(Appears in Deccan Chronicle yesterday/today) Regulatory Risk- Generally ignored by all when markets are booming. For me, it is probably the most important factor before getting in to numbers)

Regulatory risk is something that we do not factor in to our investment analysis as a routine. Unless there is an immediate incident, our focus tends to stray away and we presume that things will not change or go on as usual.

 

At one level, every business or company has some regulatory risk or the other. I am not talking about regulatory risks that are common to all. For instance, change in income tax rates affects everyone uniformly and does not kill any industry. A dividend distribution tax imposition may make an impact on the investment universe and not on any one company.

 

There are some industries that are more vulnerable than others. These are industries that are typically seen to have some social or political impact. For example, pharmaceutical industries are vulnerable to domestic as well as global retaliatory regulations. DPCO can hurt some companies more than others. And politicians find it convenient to make headline statements like ‘make medicine affordable’. Similarly, Indian companies are known to take short cuts in getting approval for products. And when they start threatening global markets, there could be regulatory reaction from overseas in terms of bans and tariffs.

 

If we take the NBFCs or HFCs they are subject to a very high degree of regulatory risk. We are very cocooned in our thinking that nothing changes. We have seen sweeping changes that killed the leasing industry. RBI can kill the NBFCs by choking off the resources side to them. The banking and finance industry is generally playing with a timing mismatch of resources and applications. In this environment, any dramatic change can just kill. Micro finance companies were given a tough time by State governments impeding their recovery efforts. Banks lose money when there is politically motivated lending and write offs.

 

PSUs have always been high risk. However, investors seem to think that the government will let go of its manipulations and put money on them. It is a chance that government will abandon subsidies on various industries. We are seeing the slackening of price controls, but the government is not really letting go. We will not know how the government will react when the global Oil prices start going up. This kind of uncertainty is tagged permanently with some sectors that are politically sensitive and where company ownership is with the GOI. Such companies have heightened promoter as well as regulatory risk.

 

Often, companies or industries enjoy some temporary benefits in the form of some tax breaks (sales tax, income tax, export sops, Free Trade Zone sops) that give a kicker to earnings. Any investor would have to factor its impact and actually de-rate the valuation for such a stock. Any company or industry that gets a regulatory bonanza is skating on thin ice. When the tax breaks go off, the earnings come down to earth. I can think of the early day IT companies which had so many tax breaks. Even today, some of them do have some breaks. We have to look at any investment on its own merits. Similarly, we see imposition of anti-dumping duties on some commodities like steel. This can give a boost for some time and we have to get rational and assume that this will not last for long. Yes, some momentum traders will create a buzz and pump up the stocks.

 

GST is a big regulatory change that will impact some industries more than other. And the outcome will get known only after two years. Hopefully, companies that were disadvantaged because of unfair competition from the unorganized sector, may see their fortunes improving. The first two years will throw out a lot of surprising outcomes, so be prepared for a bumpy ride.

 

Regulatory risks hit companies like providers of Utilities (gas, electricity, energy, water etc) very hard. To encourage investment in this sector, the government may give some sops, which would be temporary in nature. Over time, they will become limited or fixed income securities as social concerns link with politics and prevent free market in these. Ideally, we should move to a situation where there is competition. Telecom is a good example of a “Utility” sector being relatively freed. It still has a regulator but the consumer is still given a choice. This means that there is more of free market in the industry rather than tight control.

 

Regulatory risks are a two-way thing. There is the businessman constantly lobbying to get favours for his business. And at the same time, there is a group of social activists who constantly scheme to reduce industry profits. And then there is a politician who is constantly trying to win votes by populist actions against industry in general. All of this impact investment decisions by taking away the predictability of earnings. Yes, whilst we may be able to forecast or foresee a trend with some degree of certainty, the profits are not so easy to predict when the regulatory risk is high. Regulators are capricious by nature and it is futile to use logic to anticipate the future. When you factor in the regulatory risk, it will help you to either reduce or increase your asset allocation to a given investment.

 

R Balakrishnan

One thought on “Investing- Relevance of Regulatory Risk

  1. Another sector which sees a blend of regulatory and counterparty risk is the Renewables. Although regulation promises Power Repurchase Agreements actual payments are often delayed by cash strapped counterparties.

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