The debt hangover

Companies that take on too much leverage, stretch their market capitalization and sell a perennially rosy picture to investors actually believe that they can pull off the impossible. These companies pull out all the stops to perpetuate position and propagate their ‘story’ in the stock market. They tirelessly campaign hoping to hold on long enough till their business makes piles of earnings, helps them raise loads of equity at top dollar valuations that would be enough to repay their mountains of debt. The climax of this fairy tale would be a dream sell off of the company at possibly the peak market capitalization. In the fond hope of reaching Market Utopia, they ride the tiger by creating and managing excessive expectations. What most of these companies and their greedy promoters fail to factor in are the element of randomness and the tenuous play of fear on the public psyche. As luck would have it, a few rumors are enough to take them down and usually the stock market is what exposes their vulnerability first. The market capitalization goes into free fall and goes to almost nothing (usually 10% of the peak valuation). Believers in these stories lose almost everything they stake. Many companies seem to be headed towards the bottom. Tough days ahead for investors who believed in over-greedy promoters.

“It’s not bringing in the new idea that’s so hard. It’s getting rid of the old ones.”- JM Keynes.

Invest speak:

The reasons for investors losing almost their entire capital in an investment are mostly common to many failed bets. The equity tends to get wiped out most often when the debt assumed by the company is very high. High debt is assumed by promoters of companies for two reasons. One, they expect to be able to easily raise equity later when earnings start to grow. The other reason is that the promoters actually believe the debt can easily be serviced and once repaid will leave them with the entire upside on equity. What promoters fail to factor in are the fundamental changes that almost inevitably happen between the time projects are conceived and the time they get commissioned. The change in a few variables almost drastically alters project economics leaving the promoters with mountains of debt that cannot be serviced. The fall in equity valuations then turns out to be the last nail in the coffin. Confidence crashes among shareholders and they tend to rush to the exit in utter panic. Once shareholders panic, there is no stopping the denouement. Ultimately, the entire equity valuation crumbles leaving the lenders with lesser collateral, the promoters financially incapacitated and potential investors too wary. The closure of the capital tap makes it impossible even to run the business and only some proactive measures by bankers can salvage the company. The equity shareholders can only hope and pray for a miracle with little hope of redemption. Several debt laden companies seem to be heading there.

Race like a tortoise. The markets will keep pace with you.

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