Regulations are the primary external factor that impacts a business. And these regulations come in various shades- from highly regulated to little-to-no regulations.
But a business being highly regulated is not necessarily a bad thing and vice versa. In markets, money is made on the change and thus what is more important is directional sense of how regulations will impact the business.
So for example crypto is un-regulated, but it not a good thing; it is in fact the biggest risk for any business that deals in crypto value chain because directionally it is certain that regulations will come into place and thus the business will move from being un-regulated (do anything) to a more restrictive business environment.
Similarly on the other hand, being heavily regulated is not necessarily a bad thing. Sometimes the regulations themselves can support business growth. Consider the example of power exchanges; power is a highly regulated sector, but the regulations are actually helping in the growth of power exchanges.
One example of this is the DSM mechanism penalty. Power market has a concept of DSM (deviation settlement mechanism) wherein a buyer/seller of electricity has to pay a certain penalty if they draw/inject power into the transmission system over & below their scheduled limit. Earlier this penalty was an independent rate/unit, but now the regulations have linked this penalty to a certain % over the price of power discovered in the power exchanges. This way the regulations have disincentivized reliance on DSM, because the cost of DSM is more than the price at which one can meet the shortfall through the power exchanges. And thus, the DSM volumes have started shifting to power exchanges.
Regulatory directions in the power sector have been focused on increasing the share of power exchanges.
The worst situation in terms of regulatory direction is this-
In such situations it is quite certain that the overall profitability or growth of the business will get impacted. A very good example of this situation is the mutual fund industry.
SEBI has over the years reduced the fees that mutual fund industry can charge and it continues to indicate its intent to do so in the future. Some recent developments on this front-
In 2018, SEBI restricted the additional 30bps TER (total expense ratio) that was allowed for AUM generated from B15 cities to B30.
2019, new slab-based TER caps were implemented that reduced the profitability by 10-25% across the funds, with higher reduction especially at higher scale.
SEBI is now considering a proposal to further reduce this by limiting the TER on the overall fund level rather than the current practice of scheme level. If this happens than profitability of smaller schemes will take a hit.
Reports also indicate that SEBI will reduce the 30bps extra TER for B30 AUM.
SEBI has also indicated that it will look to include charges like Brokerage and GST within the TER itself.
Regulator’s message is clear that AMCs are making excess profits and that AMCs needs to pass on scale benefits.
So though AMCs will see structural growth in AUMs, they will not be able to convert this entire growth into profit growth. Further, such overhang on profitability has a very negative impact on the valuations that business can get in the markets and thus valuations of AMC stocks have corrected significantly in recent times.
Now the best situation in terms of regulatory direction is this-
Such situations are rare, but when such regulatory opening takes place, the industry witnesses a non-linear growth.
And the best example of this is the shrimp export industry in India & Avanti Feeds-
L Vannamei (white shrimps) was a large export opportunity, but regulations did not allow cultivation of the same till 2009 and thus Indian shrimp export industry was a non-growing industry.
However, the government allowed its cultivation in 2009 and as a result the industry started growing at high rates of 20%. And that resulted in multi-baggers like Avanti Feeds.
Something similar can happen in a lot of sin industries like say gambling wherein there is a very large opportunity that exists and is not being captured atleast by the formal sector. Once a regulatory unlocking happens, these industries could see strong growth.
In summary, it is not the current level of regulations but the direction of regulations that matters in investing.
That’s it for this week, new insight coming up next week. So stayed tuned!
Surge Capital is a trade/brand name used by Ankush Agrawal (Individual SEBI Registered Research Analyst INH000008941) to provide equity research services in the Indian Equity Markets.
“Registration granted by SEBI, and certification from NISM in no way guarantee performance of the Research Analyst or provide any assurance of returns to investors”
“Investments in securities market are subject to market risks. Read all the related documents carefully before investing.”
“The securities quoted are for illustration only and are not recommendatory”
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Stock specific investment disclosure:
Avanti Feeds- No Investment. Not Traded in last 30 days. Not an active recommendation in Research Service.