Opportunities for long-term investor

Last Updated: Sun, Mar 31, 2013 04:10 hrs

​There is no formula for adjusting valuations for political uncertainty or stability. Obviously, there is a premium for political stability and good governance but it is tough to quantify. Does political stability translate into higher earnings or into more stable earnings? There is a difference between 'higher' and 'more stable' and it's important for an investor.

Consider a sector like telecom services. Assuming stable policy and governance, telecom is a predictable business. A given company's revenues consist of Rs x per customer and a customer base of let's say, y million customers. In order to grow, the service provider must expand the customer base or raise the average revenue per user (ARPU) or ideally, both.

The service provider will have an idea of possible growth rates. Its investments in marketing, or in new network rollouts, or capacity expansions, will be made with those projections in mind. If the growth rates don't look exciting, or the investments cost too much, the operator will be cautious. For an investor, this is a highly predictable situation with stable trends - he knows network capacity, ARPU and user-base.

Now consider the Indian situation of endless policy flip-flops. Telecom companies have gone from being highly profitable to struggling as their cost structure has changed unpredictably and the levels of competition have also changed. Many service providers received licenses at unnaturally low spectrum costs. Then they lost those licenses on judicial reviews and the costs have since spiralled to unexpected levels as spectrum charges have been hiked massively.

For years, service providers paid the same spectrum rates even as the market grew ten-fold, from below 50 million subscribers to over 500 million. There was an 'over-expansion' driven by cheap excess capacity with over 900 million connections, many of which were inactive, or consisting of subscribers with multiple SIMs.

As spectrum costs rose, the connection count dropped to 660 million. Nobody has a clear picture of the future. Telecom companies are extremely reluctant to invest because they don't see great growth rates and they don't have faith in policy continuity.

In more cyclical business, the political element has even more influence. Construction for example, is driven by infrastructure projects. When projects stall, construction activity shrinks. Conversely if the regime clears projects fast, there can be a big boom in construction.

If you guessed right about policy changes in telecom and construction, there is money to be made. But the investor cannot make forecasts with any degree of certainty because policy keeps being changed in arbitrary fashion. So there have to be large error margins in projections.

If political instability automatically equated to poor policy, the error margins would be in one direction. The paradox is that a stable regime may be less proactive than an unstable one. Coalition politics have their own unusual dynamics.

In 1991-93, a minority government rushed through reforms. Again in 1999, a lame duck government pushed reform. In 2008, the UPA moved on issues of nuclear power and rapprochement with the US only after ditching the Left (it is a different matter that the nuclear power policy may be ill-conceived). In the recent past, the UPA had to jettison the Trinamul before it could formulate a sensible railway budget and make a move on induction of FDI in retail.

To put it another way, certain reforms will affect vested interests that have strong political representation. These things can only be carried out if the government is willing to risk instability, or the government is already unstable and doesn't expect to last. A government that hopes to stay in power may not be active - just look at the long periods of policy paralysis in the past ten years.

The period until the next General Elections and the establishment of a new government in the 16th Lok Sabha will be tense. There is a chance that the UPA will try to push on reforms in this last phase.

Reforms will push prices up. Political instability will push prices down. The moves could be very sudden and violent in both directions. Volumes are likely to remain concentrated in large caps where the derivatives segment allows for short positions. There may also be a flight into predictable defensive businesses such as FMCG, IT and pharma, where policy interference is less likely. The net trend is likely to be bearish if only because political uncertainty is guaranteed whereas the market has little faith in the ability to deliver on reforms. This could create an opportunity for the long-term investor if the market drops to levels of under-valuation.

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