Investors are generally mindful of business, management and financial risks while selecting stocks to invest. A risk that is often underestimated by common investors is the regulatory and legal risk attached to business of the company. In that sense, it’s part of the business risk evaluation, but we are far too much focused on the main business, its products/services, competition, raw material, key drivers of supply chain, business dynamics, order book and next year growth, and often do not give sufficient attention to the regulatory & legal risks faced by the company.
Regulatory risk refers to the risk to earnings, capital and reputation associated with a failure to comply with various regulatory requirements and expectations set by regulatory bodies. Legal risks are broader and could emanate from any transaction including those from change in legislations, policy norms, licenses/clearances, contract terms and commercial disputes. Without splitting the hair, we are using the term Regulatory & Legal risks as one risk category in context of stock investing.
Let us discuss a few case examples to make it little more understandable. And we are not going to look at legal risks from perspective of Tax disputes and claims here.
- Indraprastha Gas Ltd - Oil & Gas sector, more so the PSUs, is always known to be prone to risk of regulatory & policy action given the political sensitivity and subsidy issues. Within that space, Indraprastha Gas was one monopoly kind of business till April 09, 2012 when order from Petroleum & Natural Gas Regulatory Board (PNGRB) came regarding network tariff and compression charges. At the time of writing this post, the arguments on IGL's petition challenging PNGRB order and the regulations have concluded and Hon’ble Delhi High Court has reserved the judgment.
- SKS Microfinance – Stock came to the bourses with lot of limelight at time of its listing and quoted at Rs 1400 in Sep-2010 and now at Rs 70. This is what regulatory risk can do to a stock!! Andhra Pradesh Microfinance Bill passed after reported suicide by small borrowers of MFI companies allegedly because of usurious rates charged by these companies and their supposedly high handed recovery tactics. This resulted in MFIs like SKS being unable to collect dues or lend fresh loans, leading to write-off losses of over Rs 1,000 crore and is to shift its base to Mumbai.
- Hawkins Cookers Ltd – Nobody had thought that a well-established company manufacturing pressure cookers for decades will land up in problems with the Punjab Pollution control board. And that too so badly that the case will go to court affecting its actual production over a prolonged period. Judgement can be seen here. Company hopes the matter will get resolved but we all know these things can drag.
- Telecom companies – So much has been said and written about 2G licenses, spectrum allocation, cancellation of licenses, investigations, court hearings that I almost wanted to skip it here. But the key take-away for small investors is to be vigilant about sectors and industries where regulation is in formative stage, dependent on fast changing technologies or not yet ripe enough. These are the investment calls which should be taken by a stock-picker only when there is adequate margin of safety on the side of the investor.
- Gold loan NBFCs – Slowdown in business is seen by Mannapuram and others on account of LTV cap introduced in March 2012 by the regulator and there have been restrictions around bank lending to such NBFCs. These regulatory actions surely impact customer acquisition by Gold loan NBFCs and the resultant impact on their growth.
- Noida Toll Bridge Company – Hey, why am I including this company here? It’s in simple business of collecting toll charges from anyone who uses their bridge, it doesn’t get simpler than that. Then, who said regulatory & legal risks have anything to do with simple or complex businesses. The company has provision for toll hike in the concession agreement. The toll increase is proposed based on Consumer Price Index. For assets maintenance and maintaining the quality of service levels, in February 2011 the company had proposed the hike as per the formula mentioned in the concession agreement. However, due to protests and PILs filed, it had to roll back the hike, and it can well happen in future too. So legal risks can sometimes affect pricing power of a business.
- Banks – Fortunately, most Indian banks do not have that much problem on this front as of now. That’s not the case though with all banks worldwide. I remember having read that JP Morgan Chase has 10,000 lawsuits against them (home mortgage bonds, securities, many other stuff), and will end up facing upto USD 3 billion in litigation which means something like 8% of what they are expected to earn in 2012-2013.
What can investors do?
At IPO time, in RHPs we get detailed disclosure of pending litigations, regulatory risks and so on. But there is hardly any information in normal course. Annual Reports contain very little on these aspects unless the impact has precipitated by which time it’s too late for any action by the investor.
When regulatory & legal risks of any significant magnitude actually materialize, the PE of the stock can be de-rated quickly.
On part of investors, prudence demands to keep a tab on the policy & regulatory environment of an industry where they have interest, sectoral changes occuring and any specific legal cases faced by investee firms.