Kitchen sinking: Threats and opportunities
Kitchen Sinking- The term was first used by the business media in the context of financial results announced by a British retail chain- Tesco. In the month of April 2015, Tesco announced its biggest ever pre-tax loss of GBP 6.4 bn. That’s a staggering number, especially for an established business that has been into operations for more than 100 years (founded in 1919). Just the year before, Tesco had reported a pre-tax profit of GBP 2.26 bn.
Why would Tesco do something like this in one go? It is pretty obvious that the loss would have accumulated over a period of many years. What was the need to declare such a massive piece of bad news in one-go! Didn’t they think about the shareholders and the trauma that the share price would undergo?
General elections were planned in the United Kingdom during the month of May 2015. Election campaigning was going on in full force during April. Media houses were busy with publishing the political chatter that people like to read and discuss- political agendas. Amidst all this, the management at Tesco decided to give the shocking news of its biggest loss ever. Their thought process was clear. People would talk about Tesco for a day or two, and then later the media attention would again go back towards the election.
No company would like negative news to be floating around for a very long time. The easiest way to do it is what Tesco did- kitchen sinking. Give all the bad news in one-go instead of a piece-meal approach. The crucial part here is timing the bad news. Do not give the media enough time to talk negatively about you! This is exactly what Tesco wanted!
Coming to this in the Indian context. How common or uncommon is kitchen sinking? Let me start by giving one of the recent examples. Kitchen sinking is not done by just businesses, but also by governments. Indian stock markets rallied significantly during the year 2017. January 2018 was a month of complete euphoria and optimism about the economy and the markets. Then came the budget day i.e. 1st February 2018. It was evident enough that stock markets are due for correction. During the budget speech for that year, the finance minister announced the introduction of long term capital gains tax at the rate of 10%. This was the first time in the history of Indian markets that LTCG would be applicable for equities. This news of LTCG created a complete havoc in the markets and markets started correcting immediately on the next day of the budget speech. Media houses were prompt in ascribing cause (LTCG introduction) to the effect (stock market correction). It is not difficult to note that the ‘cause and effect’ relationship here is not as clear as it may seem.
Let’s come ahead a bit i.e. 5th February 2018. On this day, the country received the news of India’s biggest wilful default made till date. It was Nirav Modi and his uncle Mehul Choksi. The amount of fraud that initially came out was Rs. 11000 crores. Stock markets had just begun to digest the news of LTCG introduction, and this news of Modi and Choksi defrauding Punjab National Bank was broken. Media was again prompt in ascribing cause to the effect!
Let’s understand the chronology again.
2017- Bull market year
January 2018- FIIs started booking profits. It was evident that the market would correct
1st Feb 2018- Govt grabbed the opportunity and announced introduction of LTCG
5th Feb 2018: Punjab National Bank grabbed the opportunity and announced its biggest loss ever
What the government did with the introduction of LTCG received a lot of media backlash. In that sense, it was not kitchen sinking; rather we can call it being opportunistic. The timing for the announcement of fraud by PNB was well planned. There was already enough panic among market participants regarding LTCG introduction and FII outflow. The news from PNB just added on to the pool of bad news.
This brings us to the question: why do businesses/ governments resort to such tactics? Well, the answer is simple. These tactics are used only to keep one’s head above the water. The loss of PNB had ballooned to an extent where kitchen sinking was the only alternative. Instead of announcing multiple small frauds, the management (maybe the government) took a call of giving out all the bad news at once. They were quick in utilising the hue and cry in the media about LTCG introduction as a 'scapegoat'. The month of February must certainly have been one of the best months for newspapers. The common investor was baffled enough by the volatility and newsflow. It was not easy to overcome the fear back then!
The announcement of such drastic bad-news-bombs is not good for the markets. It creates volatility to an extent where average traders are likely to lose their pants. However, it is the nature of financial markets. Panic and crash come rapidly. Optimism and rallies take longer. It can be easily said that such activities of kitchen sinking are here to stay with us till such time that financial markets exist.
What are the opportunities in all this? Well, volatility is perceived as risk in the modern portfolio theory. However, for someone who has been in the markets for a while, would agree that financial markets and volatility are first cousins. Treating volatility as risk is okay for traders, but for someone with a more stable and long term view, volatility is your biggest friend.
Let me talk sectorally now. The Indian economy is blessed to have a multitude of sectors to propel its growth. There is no big dependency on any one sector. Many of India’s smaller neighbours like Srilanka and Nepal are extensively dependent on tourism for their survival. Even in India's case, this was once true. However, it is an immense pleasure for me to write here that this land of snake charmers is now known for its various industries. IT and pharmaceuticals have been the country's pride in the last 20-30 years. This story of a new sector emerging in the market is an ongoing process. Now is the time for new age IT technology companies to spread their wings and conquer global market share (Byju’s is sponsoring the Fifa world cup!).
The earlier paragraph might sound like I am one of the biggest bulls in India. I am optimistic about the Indian economy in the coming decade, however, I am not naive enough to ignore opportunities like kitchen sinking. This tactic is more common in certain sectors. We are going to talk about 2 such sectors- Banking & NBFCs and infrastructure.
Infrastructure companies mainly operate on contractual basis. This requires them to realise revenue in their P&L as-and-when work gets completed. Such calculations are on a pro-rata basis and require an estimate of how much work is actually completed. Getting such an insider view of information is practically impossible for analysts like me. Trusting what the management is saying is the only option at many times. Promoters and management of some companies are more innovative in their accounting. They know how to play their cards well and release good news in the market during good times (needless to mention ‘release bad news during bad times’). Giving out bad news during a time when there is surplus liquidity in the market is very uncommon. For this reason, the results announced by infrastructure companies are cyclical in nature and their margins are extremely volatile. More often than not, I have observed that infra companies report good numbers when there is ample liquidity in the market and FIIs are on a buying spree. The vice-versa is also true. (Read my in-depth analysis on the practical challenges in analysing infra stocks here https://www.tequity.co.in/post/difficulties-in-analysing-infrastructure-companies )
Banking is another sector which moves in a cycle that closely resembles the overall economic cycle. In the Indian context, banking and financial services companies have a big weight on the benchmark indices. ‘Non-performing assets’ or ‘bad loans’ is crucial for banking & finance companies. While the market is generally ever optimistic about the growth of banking & finance companies, the aspect of growing and shrinking NPAs is considered intermittently. There are times when the market is extremely worried about NPAs, and then there are times when the excitement of a growing loan book is enough to cover NPA fears. Such investor behaviour leads to cyclicality in the results announced by banking companies. As mentioned in the case of infra companies, results announced by banks are also likely to be cyclical. There will be times when banks know what the market wants to hear- good results; and then there will be times when banks know that disclosing the right NPA numbers is the only option. Most likely, kitchen sinking would again be done when there is already a parallel negative news (like slowing economy, FIIs exiting, etc) floating in the market.
How exactly can you benefit from all this? Well, let me cut the long story short. Taking the management commentary at face value is a naive thing to do. This is especially true in sectors like banking & finance and infrastructure. These sectors are more prone to kitchen sinking. While we have discussed only finance companies and infra companies from the angle of kitchen sinking, many more sectors indulge in such tactics. However, the scale at which it is done in banking & infra companies, is the highest I've seen.
I’ll sum up by saying: the best way to make money in all this madness is to bet on companies that are (systemically important + are market leaders + are too big to fail). Needless to mention, the acquisition price of your holdings is an important aspect. For long term investors, who are not bothered about short term profits, waiting for the opportune moment (read kitchen sinking or opportunism) could be a good idea!
While kitchen sinking is a risk for the myopic traders, it is a good opportunity to accumulate fundamentally strong companies for someone with a reasonable holding period. When a particular company decides to break all hell loose on its shareholders, there are opportunities that arise to acquire market leaders in the same sector.
This post is not a recommendation to buy Punjab National Bank. PSU banks, despite their lucrative valuation, are facing the triple whammy of falling market share + higher NPAs + uncertain govt recapitalisation schedule. I do not hold any exposure in the banking space currently.