The Four Sources of Fragility
India is in the midst of an unprecedented health crisis with the second wave of Covid-19 infections and yet our stock market continues to do well. As the real and the financial economy diverge, it has never been more important to understand what can go wrong with a business in case the rubber band snaps.
There are three primary sources of business fragility in a health crisis one for each of the income statement, cash flow statement and balance sheet.
First, high fixed costs as a percentage of sales makes a company vulnerable to an economic shutdown. This could be in the form of mandatory production, a high wage bill, rentals or any expense that cannot be done away with if sales fall.
Second, high inventories and receivables weakens a business’ ability to convert earnings into cash flows. Inventories could expire and delays or defaults from customers can quickly create a liquidity crisis for a firm.
Third, high debt/equity and low interest coverage ratios makes a firm susceptible to a sudden drop in sales. And we have to acknowledge that banks and NBFCs are levered and not immune to this – except that in the case of a lender, the vulnerability comes from a surge of bad loans.
There is also a fourth source of fragility for shareholders – pledged shares. A sudden drop in stock prices can trigger margin calls and forced selling of pledged shares if promoters are unable to meet their collateral commitments.
It is important to stress test portfolios using this fragility framework when the going is good. Indian investors would be served well by following Warren Buffett’s sage advice: “Predicting the rain doesn’t count; building arks does”.
Executive Director - Waterfield Advisors
3 年Well made points, Nalin Moniz. First two points could be inherent characteristics of some businesses (For e.g. Capital Goods). Apart from cash conversion cycle (which you highlighted), cash management (FCF or FFO/Net Debt, FCF or FFO/Net Interest) and liquidity & capital buffers are also important. To judge business fragility, I often look at myself as a Credit Analyst rather than Equity Analyst - focus on "return of capital" (that is, the liability side of B/S & Cash Flow statement) rather than "return on capital" (that is the asset side of B/S & Income statement).
Thanks Nalin, as ever so thoughtful.
Nalin, as an Asset Manager, I am sure you are already looking into all these fragility questions and more, on behalf of your clients, prior to investing in companies, and on an ongoing basis. The questions I have are - do you have insight into promoters pledged shares ? - how does the layman/common investor get access to this same info? - is it really material if the promoters share is less than 10% of the company equity?
CXO Career Coach & Leadership Coach, Author & Keynote Speaker
3 年The first 3 sources are linked to the real economy and are not easy to remove or mitigate in a short period of a few weeks or months. The fourth source is much more worrisome since it is related to the financial world, where sentiment is known to be very fickle and meltdowns happen very rapidly. We have seen this in 2008-09 and on a few other occasions. What is your recommendation on the ark that needs to be built today to save ourselves from the tsunami of a financial meltdown?