Two of Reserve Bank of India (RBI)’s “dirty dozen” corporate borrowers, which entered bankruptcy process under the National Company Law Tribunal (NCLT) are unlisted companies. The aggregate equity market capitalisation of the remaining 10 as of 20 April 2018 was a little over Rs3,000 crore. Many financial commentators have expressed surprise at the stock market valuations of these 10 companies. Who is buying these stocks? After all, the bankruptcy process will ensure that these stocks goes to zero.

 

Take the example of Alok Industries. The equity market cap of the company on 20 April 2018 was Rs307 crore at Rs3.14 per share. Last week, we learnt that Reliance Industries’ joint bid with JM Financial Asset Reconstruction Co was rejected by the creditors of Alok Industries. Which means that the company will be liquidated.

 

Now, one problem is that liquidation value is that it is almost always going to be far less than money owned to lenders. In the case of Alok Industries, media reports tell us that its liquidation value is estimated to be Rs4,200 crore while claims of lenders add up to more than Rs29,000 crore.

 

If Alok Industries is liquidated, it is certain that all the money will go to the lenders and they will still not get back most of their money. Under those circumstances, how can equity have any value?

 

I often cite such situations in my class by using an image, which I call “Canine Capital Structure.”

 

Canine Capital Structure

 

 

The dog in the end (the equity owner) will have nothing left over for him if all the food in the bucket is taken by dogs ahead of him in the queue.

 

The same logic applies the cases other than Alok. Whether those companies are liquidated or sold to a successful bidder, its almost certain that lenders will not recover all of their money. And if that is going to be the case, then equity can have no value. In liquidation cases, like those or Alok Industries, this is easy to visualize and understand this. Not so, however, if the company is sold. But as other commentators have pointed out it, it will not matter. Dilution will ensure that current stockholders in these businesses will lose almost everything.

 

Incidentally, this particular behaviour of the market participants is not unusual. Indeed, Benjamin Graham wrote about it in the third edition of this book, “Security Analysis”.

 

When a company has senior issues and common stock, and all its securities are of speculative calibre, the common sells too high. This is caused by the speculator’s frequently exclusive interest in common stocks and his preference for low-priced issues.

 

These overvaluations within a company are not so much in a class by themselves as they are vivid illustrations of the general tendency for speculators to buy regardless of price. When there is a senior issue available for comparison, the fact of overvaluation may often be established almost mathematically.

 

(Sanjay Bakshi is an investor and Adjunct Professor at Management Development Institute, Gurgaon.)