When stock market investors evaluate a business, they usually look for risks from competition, risks from business cycles, risks from input cost escalation and so on. But in India, investors can pay dearly if they choose to ignore regulatory risk. The risk of a regulator suddenly putting a spoke in the wheel of a sector or company that’s sailing along, cannot be quantified. It is a subjective assessment.
Every business is subject to the laws of the land. But some industries are subject to separate regulators and regulations. Some industries are vulnerable to public opinions. Some industries are vulnerable to political aspirations or vote banks. It is companies in such sectors that one needs to particularly watch out for, as regulatory risks can appear out of the blue.
Out of the blue
Let me begin with some historical anecdotes. In the eighties, we had ‘bluechip’ stocks like Nirlon, Bombay Dyeing, DCL Polyester, Orkay, JK Synthetics, Century Enka etc which had a presence in the synthetic yarns business. They were creatures of the licensing era, and were believed to have high entry barriers as they had learnt to navigate a regulatory regime where installed capacity was controlled by the Industrial Licensing policies. In 1991, industrial licensing was removed. Reliance had just at the time prepared for a global scale facility. Today, Reliance dominates the industry while others are no longer the lions they were.
There were leasing companies which mushroomed in the 1980s. They took advantage of prevailing accounting standards and policies and showed inflated profits. They also were not considered an ‘industry’, so their funding from the banking system was limited to Rs.4 crore. They had to depend on public fixed deposits and innovative funding options.
Soon, the RBI tightened the screws. Accounting policies, taxation and regulations combined to make the entire business model unviable. Of the hundreds of companies, there are probably two or three survivors- Sundaram and Chola are two that come to mind- they knew the risks and stuck to their core competencies, without depending on accounting and taxation policies to sustain their profitability.
Regulations can play spoilsport at the company level too. Remember the sudden collapse in the share price of Indraprastha Gas? A single regulatory fiat restricting their selling price and the entire profit growth vanished. It took a couple of years plus a legal battle to get their right to pricing decisions back. Or the more recent ups and downs in the IRCTC stock because the Railway Ministry kept changing its mind on whether or not it could charge a convenience fee (its main revenue source) to passengers booking online tickets.
Today, we are seeing the heavy hand of RBI come down on NBFCs and Fintech companies as it tries to level the playing field and plug regulatory differences between them and mainstream banks. These were not the rules of the game when these entities flagged off their business or designed their business models, but when the ground rules change, this has a strong impact on the profitability of these sectors and some sectors may even face an existential crisis. Quasi banking is not liked by the regulator, if such entities operate outside the regulatory framework.
Types of regulatory risks
Let us walk through the regulatory risks that industries can face and then we shall look at its impact on our investment strategies.
The most visible sector is the BFSI sector. Here the State, the super-regulator, also owns some businesses. This is tricky because it is difficult to give preferential treatment to PSU as opposed to privately owned. We have many regulators in this space. RBI, SEBI, IRDAI, NHB etc. AMFI is not a regulatory body, though SEBI does sometimes use some AMFI guidelines as a prescription for mutual funds.
We have seen NPA recognition norms changing and impacting the bottom lines of housing finance companies and NBFCs. Capital adequacy norms are often used as regulatory tools to expand or contract credit as the regulator may desire. What this means is that we have to be aware that the prospects for a BFSI stock we own can change overnight due to a tweak in regulations. The price we pay for a stock from these sectors, has to factor in this risk. The RBI can similarly impact the size or scalability of the business itself. It can put caps and collars on certain asset classes against which loans are given. For instance- Loans Against Shares, Gold loans etc.
To prepare for this risk, it is useful to know how a BFSI company makes money and where the risk is concentrated. This will help you take a more reasonable view. While I do not say that you should be pessimistic, it is useful to be aware of the risk in our portfolio. Microfinance is a shining example of risk of government policies in industries that deal with the marginalized or low-income customers or those seen as a potential vote bank.
A State government suddenly says that the loan repayments can wait or puts a cap on the interest rate at which MFIs can lend or forces waiver of some loans. Since microfinance targets the base of the pyramid of our society, it is most vulnerable to political sanctions.
The green factor
Environmental controls and restrictions are a big factor when it comes to the manufacturing sector. We have seen the demise of once upon a time blue chip companies like South India Viscose (don’t think many of our readers will be aware of this). Similarly, many small paper companies like Vindhya Paper Mills etc were impacted by environmental concerns. There were so many dyestuff manufacturers which shut down due to pollution issues.
Regulatory risk is perhaps the highest when it comes to the environment. What is safe today can be declared unsafe tomorrow. We have seen so many companies in Europe shut down in the chemical segment. In agrochemicals, the sword of a product ban hangs over many a company’s revenue streams.
If an industry is seen as producing ‘essential’ goods, it becomes a guinea pig for price controls. The pharmaceutical Industry is subject to price controls on many products. This is an ever-changing list of essential medicines and inclusion or exclusion from the list can impact any company’s product mix and profit margins. Recently, price control was extended to medical devices like ‘stents’ and prices collapsed dramatically. In fact, a foreign company even withdrew a product.
For a foreign pharmaceutical company, the advent of ‘compulsory licensing’ has meant that the profits from a new product are lower than what they were in the past. Even a fairly elitist industry like airlines can be subject to price controls, with domestic airlines subject to fare caps and floors since Covid. It is a constant battle between public good and capitalism. Even when business does overcome and manage the political environment, there are some speed bumps the politicians end up inserting, from time to time.
Sugar companies have been at the receiving end of state and central regulatory fiats since they started. Their profitability is perhaps among the most unpredictable. Ethanol has given a new lease of life to them as have the power generation capabilities they built up. We still cannot say with certainty what this industry will look like in five years or ten years.
Subsidies and taxes
The recent imposition of a tax on abnormal profits on refineries is a classic example of regulatory risks cropping up, when the State smells ‘super normal’ profits. Any sector where government subsidies and price controls are in play, are highly vulnerable to sudden taxes. Our PSU oil refiners find themselves squeezed as the crude prices sky rocket and political compulsions force the government to keep pump prices in check.
The oil PSUs are bearing the loss as the government is not inclined to reduce the taxes. So many people who loaded on PSU stocks as dividend plays or privatization plays are disappointed at this turn of events. We have seen our fertilizer industry lie in the doldrums because of selling prices being fixed far below (sometimes one-tenth) of production costs with the Centre reimbursing the producers for the loss. The entire industry thus becomes dependent on the whims of the government in paying the subsidy on time or revising it when costs escalate.
With respect to taxes though, there are some risks that we cannot provide for. A change in the income tax rate or corporate tax rate impacts everyone and we cannot plan for it. For GST it is still early years and we may still see some shuffling. As GST collections rise and stabilize, we can expect more rationalistion in the GST regime. I will not worry too much about small changes here and there. One debate we can always have is whether change in accounting practices is a “regulatory” risk.
As far as I am concerned, it is a big NO. It only changes the way accounts are presented and not how much free cash flow a business throws up. Simply charging lower or higher deprecation does not change the bottom line in the real sense. Yes, if there is an income tax rate change of depreciation, it may impact taxation to some extent, but I do not factor it as a big risk.
Loss of monopoly
Sometimes regulatory risk to PSUs can come from their own owner seeking to end their monopoly or at least proposing it. We have seen pricing and auction policies on coal adversely impact Coal India. In 2014, when the regime change happened, there was a high level of expectation that the PSU sector will see extinction. Eight years since, despite much talk on strategic sales and privatization, we are yet to see any material progress on either. PSU banks have been consolidated but State ownership still remains. Air India is perhaps the only one we have seen that has changed ownership.
Sometimes, regulatory tightening by SEBI or other financial regulators can have specific implications for a company you invested in, without any generic sector implications. Issuance of preferential shares to promoters/others, warrants etc are unfair to the non-promoter shareholders, but have been the result of regulatory intervention to support the promoters/business interests. Now we are seeing the new Insolvency laws prefer ‘financial’ creditors and also take away the advantage of specific securities that a lender may have. Insolvency laws also can result in extinction of the entire share capital of a defaulting company (rightly so, I think), but sometimes investors still hang on or latch on hoping for some scrap value.
Then there are industries that face regulatory headwinds from every direction. Tobacco is a good example. Yes, there is only one dominant player. An industry that we love to hate. But the State cannot forgo the revenue that it rakes in from this industry. So what does the future hold? No one knows. Logic says revenue is more important to the State than the societal good. Maybe the tax revenues they bring are less than the negative financial implications of costs on the health sector.
However, it is like a Damocles sword hanging over the players’ head. You say, what about alcohol? Yes, the politicians love to talk against it and many politicians love to own it. Vice is generally recession proof. As an investor, before we plunge in, it is useful to understand the regulatory risks that impact the industry. It could be anything from indirect taxation to price control to product restrictions. This prepares us for the probability of a hit to the earnings that can potentially happen.
Overall though, we cannot avoid sectors with regulatory risks as that would dramatically shrink our investing universe! On the contrary. I like to keep an eye out for them and when they manifest, there is a sharp fall. Then I take a call. Is this regulatory change of a permanent nature? Or is it a knee jerk one and can be reversed? Or is it a part of a routine exercise that has already been factored in? I must also confess one thing. When the owner is the regulator, I tend to avoid investing in those companies.