The storm over a recent adverse report on the Indiabulls group by Canadian research house, Veritas Investment Research, has interesting dimensions. Most investment analysis focuses on the positive and most analysts are reluctant to give ‘sell’ ratings to the companies they cover.
Veritas reverses this pattern dramatically. In the past year or so, it has delivered indictments of the balance sheets of several large Indian companies allied to strong sell recommendations. Indiabulls is the latest one. Previous ‘sell’ recommendations include Reliance Industries, Reliance Communication, DLF and Kingfisher Airlines.
There are several reasons why ‘sell’ ratings are unusual in the securities analysis industry. Most institutions and most retail investors for that matter, don’t short sell. They may unload holdings if they fear fundamental deterioration, or just avoid a stock. So the analysts may be short of clients if they give sell recommendations. In many cases, the analyst is an employee of an institution that considers ‘sell’ ratings politically incorrect.
Another reason is, companies hate sell recommendations tagged to their stock and the analyst risks losing all contacts within the company. A third reason is that regulators display an unreasonable dislike of short-sellers and focus unwelcome attention on an outfit that gives a sell recommendation.
Veritas claims to sidestep all this by using a subscription-only, arms length model. It is an independent firm. It doesn’t trade the stocks it analyses. Nor does it maintain communications with the companies on its radar, working only on the basis of publicly-available information.
Does it facilitate insider trading, as Indiabulls is alleging, in a criminal complaint? If it does stick to publicly available information in its reports as it claims, it cannot by definition, be doing this. But returns for its clients could be boosted in a more nuanced, and apparently legal, fashion. Let’s say, Veritas analyses a company using publicly-available information and issues a sell recommendation. It disseminates this report to its subscription clients. The clients take short positions, perhaps by borrowing stock, or by selling the stock futures if the company is available in the F&O segment.
Once the positions have been taken, the sell recommendation is leaked into public domain. Given that Veritas is taken seriously as a research outfit, non-clients decide to get onto the sell. Downside momentum builds up in the stock as a result of greater volume action and this boosts the returns of the early short-sellers who are Veritas’ clients.
As far as I know, this model is not illegal, even assuming such leaks are deliberate rather than occurring naturally as market leaks inevitably do. This is a model that has been followed openly by at least one American firm, Sharesleuth. Sharesleuth is funded by trader Mark Cuban, who takes early positions when the research discovers a potentially lucrative trade, usually on the short side.
Then the news is disseminated widely to ensure that other traders get into the act and impart momentum. Sharesleuth pushes the envelope further than Veritas in that it does its own investigations, seeking to uncover outright frauds and shady practices, rather than relying only on the interpretation of public data. In a khabar-obsessed market like India, it’s easy to trigger market momentum in either direction with a couple of well-placed rumours. Most of the time, the khabar is garbage and it’s usually designed to pump a stock up.
In that context, a research outfit that actually does credible work and exposes inconsistency in public balance sheet data is doing the average investor a big favour. I cannot comment on specifics in any of the Veritas reports because I haven’t seen them officially. There is no foolproof way to check the authenticity of versions floating around in cyberspace.
But one can see what has happened to the Indian companies that Veritas targeted. A debt trap has destroyed Kingfisher, and it has left Reliance Communiation struggling with a succession of recent 52-week lows. Reliance Industries’ problems with KG-D6 are also very much in the public domain. DLF’s latest quarterly results show that it is deleveraging and trying to cope with a grim real estate landscape. Another point worth making is that these are key players in their respective industries. If they have problems, the issues are likely to be systemic across respective sectors.
Short-selling is not an essential technique for the long-term investor. But it is integral to any trader’s profile and it is one way to derive returns in falling markets. The only practical way to short in India is via the futures market since borrowing stocks is very difficult. It requires a lot of discipline and courage and a careful assessment of risk, margins and potential stop losses.
