Beware of companies in low tax sectors-these may bite you

While reading about failure patterns of listed Indian companies, some themes caught my eye. One of them is that certain sectors had a high share of corporate mishaps. Whether it is the plantation investments Ponzi schemes of the 1990s, real estate boom of the early 2000s, some things never change. The below post tries to analyze and explain why

1. Agriculture-Tax free income hence cannot correlate tax payments to reported income. Also, there is usually indirect tax exemption as well, so possibility to raise 'accommodation bills without any other offsetting check/VAT chain'. Forensic audits ordered/pending for Kaveri Seeds and Camson Biotech, and the near insolvency of India's largest rose grower Karuturi networks, illustrate the point, that accounting issues in these sectors do exist. Other examples like Transgene Biotech also exist. 
2. Education-Like how Chinese shell companies were incorporated abroad (with local operating partnerships) to circumvent Chinese FDI restrictions, Indian companies resorted to agreements with trusts etc to make money from the traditionally non profit education sector. This did not end well for Educomp and Everonn, both of whom are facing distress..
3. Scrap Sales-This sector again operates on cash, hence for companies whose raw material/finished product uses scrap/recyling, there is a risk of siphoning out. While companies like Ganesha Ecosphere have thankfully not reported frauds so far, this risk exists.
4. Real Estate-Nearly all the players experience high leverage and low profits despite ever mounting prices. It seems promoters become rich(eg DLF) with outside interests(eg land) disguised via land ownerships/shell companies, while shareholders face negative returns
5. Jewellery-This industry is notorious for trust based/cash transactions. There were pan India strikes when PAN was introduced for high value transactions, and when excise was proposed-even at a much higher exemption threshold. Examples of frauds in this sector include Winsome Diamonds, while financial distressed firms include Gitanjali Gems

Bottomline-Triangulation of data is always useful and being subject to direct/indirect taxes(and the resultant audits/returns/investigation) helps outside investors to detect red flags, or exit somewhat in time. Of course, as I outlined in an earlier post, this exit may be premature http://specialsituationsindia.blogspot.in/2016/04/should-you-buy-on-dips-after-news-of.html but one is informed atleast

Beyond 'sin stocks'-companies whose business models depend on general bad health

While we all know about the classic 'sin stocks'(gambling, alcohol, tobacco, arms), not many would have thought of other stocks as benefiting from human vices/distress. However, if we look at what drives certain business models, we remove the blinkers and realize that certain stocks thrive on tragedy and on general economic distress.

1. Healthcare/Hospitals-Correcting lifestyle diseases caused due to pollution. This especially applies to speciality clinics
2. Pharma-Lifestyle diseases
3. Snacks-Ready to eat/unhealthy-yet this appeals to obese people and 'salt sugar fat' unholy trinity helps to ensure this. 
4. DG Set/Inverters-These are energy inefficient but as per Economic Survey estimate, quite prevalent due to poor grid power
5. Real Estate in city centres: These survive due to long commutes and poor public transit-hence people prefer to stay in cities rather than in suburbs like what happens abroad
6. Security Systems: Depend on penetration of crime. Zicom and Quickheal are examples of this
7. Mobile broadband: Depend to a large extent on underpenetration of wired broadband. Otherwise, the natural choice for homes and offices is wifi/fixed line
8. DTH: Depends on the cable operator not being present or not competing efficiently. However, this suffers from the tax arbitrage enjoyed by the (till now) unorganized LCO(Cable operator)
9. Gyms/Fitness: Lifestyle diseases and obesity lead people to these options rather than the (simpler) morning walk.
10. Skin cleansing: Companies like Kaya Clinics cite the increasing pollution and social pressure as reasons for people to take their treatments

I am not passing any judgement on these companies/sectors but am pointing out the scope of immense disruption here, if things change for the better.

Should you buy on dips after news of search and seizure/ income tax raid?

As a chartered accountant (one of my dual hats, the other being MBA), I look for places to apply the learnings in practical life especially investing. One of these includes the impact of regulatory/tax/accounting matters on the pricing of stocks.

Recently, I read an article(http://www.business-standard.com/article/pti-stories/ashoka-buildcon-shares-recovers-4-pc-116040700846_1.html)  on the stock price crash and recovery of a Mumbai based infrastructure company Ashoka Buildcon(https://www.screener.in/company/ASHOKA/consolidated/) . The company is linked to a jailed politician and there was a 'search and seizure' operation by the Indian Income tax authorities. Due to the seriousness of this(more on this below), Clause 36 of the listing agreement mandated the company to disclose this price sensitive information to avoid a false market in the shares, and therefore it revealed it to the exchange through a press release.

Under the Indian income tax law(http://legalsutra.com/1388/search-and-seizure-under-the-income-tax-act/), the provision to inspect the company's premises and take copies of documents is subject to administrative safeguards which need to stand the subsequent quasi judicial/judicial scrutiny. The relavant extract from the legalsutra article is below
The existence of reasonable belief is a condition precedent for a valid search and the section does not permit indiscriminate search and seizure. The belief must be honest and based on cogent material and not on anonymous calls and letters.[17]Materials which may be only remotely or distantly relevant, may not be sufficient to satisfy the test of relevance. ‘Reason to believe’ means that the officer has faith or accepts a fact to exist. It was laid down in the case of ITO v. Seth Lakshman Mewal Das[18] that belief must be genuine and not a mere pretense and has to be held in good faith and not a reason to suspect.

Presuming that the search is not to harass someone with political inclinations contrary to the ruling dispensation (unfortunately, the Indian tax authorities are not totally independent of the central government hence this is possible), the very fact of a search indicates something is fishy. However, the long judicial process of the courts means there could be 3-4 years before trial, and hence an investing chance in the interim.
 
My first impulse was to buy on dips reasoning that the charges of bribery, corruption and tax evasion are on par for the murky infra sector, and that the share price would revert to the mean once the market realizes the transitory nature of this news. This reasoning was generalized and not fundamental based, so I thought let me crunch some numbers to validate this hypothesis.

Hypothesis: Stocks recover to their earlier price within a reasonable time of the news(say 1yr), after an initial correction
Test: Compare the undisturbed price(Day-1) to Day 0(day of news), Day+7 and CMP as at Apr 8,2016.
Limitations: Does not factor in earnings impact or comparison versus sector and general nifty
Results:

Irrespective of the limitations, it is clear that buying on dips is NOT an open and shut case. In fact, income tax raids may be the unveiling of accounting fraud, or pave the way for out of court settlement and/or strained relationships with the tax authorities and delays in assessment closure.

In my view, only the possible situations would make it 'safe' to enter on dips, and as they can be assessed only with a detailed study of company and tax laws, this is not for the lay person.

• Notes to financial statements have clearly disclosed all pending tax litigation and the company's stand seems plausible/defensible  including reference to reputed external counsel
• The situation seems politically driven (eg-Ashoka Buildcon)
• The company has sufficient liquidity to make interim pre-appeal deposits to appeal tax orders
• Past record of such search and seizure incidents without consequential impact