Why CARE Ratings? June update!
Why CARE Ratings? June update!
A quick review of the rationale behind investment in CARE Ratings, performance update as of 28th June and more details from your smallcase!
Hi,
Hope you are doing well and enjoying the arrival of the monsoon.
In personal news, I am in Mumbai for few weeks, visiting my parents. If you are planning to fly anywhere in India, check the Covid guidelines of the state you are travelling to. For example, Maharashtra wants a -ve RT-PCR report before they let you board a flight - and yes they are serious about it. I discovered this at the airport and had to reschedule.
Coming to the highlights of the smallcase portfolio -
Performance Update - 28 Jun 2021
Your portfolio is doing well v/s market -
Note that for me to justify my existence, the portfolio should give enough outperformance over the benchmark (Nifty MultiCap Index) to compensate for -
My Fees - typically 1% of portfolio or less
Capital Gains Taxes - as compared to mutual funds, direct equity investment involves a tax of ~10%-15% on net gains in the portfolio.
I will continue to take calculated risks and hope to achieve considerable outperformance across market cycles.
Highlighting CARE Ratings -
About the business
Suppose you have a company and want to raise 100 crore as debt capital - you can do it via two broad options – borrowing from a bank or raising a corporate bond. A company with good prospects of repayment will get the loan at 10% and another that is perceived as risky will get it at 15%. You will have to convince investors/banks why your business is low risk and you deserve a loan at 10%. Now there are 2 ways to do it -
Without Ratings Agency - You go to lenders and say - “We are looking to get a loan at 10%, we think we are a low-risk business. You can analyze and assess this yourself”.
With Ratings Agency - “We have got a reputed credit rating agency (or CRA like Crisil, CARE, Fitch) to analyze your business in detail and give an independent rating. They understand our business, understand the industry, have interviewed our management, analysed our books, checked our accounting policies and then come up with an opinion. So we are looking for a loan at a 10% rate, and we think this is a fair ask because Crisil has given us a top AAA rating based on their analysis.”
The second approach (with rating agency) is more likely to succeed and is also the reason why you would be ready to pay money to an agency to rate your business.
By getting ratings from a third party agency, you get the following benefits -
Adds credibility to your pitch
The lender (bond investor or bank) will have to do ‘lesser’ analysis work as the report from the rating agency will give the broad analysis.
Ratings are used as a shortlisting criterion and will get you interest from more lenders.
Often, having the loan/bonds rated is a mandatory regulatory requirement.
The companies that give ratings are called credit rating agencies (CRAs). There are 5 major agencies with the leader being Crisil followed by CARE Ratings at #2 spot. You can think of CRAs as a business similar to Audit/Accounting firms, with the following similarities -
It’s all about having the best people and processes.
Reputation is very very important - once lost, it can break the business.
The top players take disproportionate market share - like big 4 in accounting and big 3 (Crisil, CARE and ICRA) in credit ratings. They also charge a higher price.
Business growth is linked to overall economic activity in the economy.
The value add is from 2 sources - 1) Trust from third party analysis and 2) Helping to meet regulatory requirements.
Scale is a competitive advantage - as now you can hire the best people, invest in the best technology v/s peers and have lower fixed cost as % of revenue.
The story of CARE Ratings
The story has 4 phases phases -
Phase 1 2014 to 2018 - All is good: - After the IPO, CARE was growing well (profit growth of 50% in 4 years), maintaining high margins and market share. The markets were loving the company valuing it at 35x earnings. But they say the true test of a business (and an investment portfolio) comes in times of crises.
Phase 2 - 2018 - ILFS Crisis Hits - In 2018, the Indian banking NBFC sector was hit by “ILFS crisis”. Essentially ILFS - an NBFC - had taken 90,000 crores worth of debt and defaulted on some repayments. The word realized that the ILFS management is not in a position to repay its debt, thereby risking the spread of contagion in the NBFC/Banking space. The government had to step in and do a bail-out. Government investigations also found fraud and started bankruptcy proceedings.
CARE had regularly provided ratings for ILFSS and just before the default - the last rating it had assigned was the highest rating of AAA - a rating reserved for blue-chip companies with a very strong ability to repay loans. The investors and lenders were incensed – “if something rated AAA by CARE can default so quickly, then do these ratings even add any value?” - the investors wondered. Not just ILFS, CARE was also seen giving high ratings for some other companies that defaulted. A big reputational damage had been done.
Phase 3 - 2018-2020 - Aftermath of reputation hit - from 2018 to 2020, the company's profit plunged by 50%, driven by both drop in revenue and a precipitous decline in margin. The company’s share price also took a massive hit dropping by ~75% from peak to trough. CARE found it very difficult to get new business from clients who had lost faith.
SEBI did an investigation and found that CARE had failed in its responsibility of properly evaluating credit risk and had overly relied on the claims of the management, rather than evaluating the facts independently. Barring Crisil (the market leader), two other rating agencies got investigated by Sebi and were penalised. ILFS’ auditor - Deloitte - the audit agency - also came under investigation but lapses on its part were not found to be not that serious.
After some denial, the company board had it enough and put the CEO of CARE on mandatory leave. New management and reorganisation were on the cards.
Phase 4 - 2020-2021 - New management sets things right - the new CEO was announced and over a period of 4 quarters the markets analysed his performance to see if he's actually walking the talk. The latest quarter results and conference call had some good updates for the investors -
Loss of market share had been arrested and a small uptick was seen.
Margin loss had been reversed with an uptick in the recent quarters, along with some promise to improve further.
The management is positioning CARE as a quality player and not a low-cost value player.
Not just top management, but many middle management leaders had also been replaced with new faces - which helps with addressing reputation damage.
Salary of employees was raised to get it in line with market and retain top talent.
Started investing in technology for low ticket SME loan ratings and other tasks that can be automated – results of this investment will be seen over the next few years.
Investing in new kinds of fee-based services that should generate 30 to 40% of the company's business in the next 3 to 4 years.
Why invest in CARE ?
The Simple Investing’s flagship - Value and Momentum Picks Smallcase - is a mix of up to 15 stocks split equally between value and momentum picks. CARE falls under the value bucket of the strategy.
We invested in the company in the second quarter of 2020. At that time the market was super pessimistic and CARE was showing up as a deep value investment - a company with 250 crore cash and earning 100 crores per year - available at 1,200 crore market cap. Even if CARE continued to lose market share, there was not much to lose from an investment at that price.
Like a typical value pick – the stock languished and underperformed the market for a long time before the market noticed it and bid the share up. It's up 87% from the purchase price.
There is still value in the stock and we continue to hold. CARE trades at 17x earnings v/s 55x for Crisil and 38x for ICRA - so yes it’s cheap on a relative basis. More importantly, it trades at a discount to my DCF-based estimate of fair value.
If you have any questions, do reach out or drop a comment on the substack page.