Hindenburg Research’s report on Adani Group: Key take-aways for stock evaluation

Hindenburg Research’s report on Adani Group and the fact that they are shorting Adani stocks has gained traction in the last week with many content writers explaining the report and providing their analysis in amazing ways. Curious to dive deeper into this issue, I have also read the report and following are some key observations from an educational stand-point. The report has been quite helpful in deducing how a retail investor too can evaluate a listed company and identify red-flags before making an investment.

The first key take-away is the importance of current ratio. As explained in my old articles, current ratio is current assets (assets which are due within 1 year such as accounts, trade and other receivables, inventory, etc.) divided by current liabilities (liabilities which are due within 1 year such as accounts, trade payables, other short-term payables). The current ratio of 1 is the ideal current ratio. A value greater than 1 is favourable because it means that we have more short-term assets above short-term liabilities indicating surplus to repay this short-term liability. And current ratio below 1 is worrisome because we have more short-term liabilities over short-term assets. Many subsidiaries of Adani Group have current ratios below 1, according to the claims in the report. The reason why this is worrisome is because it creates a liquidity pressure in the short-term. If, for any reason (whether in the company’s control or not), the company is not able to generate enough cash to repay its liabilities, these short-term liabilities may be dishonoured and the company may come under a default. This means that the company is struggling to generate cash to smoothly run the business and the possibility of eventual bankruptcy or seeking bail-out is higher (not to say that it always leads to bankruptcy because these liabilities can also be rolled forward which is a temporary cushion for an even higher interest payment). The importance of current ratio has always popped up in many cases in the past in India. However, it has often been neglected. For example, the IL&FS default happened partly because the macro environment pressurised the company’s working capital liquidity and hence, it defaulted in its repayments of short-term debt leading to a huge cascade of events we have all seen (for detailed explanation click here). This report is a validation that current ratio is of upmost importance and must not be ignored at any cost. Hence, if you are trying to evaluate a stock for investing short-term or long-term, consider having a look at its latest current ratio.

The second key take-away from the report is the concept of Delivery Volume (also referred to as Volume Delivery). When we usually talk about volume in any stock, we generally refer to the number of trades executed for that particular stock. However, delivery volume is the number of shares exchanged as opposed to number of trades executed. One way delivery volume can help us indicate manipulation is when the delivery volume is substantially lower than volume (traded) on one day. It is beneficial to analyse this data over a period of time to identify the outliers (i.e. days when the delivery volume is substantially lower). In my understanding, if this delivery volume is lower than traded volume consistently over a period of time then maybe it is not always manipulation but increased demand or interest of traders in that stock. Hence, this metric may be weak but it is a flag to consider when you are investing a substantial amount of your money into a stock as it will give you an added risk probability in your portfolio.

The third key take-away is the importance of change management team. This is also an indication most of us tend to forget to substantiate. The report claims that Adani Group companies faced sustained turnover in the Chief Financial Officer (CFO) role because of its irregular accounting practices and sketchy dealings. We have observed in many cases in the past where, before a company’s problems go out of hand in the public, a person with significant control in the firm tends to resign or the top management is constantly changed. This is a very important indicator which is why some of Financial Time’s newsletters have a section dedication to management team. This report once again highlights why this section cannot be ignored and as an investor, we must search the company’s management turnover history since it may have a lot to say.

The fourth take-away is the importance of auditors. Listed companies need to audit their financials each year. Every audited annual report hence has a section on auditor’s opinion. Apart from reading that opinion, it is important to scrutinise the auditors itself. Sometimes non-experienced auditors may be auditing financials of large entities indicating high risk of errors because of lack of experience. While this is a very small element in the entire spectrum of events, lack of stringent audit can lead to large scale scams. Even if one argues that all auditors at one point make errors, we must understand that (1) with experience, the chance of identifying an error is higher leading to highly accurate output and (2) a renowned or big audit firm will have multiple people involved in the audit process and also fear repetitional damage in case of concealing material information from public and hence, the information produced by the auditors is comparatively reliable.

Some other interesting points raised in the report which we must consider are those of shell companies, background of top management, history of penalties and scrutinisation by authorities, the pace of growth, and timing of gaining fame. The concept of setting up shell companies in tax-haven jurisdictions like Cayman Islands, Mauritius, etc. and rolling money across them to save tax, manipulate stock and many other things is not new. However, if in your evaluation you find many subsidiaries registered in these jurisdictions or history of penalties of such actions then you should be cautious of the risk that this could be a huge scheme which can backfire. When it comes to the background of top management, it is a good habit to have a small search on the criminal history of key management if you aim to invest long-term. Management with crimes in the past may be a sign that the company is in the wrong hands, but that is just a small part of your entire evaluation. Similarly, the company’s criminal history is important to research. Lastly, the “sudden-ness” of a company’s growth or a person’s wealth multiplication must be scrutinised because although it may be good news on the front, deep down the cause may not be fundamental growth of the business but simple manipulation. On the flip side, due to this sudden improvement in growth and wealth puts you in the radar of scrutiny and if some indicators go against the norm (not because there is a criminal activity but genuinely some temporary but manageable issue in the company), there will always be short-sellers banking on the opportunity. This also links to another concept of narrative economics which we touched upon earlier (click here for detailed discussion on narrative economics). The narrative (whether true or fake) that a firm is involved in fraudulent activities can also impact the stock and even lead to liquidity crises as we are observing partially in the crypto industry and which we have previously observed during the Indian NBFC crisis too where the stock price of fundamentally strong NBFCs plummeted because of the IL&FS default. These are possibilities an investor must be aware of – risk of sudden improvement – to make any investment.

These are a few take-aways I believe will help investors be more cautious of their investment research in the years come.

Disclaimer: This article is in no way a recommendation to buy or sell any instrument whatsoever for anyone. This article also does not say whether Adani Group or Hindenburg Research is right or wrong in any way whatsoever. This is just an opinion and an individual, independent analysis aimed at educating the audience. Always make your investing decisions through an expert and through your personal research.