The emperor's new valuation

Short-sellers have a role to play in market processes - but it is regulators that really make markets move

Everyone has heard the story of the emperor’s new clothes. Modern shareholder capitalism is built around the principle that those who call out emperors for having no clothes should profit from the effort. Bears and short-sellers are essential to the function of markets; they keep valuations from getting out of hand.
 

That does not mean anyone likes them. Bulls can be lying through their teeth, be invested in the companies they talk up, could in fact be spouting complete and provable nonsense, but they will still be platformed on television and given a warm reception on social media. Bears will be decried as insufficiently nationalistic; short-sellers as malign and evil. This duality is absurd; both sides, after all, seek to make money by predicting the future, and if they do their jobs properly then their advice helps other people make or save money as well.
 

An extreme case of this absurd discourse was on display recently after the release of the report from Hindenburg Research about the Adani Group. Critics tore into Hindenburg for the “timing” of the report, during the Adani Follow-on Public Offer — as if this was the first time a report has been released when it will have the maximum impact. Would they prefer the information came out after all sorts of investors had committed cash to the group? Nobody would be interested in the small child’s declaration that the emperor had no clothes on — if that declaration had actually come a few days after his imperial majesty had stopped parading through the streets.

Illustration: Ajay Mohanty

 

Others complained that Hindenburg had an interest in Adani shares going down. Well, yes. That was made explicit in the report, and is why any assertions in the report should be read critically and with extreme scepticism. I just wish the same critical eye and a fraction of this supposed concern about incentives was directed towards the multiple sell-side analysts trotted out on what passes for business television in this country, especially given each of them has said every year for the past decade that India is on the cusp of a historic opportunity.
 

Yet others have been angry that a research outfit with five full-time employees thought that it could call out the operations of a giant group that employs tens if not hundreds of thousands. Doesn’t that just make it more embarrassing for the emperor, though? It’s like saying: “That is a very small child that just said the emperor has no clothes on! How dare it?”
 

And, finally, there are those strange souls that see a research report on an Indian conglomerate as part of a vast, transnational and possibly centuries-old conspiracy to Keep India Down. There is only one possible response to this: Grow up. Nobody in the West cares enough about India or Adani to put all the effort into creating a giant conspiracy that links together BBC documentaries and short-sellers. If you think the report is wrong or made-up, you don’t need to search very far for the reason it might have been made up: to make money. It was published by people who have sold Adani short. It says so several times. You don’t need any more extensive conspiracy than five research analysts who want to make some money.
 

The report itself is an interesting mix of well-known concerns about Adani Group companies’ debt levels, the opacity of its funding sources, questions about the past run-ins with regulators or the police of Adani executives, directors, and family members, and general exasperation at several Adani-owned companies’ price-earnings ratio. Many of these things were public knowledge prior to the report, if not generally and extensively discussed.
 

That Adani Enterprises, say, has a price-earnings ratio in the 300 or so range is the basic data point that would have attracted the short-sellers, indicating that there was a big and juicy downside to the stock. A P/E ratio that is an order of magnitude greater than that of others in the field is often a sign that something has gone wrong somewhere. But it is not unusual. Till Elon Musk set out on a quest to destroy his own riches, many analysts viewed Tesla’s P/E ratio as being in the 300 range for years. No other car company came close.
 

Being overvalued is not, in and of itself, proof of “the largest con in corporate history”, as Hindenburg put it. The more dangerous implication in the report is that money might be siphoned away through related-party transactions, yet that is only an implication and not a direct accusation, and there is no real evidence provided. Say there’s a bit of gold-plating in procurement from related parties, at the rate of dozens of crores a year. That still doesn’t mean this is “the largest con in corporate history”.

Yet the report, even if its accusations are incorrect or overstated, may still have an important role to play in market functioning. The point of short-sellers’ accusations in a macro sense is to correct company valuations, and thereby ensure that investor capital is more efficiently distributed.
 

Unfortunately, however, a short-seller’s revelation the emperor has no clothes is only the first step in this market process, and one that doesn’t work in isolation. It is not until the regulators issue an official confirmation that the emperor is in fact unclothed that the market really begins to move.
 

On Twitter, some support for Hindenburg Research came from the famous short-seller Bill Ackman, who described the report as “highly credible” and compared it to his own 350-page report, a decade ago, on the multi-level marketer Herbalife. Mr Ackman called Herbalife a pyramid scheme that was essentially worth zero. The price of the shares has fallen since then, but not to zero. Why? Not because Mr Ackman was unpersuasive. But because the Federal Trade Commission conspicuously refused to call Herbalife a pyramid scheme, as part of the regulators’ settlement with the company. Mr Ackman lost money on his short, even though he probably told the truth.
 

Others have made the comparison to politically exposed Chinese conglomerates that were the targets of short-sellers over the past decade — HNA and Evergrande in particular. As Bloomberg’s Shuli Ren pointed out, “for years, short-sellers hounded HNA and Evergrande to little avail”. It was only after the regulators indicated that state support to these enterprises and their efforts to build the national economy had ceased that the market began to revalue them.
 

If we are genuinely concerned that the Adani group companies being overvalued will lead to a misallocation of capital or slow down India’s growth ambitions, we need to make it clear that they will receive no regulatory forbearance. A statement from the government on the status of inquiries by the securities regulator into company financing is perhaps overdue. (Such inquiries were confirmed in Parliament over a year ago.) But, either way, take short-sellers seriously even if their claims are overstated. Their work does not hinder the process of investment and growth in India. It helps.

The writer is director, Centre for the Economy and Growth, Observer Research Foundation