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Why should you not invest in Debt-free companies (#31)

Hello😄👋This week, we covered the Market snapshot, Reliance bond raise, and why investing in debt-free companies might not always be the best option followed by interesting visuals & curated reads.

1. Market snapshot

Markets had a good week, gaining 2.4%. Financials was the top gainer (up 4.7%) after months of under-performance. Followed by Energy/ Oil & Gas and Power & Utilities sectors, each up by 4%. 

Last week’s top gainers- Pharma and IT are down this week by 2% & 0.4%. 

Microcaps & small caps are still outperforming – gained 5.4% & 3.3% during the week vs 2.4% for large caps.

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2. Reliance bond raise & why investing in Debt-free companies is not always be a good option

Yesterday’s headline read “Reliance Industries rises after arm buys stake in Dunzo.”  Interesting that Reliance has thrown the gauntlet in the hyperlocal delivery segment, but was this the only factor driving Reliance? I guess not.

An equally interesting development from the house of Ambanis was the announcement of raising $4 Billion via forex bonds of 40 years at an amazingly low price of 2.8% to 3.75%.

For context, this is the largest & longest duration corporate bond issue in India and at the tightest spreads ever. Big deal!

A finance classic “Debt: The First 5,000 Years” by David Graeber carries this quote: The criminalization of debt, then, was the criminalization of the very basis of human society.

Well, debt is a severely criminalized word in the Fintwit community. Tweets like “here is a list of 10 debt-free companies” often work like magic for many investors who believe this is the elixir to high investment returns. In reality, zero debt companies are likely to underperform companies with manageable debt when the sector has growth tailwinds.

We are going to learn about the concept “Trading on Equity” to explain why Debt expands ROE for equity investors and why Reliance’s low-cost debt refinancing might be the reason for the rally. 

Note: If you only look to invest in Debt-free companies, take note:

Okay, you stayed! 

Is having debt always bad? No.

Understanding the exact use of borrowings is crucial:
Debt is bad if the use of borrowed money is not towards incremental Capex or entering new product segments but for paying dividends or salaries etc. which might not lead to any growth & expansion. One must understand the concept of “Trading on Equity”.

When the Return on Investment (ROI) on capital is higher than the borrowing cost, then financial leverage works in favor of equity shareholders and
Return on Equity (ROE) expands. A further interest of debt also helps companies in saving taxes.

However, this only works till the company reach an Optimal Capital Structure. 

So, how much debt is optimal? 

Truth is that there is no exact figure which can signify the optimal capital structure! It is subjective and “it depends” (sorry, I am an MBA). But lemme try:

The optimal debt level is the one at which even in the bad phase/down cycles in the business or the industry, the company is able to cope up with the interest payments comfortably.

Look at the chart below:

As per the chart, the maximum market value of the company is at level ‘a’ without any debt. With the increase in leverage (Debt/ Equity), the value increases to level ‘b’ and then begins to taper off. Any further leverage beyond this puts the company at risk of bankruptcy and increases the cost of capital (WACC) higher than incremental returns.

PS: Research indicates that stocks tend to outperform during the early phase of deleveraging (we compiled a list of companies reducing debt here) or when nearing completion of Capex (check here).

What’s happening at Reliance?

Reliance Industries has big Capex plans in three future growth areas – gigafactories for Green Hydrogen (~ INR 75,000 cr), bidding for 5G spectrum, and omnichannel retail.
In this case, Reliance simply wants to pay off an old loan by borrowing a new one. The reason is rather straightforward: This loan has a lower interest rate than the old one. So, raising this bond will help the company to reduce the interest cost and increase profitability. The cost is significantly lower than the Banking MCLR rate – a rate below which NO loan can be given by Indian Banks (currently 7%+ for Indian banks).

Folks, we are living in weird times when the interest rate across most developed countries is tending to absolute zero. So this foreign bond should come as no surprise.

In India, the cost of borrowing has been on a decline. In the last 7 years, the share of loans given by banks attracting interest less than 10%, has risen from 10% to 75%!

Bottom line: Looking for debt-free companies may not be the most optimal investment option out there.

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3. Chart of the week: Global Auto OEM market cap

The global automotive industry was valued at $1 Tn just before the pandemic & is now valued 3x at $3 Tn, with a decline in the number of cars sold.

What explains this?

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4. Curated good reads & company updates:

4.1 Understanding the core business of Banking with case studies on RBL Bank and Yes Bank by Nishant Maheshwari. Follow on reading: An interesting article on what is a bad bank & the current situation.

4.2 Check out our comprehensive thread on the electric vehicle component industry, initiatives taken & interesting companies to look at. 

4.3 If you like to analyze FII inflows and outflow activities, this post by Eden Capital has good sector-wise data points.

Company updates:

4.4 Ujjivan SFB released results- Good growth in loan book & retail deposits and disbursements up by 120% YoY. Shows depositor confidence despite recent stress and changes in management. We are discussing this on Multipie here.

4.5 Thermax Ltd received an order of Rs 545crs from Indian power public sector company to set up 2 units in UP. Capital Goods companies are seeing a big revival.

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5. Select highlights from Multipie:

  • If you are looking to shortlist Mutual Funds, this can be a good place to start. Take a glance at the top 25 most held Mutual Funds on Multipie.
  • Mihir shares a rich quality resource list to get better at decision making while investing. Hop on here and bookmark these.
  • Did you know about the latest news feature on Multipie? You can now stay updated about the trends and updates on your stocks and watchlist. This feature is currently on the web and will be live soon on the app!
  • Most of us might have had this dilemma. Mutual Funds Vs PPF: Which Is the Better Investment Instrument? Preeti describes the difference between the two with some good reasoning here.

See you next week. Until then, happy investing!

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