Sunday, April 10, 2016

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(  on the stock price crash and recovery of a Mumbai based infrastructure company Ashoka Buildcon( . 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(, 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

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