Bottomline: Give your portfolio a regulatory shield

Many investors like to steer clear of businesses in sectors with high regulatory risk, like power, oil and gas, mining, telecom and sugar, because the fortunes of businesses in these sectors isn’t determined as much by supply and demand equations or competitiveness but by policies and regulations. The regulatory risk in such sectors is very high with a shift in policy having the ability to completely alter income and profitability for incumbents. As such, businesses in these sectors cannot be expected to command long-term valuations at par with businesses like FMCG or IT services, for instance, where there is low regulatory intervention.

But even sectors not traditionally seen as at high risk of regulatory changes can be impacted by rule changes. The auto sector had to cope with changes in moving from one emission standard to the next over the past years. And the FAME scheme gave a fillip to EVs. But EV subsidies are now being scaled back, and imports are going to be permitted by players willing to commit to local manufacturing. Such moves can queer the pitch for those already in the fray.

Off late, the financial sector, surprisingly, has been at the centre of regulatory action with the Reserve Bank of India (RBI) first pulling the rug from under Paytm Payments Bank for persistent non-compliance, then sending a stern directive to IIFL Finance on violations in its gold loan business, pulling up JM Financial on irregularities in its loans against securities and barring Federal Bank and South Indian Bank from onboarding any new customers of co-branded credit cards. These actions all seem directed at addressing infractions in operations by these lenders, as well as nipping any risks in the system at a time of high credit buoyancy to prevent any unfortunate accidents that would hurt retail savers and investors most.

While many of the regulatory actions may be well intended and the consequences well weighed, it is the ability to cope with them that will separate the men from the boys. From an investor’s point of view, while it is impossible to predict the next rule change—which could be positive or negative, mind you—what counts is the ability to navigate better through these changes than peers. So, how do we assess that? Here are some pointers to keep in mind.

A starting point for investors is to study whether the company they are investing in has a good track record of compliance. Frequent run-ins with the regulator are a bad sign. In sectors that are highly regulated, there may be frequent differences over matters like computation of costs, income etc, but these should not seem out of the ordinary. GST notices and I-T notices are also par for the course unless there is something alarming. Here, the record of the company winning such disputes can be a metric to track. If a company is mostly on the winning side, you can assume these matters are more about "fairness" from two different points of view rather than any intent to cheat or underreport.

In pharmaceutical companies, for instance, a history of good USFDA compliance is a positive, whereas one of the frequent strictures is a clear negative.

An unquestionable quality of governance is a big plus for any shareholder. Well-governed companies are likely to be less prone to regulatory action. This will start at the board level. A high-quality board of professionals with independent committees overlooking various aspects and members showing high attendance are positive signs.

A strong presence of prominent institutional investors among the shareholders also ensures that a company’s actions are closely tracked, and feedback on any moves that are seen as shareholder unfriendly are quickly communicated to the management and the board.

A well-governed company is less likely to fall afoul of a regulator and even if it does, it is likely to take the steps necessary to redress any such fallout more expeditiously.

Some proxy advisors and others publish governance scores for listed companies. These can be a starting point for those not quite familiar with the subject.

Companies that are best-in-class are more likely to be able to weather changes in policies or regulatory action than those whose business models are less resilient. Take the auto sector, for instance, one would expect that large players like Bajaj Auto, TVS Motor and Hero MotoCorp will be able to more successfully navigate changes in the EV incentive scheme than some recent incumbents. Even in four-wheelers, leaders like Maruti-Suzuki, Mahindra & Mahindra and Tata Motors (with JLR) stand a better chance of withstanding fresh competition in the EV space, with some likely course correction and strategy changes.

In the financial sector, leaders like HDFC Bank, ICICI Bank and SBI are likely to be more resilient in times of tighter regulatory watch, swift market evolution and digitalisation.

More than the above, perhaps the most important rule of equity investing that you must adhere to is diversification. It pays to not put too much of your money in any one stock or sector. The more diversified your portfolio, the lesser the impact of regulatory changes in any sector on your fortunes will be. But be careful not to over-diversify, as this can be counter-productive—limiting returns on your investments.

Warren Buffett quipped: “Diversification is protection against ignorance”. But some is necessary to guard against unforeseen developments. Remember here that Berkshire Hathaway’s investment in Paytm didn’t go quite right. But this would hardly dent its returns.

To sum up, stay with quality to cope with regulatory challenges.