold the debentures or fixed deposits of a company you should insist that the
market value of its equity is a lot more than it's total debt. That is, you should insist on a large equity
cushion.

If a large equity cushion is not available but the interest-coverage ratio is satisfactory, then (1) either this
company's stock is highly undervalued in which case you should avoid buying or holding its debt and buy
the stock instead; or (2) more likely the stock is not undervalued and the fall in the stock price should be
taken as a warning that all is not well with this company. Therefore, if a large equity cushion is not there,
then regardless of the reason, it would be prudent to avoid buying or holding such a company's debt.

In the case of our example suppose the market price of the company's shares crash to Rs 30 each
indicating a total equity valuation of Rs 30 crores against a debt of Rs 50 crores. Now the company owes
much more than the total value of its shares. Either this company's stock is undervalued. Or, more likely,
the company's earnings are likely to plunge and the stock price is discounting that possibility.

Conclusion

There are a large number of Indian companies whose debenture holders and fixed deposits holders own
claims, the total value of which is a lot less than the total market value of the shares of such companies.
This indicates the absence of adequate stock equity cushion and should be taken as a warning by their
creditors. Mr Market is telling them something important. Those who ignore his warnings may end up
losing their shirts.

Note

This article is submitted by Sanjay Bakshi who is the Chief Executive Officer of a New Delhi based
company called Corporate Investment Research Private Limited.

© Sanjay Bakshi. 1997.

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