Why did the valuations of the Adani Group firms become astronomically high? Were the firms’ share prices destined to decline by 85% after Hindenburg’s report? After the drop, have they attained their correct valuation?
Adani stocks rose sharply from February 28 to March 17, 2023, and have been range bound since then. Prior to that, they sank like a stone for a month post the release of the Hindenburg Report on January 24, 2023. These rapidly unfolding occurrences have created much confusion among analysts and investors. The Adani group has had to curtail several projects since the decline which is checking its rapid earlier growth.
Hindenburg has acknowledged short-selling the Adani stocks abroad. The key aspect of their Report is that the Adani group stocks were over-valued by around 85% through a variety of manipulations. That is, the actual value was one-seventh of the market valuation at the peak. Such overvaluation provides the short sellers the opportunity to make money. The Report led to a decline in confidence all around and to a rout in the Adani stocks.
The Adani group stocks went down by an average of about 65%, though some of their stocks declined by almost 85%. What has changed to cause a turnaround in the Adani stocks after February 27th and again after March 17th? Is this temporary or a reversal of the trend?
Production of the companies of the group or its profits has not seen any significant change in the last few months. It owns airports, ports, mines, infrastructure, etc., which will continue to generate profits. The problem is that due to the unduly high valuation of the shares of the group, the returns have been unduly low – 1% at a P/E ratio of 100. So, the changes in the valuations down and up are not based on changes in the real factors.
One can ask, why did the valuations of Adani group companies become astronomically high? Further, were the Adani group share prices destined to decline by 60 to 85%? After the drop, have they attained their correct valuation? One needs to understand how the prices of shares can be manipulated in the stock markets.
Factors Underlying Valuation
The high valuations were due to, a) the acquisition of assets at cheap prices which ensures higher profitability and a rapid rise in the group company’s share prices, b) leveraging the over-valued assets to raise large loans to acquire more assets and c) round tripping of own funds and others to invest in the group companies.
So, who was investing in the Adani company stocks and why could they not prevent the rout after January 24th? Also, have these investors found the money to engineer a sudden turnaround after February 28?
Managers of companies want as high a valuation as possible of their company shares. So that when they are used as collateral to get loans from banks they can obtain larger loans to expand the group faster. Management also raise money from investors – Indian as well as foreign – to expand operations. A high valuation makes the company look more robust and that helps in raising more funds. A rising stock market price also attracts more investment from retail investors and to a further rise in stock prices.
The managements have friendly stock brokers, fund managers, etc., who help prop up their stocks by advising retail investors to invest in them. Managements indirectly, through other related entities, also give funds to these intermediaries to buy their stocks. It cannot be done directly since that would come under scrutiny as related party transaction and market manipulation which is illegal.
The global financial architecture enables shadowy money to flow in from abroad via tax havens to buy shares. This is `round tripping’. These funds may either belong to the company’s owners or their associates. The associates could be corrupt who have taken funds out of the country – they could be politicians, bureaucrats, etc. Participatory notes were used for this purpose since they help hide the identity of the investor. Shell companies are widely used to round trip black funds both out of the country and back.
The black funds are sent out of the country via the process of `layering’ so that they cannot be traced easily by the government, even if it wants to find out. Usually trusted people and family members are put in charge of funds abroad so that they can help in ’round tripping’.
Business groups resort to cronyism to get favours from rulers who can manipulate policies in their favour. This helps obtain contracts, projects, permissions, etc. More importantly, they can acquire assets cheaply, like, mines. Running businesses say an airport, can be acquired cheaply if the government signals to the owners of the business that they should sell out. The rulers can coerce unwilling sellers through the use of official agencies – carry out income tax raids, initiate ED investigations, etc..
Cronyism ensures high profits for the favoured businesses. Rules can be bent without the fear of investigation by the authorities. If the share price rises unduly as signified by a high price-to-earnings (P/E) ratio, SEBI should investigate but may not do so or do it at a snail’s pace. At a P/E ratio of 200, the investor is getting a return of 0.5%. The chances that this ratio can rise further and yield a capital gain are low. Then why would someone invest further in this stock when even a bank fixed deposit can get the investor 7%? ED and Income tax department should smell a rat and investigate the flow of funds into the company.
Investors, Indian and foreign, are assured that the favoured businessman will continue to grow rapidly and will invest more in such a company even at a low current return. Cronyism implies the capacity to manage an opaque business environment. It ensures that even if the general business environment is weak, the favoured business will earn good profits.
Shorting of Adani Stocks
The pattern of ownership of Adani Enterprises Ltd. (ADEL), the flagship company of the group, is instructive. Promoters, Indian and foreign, hold 72.6%, foreign institutions hold 15.4%, others hold 4.4%, financial institutions have 4.3%, mutual funds have 1.2% and public 2.1%. Indian financial institutions and mutual funds cannot act against the promoter group. In brief, there is little floating stock in India which could be used to short the shares of the company. A large part of the holding of others and foreign institutions is also likely to be under the control of the promoters.
So, shorting could only be done abroad from out of the small amount of foreign institutional holding. Hindenburg reported that it used US-traded bonds and non-Indian derivative instruments for this purpose. It is speculated that some big foreign investors may have also been involved in shorting the Adani stocks. The name of George Soros has cropped up but no evidence is directly available of this.
The market cap of ADEL on January 24 was around Rs.3.9 lakh crore. If it is assumed that foreign holding of about 5% was what was shorted, it would mean Rs 20,000 crore. If the Adani group could pour this much money into the foreign bond market and derivatives, the short selling would not have succeeded. This is not a big sum of money for the Adani group which was able to engineer the subscription to its Rs.20,000 crore FPO within a day.
Derivatives require putting up margin money rather than the full value of the underlying asset being traded. So, large transactions are possible with a small amount of funds. So, Hindenburg did not require huge sums of money to short the stocks.
Adani’s group was taken by surprise since shorting is done in secrecy. Also, the group was possibly keeping the powder dry for the FPO and did not intervene quickly enough. This was an error of judgment. Once the rout started it could not be stopped as it spread to other Adani group companies. Since the markets are interconnected, synchronously the price of Adani shares dropped in the Indian markets also.
As the contagion spread, the requirement of cash to prevent further decline in the Adani stocks grew rapidly. 5% of the group’s Rs.19 lakh crore of market capitalisation required support of Rs.1 lakh crore and not just Rs.20,000 crore.
The problem was compounded by the loans taken against the pledging of shares. Since only 50% of the loan is granted against the pledged shares, as the price of shares dropped, either more shares needed to be pledged or the banks would have sold the shares in the market and the prices would have declined further. The alternative was for Adanis to prepay some of the loans which is what was done in early February using the liquidity that they still had.
Further, when the prices of Adani stocks declined, no bank would have come forward to lend more funds. Thus, the high leveraging of the Adani companies led to illiquidity/over-commitment in a declining market. Clearly, there were multiple pressures on the Adani group which squeezed their liquidity making the situation go out of their control.
The FPO fiasco
The FPO was fully subscribed on the last day, January 31, 2023. But, it was suddenly withdrawn on moral grounds the next day and the money was returned to those who had subscribed to it. Most likely, the reason was to release some liquidity for supporting the stock in the market.
The FPO was subscribed till the penultimate day and suddenly got fully subscribed. This illustrates the modus operandi used by the group for its rapid growth. Why would any serious investor invest in a stock by paying around Rs.3,200 (FPO price) when it was available that day at Rs.2,900 in the market? The retail investors avoided investing.
Who subscribed on the last day? Some super rich businessmen and foreign investors. Why did they do charity by investing at a loss? The first group due to pressure from those in power – an aspect of cronyism. The second source was very likely, related parties.
Why the sudden rise?
The sharp rise in the stocks of Adani group companies post February 28th implies that the group has obtained liquidity, not only through their own mobilisation but also by convincing others that the price would not fall further. For instance, GQG has invested Rs.15,000 crore. Here also could there be some deal or money given to them by some friendly party to invest? Of course, they are getting the assets cheap, at a fraction of the price they would have paid on January 24th.
Even after the steep decline, on March 8, the P/E ratio of ADEL was 112 and the dividend yield was 0.049%. Further, the ratio of profit to market capitalization (after it halved) of the Adani group was 2% – much less than that of the Bajaj group at 3.4% and the Jindal group at 10.8%. Given the unattractiveness of Adani shares, could it be that some powerful entities, who helped the growth of the empire, are acquiring a part of this empire at a lower valuation? Clearly, high finance is murky and clothed in secrecy. The truth hardly ever comes out.
The global banking crisis triggered by the collapse of SVB on March 10th has caused uncertainty in global and Indian markets. This has most likely impacted the rise in the Adani group stocks.
In brief, the Adani affair points to the dubious roles of cronyism and international financial architecture that enable the rich to manipulate their finances through round-tripping, black income generation, etc. The SC appointed committee is not mandated to look at these factors since it is tasked with investigating the role of regulatory agencies like SEBI. So, a JPC may be the only way that the wider questions could be addressed.
The article was first published on The Wire as Explained: Factors Behind Changes in Stock Prices of Adani Group Firms on March 22, 2023.
Read more by the author: https://www.impriindia.com/insights/global-capital-impact/
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