Quality Issues Can Dent The Valuation Premium

| About: iShares MSCI (INDA)

Summary

Some of the developments over the past few months have raised questions over the quality of management and independence of Board at major corporations.

Combined with macro concerns like inflation, etc., they have the potential to derail the ‘India story’ and negatively impact the quality premium enjoyed by the market.

With poor exits for private businesses and rich valuation already high on the list of investor worries, these developments are worth watching closely.

Indian market, iShares MSCI India Index (INDA), is underperforming other emerging markets, but from a valuation standpoint, the market continues to enjoy a premium, which the market has enjoyed for a while. This premium is attributed to various things, some macro factors like democracy, etc., but mostly related to the quality of management including better transparency, accountability and shareholder friendly policies compared to some of the other emerging or frontier markets, even though family-managed and majority family-owned businesses still form a significant chunk of the total pie. Lately, there have been a number of cases, which were largely ignored by the markets, but left unchecked; they can dent the credibility premium for the broader market.

Recently there have been reports that Infosys (NASDAQ:INFY), one of the biggest constituents of the index, stopped remaining installments of the severance payment promised to the former CFO, who moved to Olacabs (Private:OLAC), a competitor of Uber (Private:UBER) in India. Even though the amount in question was small, almost $2.6 million, the reason behind, i.e. unhappiness of company's founders, definitely seems concerning. The founders, who still own close to 12-13% of the share, are not on the Board and the development raises questions about the independence, quality and power of the Board of one of the biggest publicly listed entities in the country. If the Board is pulled up for such an issue, one can only imagine the Board's ability to undertake major strategic changes that are desperately needed for a business that is suffering from poor topline growth among other things.

Among the mid-caps, Welspun India, one of biggest textile manufacturers in the world, announced the loss of a contract with Target (NYSE:TGT), one of its major customers, over substitution of Egyptian cotton with non-Egyptian variety. The misrepresentation also led to Wal-Mart (NYSE:WMT) dropping the products. There have been some interesting cases related to international arbitration awards and poor follow through of the same by the Indian promoters. Most recently, Tata Sons, probably the most respected of large groups in India, have filed objections to the enforcement of $1. 17 billion LCIA (London Court of Arbitration) award in favor of NTT DoCoMo (NYSE:DCM). More than the failure of the telecom JV, the credibility loss may do more damage, significant considering the heavy reliance on foreign capital for the sector in general. Off course, the credibility and quality of management at public sector banks are well-covered and understood by the markets, as reflected in the trading valuation of the stocks as well, with most PSB names trading at a significant discount to book value.

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Image source: WEF competitiveness report 2016

In a Bull market, everything goes, but a growing credibility chasm can pose a challenge to the market's ability to attract capital as well as allowing exits during more muted times, besides destroying the valuation premium. Just yesterday, World Economic Forum came out with its annual report on global competitiveness, which showed India improving its relative position by sixteen spots, but as the chart above shows, corruption remains among the top concerns and obstacles for doing business, besides tax regulations. Complaints about poor exits avenues from startups and small-medium businesses have been there for a while and any further deterioration may not be good for an economy that relies heavily on foreign direct investment.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.