Us-64: A Swot Analysis

Despite the leveraged capital structure, Unit Scheme 64 will lag behind its benchmark and peers

The country's largest and oldest mutual fund Unit Scheme- 64 (US-64) has always been an exception to the rule. All these years, it has had the dubious distinction of not having to disclose its net asset value (NAV) and using that as a benchmark to sell and repurchase its units. Now, the scheme stands out for the fact that it is operating on borrowed capital.

The spate of bad news seems never ending when it comes to the way the biggest player in the mutual funds industry has been functioning. As the findings of the Tarapore Committee report come to light, the concerns are only becoming more grave.

 

Juggling of accounts and overstating of income, investments in unworthy debt instruments, the conspicuous absence of any research-led investment process and many more such allegations on an institution that caters to 4.3 million investors and manages assets of more than Rs 50,000 crore is rather frightening.

Now that US-64 has re-opened its sales window, we demystify the potential in this leveraged fund. We also do a critical analysis of the scheme's strengths, weaknesses, opportunities and threats in its new avatar.

How does the scheme work?

US-64 in its current form is not a plain vanilla mutual fund. Thanks to the tremendous redemption pressure (roughly Rs 5,000 crore) in April-May 2001, the management had taken a decision to borrow money from other UTI schemes and from banks to meet these repurchases.

The management had then thought it appropriate to avoid selling securities in the market as volumes in equities had already fallen to new lows after the unraveling of the scam and the announcement of the ban on badla.

"Since the redemptions in the scheme coincided with uncertainties in the stock market, the management had taken a conscious decision not to sell in the market and redeem units out of borrowings, " UTI chairman M Damodaran explains. Borrowings in June 2001 totaled Rs 6,900 crore, taking the capital ratio of the fund to as high as 1:1 in equity and debt.

Since then, the fund has reduced the borrowings by Rs 2,900 crore, says Damodaran. In effect, therefore, the fund has nearly a 1.8:1equity-debt allocation with market borrowings amounting to Rs 4,000 crore. With this capital structure, US-64 works more like a hedge fund.

Consider this: The market value of US-64's investments as on December 28, 2001 was pegged at Rs 13,648 crore. Since the unit capital of the scheme is known to be Rs 12,778 crore, the fund must have had negative reserves of Rs 5,355 crore.

This is because the net asset value per unit was Rs 5.81 as on that date (reserves is the unit capital minus the asset value based on per unit NAV disclosed by the fund). Since the total market value of the scheme's portfolio indicates a sum of Rs 13,648 crore, the difference between this value and the sum of unitholder's funds is borrowings plus other liabilities and provisions. That is, the total asset base is funded out of the unit holders capital of Rs 7,423 crore and borrowings of Rs 4,000 crore.

This is typically how hedge funds or, more specifically, the leveraged funds operate. Based on a small pool of unit holders' funds, these funds borrow in the market to fund a bigger pool of investments. The returns on this smaller pool of investments, after deducting the interest cost to be paid to the lenders, are then distributed to the unit holders.

In effect, the fund is able to generate revenues and profits out of proportion with their invested capital. In US-64's case, borrowings account for almost 35 per cent of the total asset base.

The residual amount in all likelihood is the provisions for doubtful investments and depletion in value of the portfolio or mark down for thinly traded and illiquid scrips. This seems logical because the fund's portfolio still shows value attached to a number of untraded securities and default category debt while the UTI chairman claims that all the provisions have been made in accordance with the guidelines issued by the market regulator, the Securities and Exchange Board of India (Sebi).

So if we assume that the fund's NAV is computed after taking into account the requisite provisions, and incremental provisions will have to be made only if new non-performers emerge in the portfolio, what kind of an appreciation can one expect in the fund?

For the fund to post a positive return, its portfolio will have to appreciate over and above the borrowing cost. For the April to December 2001, borrowing costs accounted for 20 paise per unit which has been already deducted from the scheme's NAV.

The daily interest expense on the outstanding borrowings which is still to the tune of Rs 4000 crore will be deducted from the scheme's NAV on a daily basis. Assuming that interest is charged at the rate of 10 per cent, and borrowings remain constant at current levels, the fund will have to pay 16 paise toward interest till June this year. The management expects the scheme to reduce borrowings further, so that borrowing costs could be lower, but this seems unlikely.

This is because the scheme can effectively reduce borrowings only if either there are enough inflows which can be used to repay the debt, or securities in the portfolio are liquidated to pay back the borrowings. As of now, the former doesn't seem to be happening.

As for unloading shares in the market, it is a function of how well the equity market performs. Given the uncertainties surrounding the market, this does not seem like the best time to realise good value for equity holdings.

In fact, the market may not be able to absorb the amount of stocks US-64 would want to unload. Even if we assume that the equity market do extremely well this year, the chances of US-64 beating the market is bleak.

US-64 will trail behind market averages

A sensitivity analysis of US-64 portfolio reveals that given the current portfolio, the scheme will only trail the market index. Believe it or not, the equity portion of the portfolio has a beta of 0.23. Beta is a statistical metric that indicates how much a scrip would move up from a unit change in the Sensex.

To arrive at the beta of the equity portfolio of US-64, we derived the beta of individual scrips in the portfolio for the five-year period ending December 2001 and calculated average beta of the portfolio weighted by the individual scrip's weight in the portfolio.

A beta of 0.23 means that if sensex moves up by 100 per cent, the equity portion of the portfolio will move up by 23 per cent. This low beta is on account of the fact that, the portfolio has a number of scrips that are dormant and do not move even when the market is buoyant.

If we assume a 10 per cent running yield on the debt portfolio of the scheme which constitutes about 38 per cent, the equity component will have to run up nearly 58 per cent for the fund to gain an overall 40 per cent. And if the equity component of the schemes were to appreciate by 58 per cent, the sensex will have to forge ahead by -- oops! -- 252 per cent. From current levels of 3400, sensex will have to see 11968 levels!

Though this may look like an exaggeration, it is a calculation based on the behavior of the stocks in US-64's portfolio currently. In the absence of US-64's NAV history, this is the only way to conduct a sensitivity test.

But UTI chairman says he isn't looking at a linear progression. On the contrary, he has been gung-ho about block sales. Says UTI chairman "If we are able to exploit our size wisely, we should be able to post return substantially higher than the overall market."

However, the fact that the fund hasn't been able to execute even one strategic sale till now doesn't inspire confidence. "Even if there is potential in some of the holdings, the ability of the fund managers to negotiate and execute deals is a big question. The competence of UTI's fund management has always been a suspect" says a market analyst. Our own analysis of the stocks in the portfolio shows that probabilities of huge gains through strategic sales isn't too bright.

Strategic sales can't do magic

We looked at the top 30 equity holdings of UTI which constitutes about Rs 6400 crore and analysed the possibility of a strategic sale in some of these companies. On the face of it, some of them do look like they are good candidates for sale. But a closer look suggests that, barring a few companies like ITC, Larsen & Toubro and ACC it may be very hard for UTI to lure strategic buyers.

Then again, even if there are buyers, getting a deal through at a price higher than the market price will be tough. Nevertheless, there may be other companies, perhaps the smaller ones, in which UTI will be able to push through block sales.

The mega fund always has the option of selling some fundamentally sound scrips like Infosys, HDFC and Satyam through negotiated deals to foreign portfolio investors, ensuring that UTI won't take a knock in the price when selling the shares in the secondary market. However, this kind of sale is possible only in blue-chip companies.

Even though UTI has expressed its intention to sell some of the blue-chips in the portfolio, this may not be wise as these holdings may be the first to rack up gains when the market perks up. Besides, if some of these stocks are out, the portfolio may be saddled only with worthless companies with poor prospects.

UTI can also opt for a strategic sale of its public sector holdings, said an investment banker. To do this, the institution could club the sale of its holdings along with that of the government's if the latter has plans to divest its stake to strategic buyers. And, in cases where the divestment will take place through the capital market, UTI could also offer its holdings for sale, the investment banker added.

Interestingly, UTI has reduced the holding size in all its top holdings . Industry experts suggest that the best way for UTI to realise the full value of its investments is to pursue the virtues of an active institutional investor and guide companies in creating higher shareholder value.

Other financial institutions can also play a significant role in this respect. This is definitely a long drawn process, but there are no other short-term viable options. Given that US-64 will move at snail's pace even if the market surges ahead, we would advise investors to refrain from investing in the fund.

Also, if the fund's portfolio has to be effectively restructured, it might involve too much time and the costs may be too high to see any handsome returns in the next one year. Fresh investment should be strictly avoided. Existing investors should avail of the guaranteed repurchase option in May 2003.

Inside Box

Swot analysis

Strengths

* Holding size: Large holding size enables realising better value for investments by way of strategic sale

* Quality of information: Larger the size of the fund, the better is the access to information, bet it from the company's management or from brokers.

Weakness

* Non-performing assets in the portfolio

* Impact cost on market orders

* Fund management still in a state of inertia, no strategic sales yet

* Realising asset value will depress prices

Opportunities

* More buy-backs and open-offers will mean that the fund can exit shares without taking a knock in the value of the holding

* Relaxation in creeping acquisition limit for promoters has enhanced its prospects for strategic sale to promoter groups

* Possible tax sops for new investors in the fund, and consequent inflows can reduce borrowing costs

Threats

* Equities may fail to look up

* Redemptions may happen sooner

* Shrinking corpus of other UTI schemes: This makes inter-scheme sales next to impossible

Myth and reality

* There is an arbitrage opportunity in the scheme: The fact that US-64 is being repurchased at Rs 10.50 currently(upto 5000 units) and that fresh units can be purchased at Rs 6 is being misconstrued as a arbitrage opportunity by many. Arbitrage opportunity would exist only if the fresh units are repurchased at Rs 10 in May 2003.

Fresh investments in US-64 are subject to market risk while the existing unitholders can redeem their units at Rs 12 or Rs 10 depending on their holding size.

Hence, selling units at the current repurchase price of Rs 10.50 and redeploying the proceeds in the scheme at the prevailing NAV does not result in any risk-free gains. It is almost equivalent to converting a fixed-income instrument devoid of any risk into a risky equity instrument.

* NAV is too low to fall any lower: The net asset value number in absolute terms does not hold any significance. The absolute value of the scheme is only the value of its assets as on that particular date.

The value of assets can appreciate or depreciate depending on the value of its individual holdings. A lower NAV does not mean better scope for appreciation. On the other hand, a higher NAV doesn't mean lesser gain.

For instance, if you invest Rs 1000 in a fund with a NAV of Rs 10 and if it falls to Rs 8, you lose Rs 200. Similarly, if you invest the same amount in a fund with net asset value of Rs 100 and if it fall to Rs 80, again your loss will only be Rs 200. In other words, you gain and losses would depend on the percentage gain or loss in the net asset value and not on the level of absolute value.

* US-64 is better than many private sector schemes which have lower NAVs than US-64: Most mutual funds which have NAV of less than Rs 5 today are technology sector funds. It isn't fair to compare the performance of a tech sector fund with US-64 which is not a pure equity scheme.

Last year, the BSE IT index lost 41per cent while the BSE Sensex lost only 17 per cent. Given that U64 has over 35 per cent invested in debt which should ideally give a steady return, and the rest in a diversified portfolio of stocks its performance should have been far better than the tech schemes.