Haphazard Linkages

Freudian Vulture Fallacy

2018-08-03T11:04:00.001+05:30

“Sometimes a cigar is just a cigar.”

- Sigmund Freud

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CAN YOU SEE A VULTURE?

"The Virgin and Child with St. Anne" by Leonardo da Vinci (1503)

In a 1910 essay, Freud made a valiant attempt at divining an aspect of the painter Leonardo da Vinci’s personality through the above painting. Freud peered at the picture after tilting his head to the left, and noticed a vulture. Off went Freud on his psychoanalytic jet and concluded that the picture hid an insight into the painter’s life.

It seemed to speak volumes about da Vinci’s ‘homosexual’ childhood fantasy. Freud relied on a translation of da Vinci’s writings, apart from the painting, for his interpretation.

Only the unforgiving arrow of time would pass true judgment on Freud’s mental frolics. The great man had mistranslated the word for ‘vulture’. The edifice on which Freud’s theory of da Vinci’s sexual fantasies rested was an illusion. Freud apparently considered the essay to be the only beautiful thing that he ever wrote. Some loyalists even attempted to save Freud by imagining a vulture to validate the discredited theory.

I have since christened this behaviour, Freudian Vulture Fallacy.

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Decision making in financial markets is heavily influenced by the manner in which we receive and interpret information. Some gift-wrapped information packages are so ornately put together that they beguile the mind into decisions that betray Freudian Vulture Fallacy. But only with the benefit of hindsight.

Some charts to illustrate the point.

JUNK: 250-DAY WORST LOSS DISTRIBUTION. 5 YEAR HISTORY

QUALITY: 250-DAY WORST LOSS DISTRIBUTION. 5 YEAR HISTORY

The charts depict worst top-to-bottom loss profiles over the past 5 years for a basket of Junk and Quality Indian equities. Red notch depicts the present drawdown. 2018 has been harsh, but particularly severe on smaller and junkier companies. Some things stick out: Quality has better overall drawdown behaviour compared to Junk. Quality has held up well this year. Is it time to be long Quality?

Market chatter in recent times has been rife with ‘preference for quality’. Over the years, it is debatable if this narrative has been well invested. It certainly is well regurgitated, though. It is the weapon of choice of the learned in present times. And those of us that aspire for erudition.

Junk has fallen so far from the top, both on absolute basis and relative to Quality that it seems to represent relatively better value. Is it time to long Junk/short Quality? Or long Junk, in the very least?

Third, and final chart, for this edition.

WHAT REGIME ARE WE IN?

Price behaviour has taken us back to a Quality regime. We are in QE unwind mode and increasing rates environment globally. Increasing rates trajectory domestically, too. Broad market conditions seem to favour Quality over Junk.

So, long Quality?

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NBFCs with little differentiation in product profile, or competitive edge, represent levered bonds paying a 12-15% coupon (‘ROE’); after throwing in 6-10 times leverage. Is it rational to pay more than 1x book value for a ‘levered’ bond return business, which is akin to picking up nickels in front of a bulldozer? If TBTF (too-big-to-fail), or growth, is the investment premise, what multiple of book is a ‘rational’ limit? 15x price-to-book? 20x?

‘Yielders’. Commercial real estate. A portfolio of commercial real estate assets is built on a 70:30 debt-to-equity capital mix. The debt costs 12-14%. Why would anyone want to lease this out for a 6-8% rental yield? Why would financial investors want a piece of this ‘action’? Negative carry is rational if one is cautiously optimistic of long-term capital appreciation. In the absence of this, why would anyone want to be in this business?

‘Renewables’. I get into a multi-decade agreement with governments to provide power at rates that have hit rock bottom in bidding auctions. My input costs have unfriended me. Cost of financing threatens to move higher; capital costs are steadfastly sticky on the way down. Wind and the sun have a mind of their own; in terms of the quantum of power they are willing to offer usefully for us. Yet, recent renewable energy deals for rock-bottom auction price projects command higher multiples than fixed rate agreements signed at higher prices.

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Freudian Vulture Fallacy at work.

Do you see any such instances? I’m curious to hear from you.

The Strange Life of Abraham de Moivre

2018-07-11T20:15:00.001+05:30

This edition is about a topic that fascinates me: bidding behaviour.

On how people make decisions under conditions of uncertainty. And the notion of ‘rationality’.

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Many of you participated in a game I played with you recently. (I’m sure you are glad that I didn’t ask you to predict your expiry dates!)

An investment prospect offers 100% return potential over your benchmark return (your ‘required return’). How much of this excess return would you be willing to pay/share upfront to participate in the idea?

There were no right answers for this ‘buy in’. Only interesting answers.

Chart time.

Buyin for ‘50%’ represents 50% and above.

Participants comprised of finance and non-finance backgrounds. The left bins generally had finance people; who opted for some variant of upfront fee and profit share structures. Many non-finance guys populated the higher bins. Interestingly, several finance folks populated the 50% and above bin. And I had some friends who were steadfast in populating the left most bin (no excess return propositions for them!).

This outcome may strike as an instance of irrational behaviour.

Why would anyone be willing to share such a large portion of the excess return?

When faced with an uncertain future outcome (100% return over respective benchmark return), participants quoted figures that seemed to make sense to them. The higher bins had a common thread of trust equating to a higher upfront buyin. Some of us are willing to take punts on iffy prospects, as long as someone non-iffy is handling our money. Take away the trust, and the upfront share dwindles quickly.

Now assume I ran this game with each participant being able to see the average buyin number. In such a setup, the right bins would castigate themselves for quoting high figures and wish to lower their quotes. The zeros would perhaps bump up their quotes, or stand to lose the opportunity of participating in the game. Further, if this game was an English auction, with the highest bidder winning, it is anyone’s guess where the winning buyin would settle at.

Now consider this line of thought. If my minimum required return benchmark was, say, 10%. A prospect offers a 20% return potential (100% over my benchmark). On the excess 10% return, I should logically be content with 1% share for myself (excess return = 10% multiplied by my benchmark of 10%). I should be willing to share 99% of the excess return! I would outbid everyone andmake more than my benchmark return of 10% (10% + 1% share for myself).

Most of us would find this line of thought quite ludicrous.

In competitive markets, however, such behaviour tends to set prices. The marginal investor(s) with the lowest return expectation sets prices. The investor with the lowest return expectation would push prices to levels where they make their minimum required return. If my required return was higher, I would have to sit out of bidding. Until prices dropped to levels where I made my required return.

Since I cannot see the average return expectation of the market as a whole, I would have to get creative if I desired to continue participation. (1) I could find new avenues not seen by others; (2) lower my hurdle rate, (3) get fancy about ‘fair’ value assessments with some creative jugglery, so it all begins to ‘make sense to me’.

(1) is difficult to do on a sustained basis (which is why anonymity is such strong currency in investing). Generally, the markets find it easier to indulge in (2) and (3). (3) has the highest amusement value.

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A closing tale on probabilistic thinking.

Those of you that had the (mis)fortune of crossing paths with Abraham de Moivre in school probably missed peering into his queer life.

De Moivre is vaguely remembered for his namesake formula that forever married trigonometry and complex numbers. However, his biggest contribution, arguably, came in the area of probability. De Moivre penned a book – The Doctrine of Chances – in 1718. This book has the distinction of being only the second book ever written on probability. Gamblers loved it in the 18^th century; many love it to this day. For reasons best known to him, de Moivre also delved into the morbid subject of mortality, and came up with a treatise on estimating the value of human lives. This blasphemous pursuit was then used to price annuities upon those lives. In so doing, he provided a platform for the creation of the business of Insurance.

Unsatisfied with having spawned two industries, de Moivre used his experience for the ultimate experiment…

He predicted the date of his own death.

Perhaps bored after a long and eventful life, de Moivre took to sleeping 15 minutes extra each night to fill up his day. He predicted that if he continued this chore, he would die on November 27, 1754.

The day came and passed. So did de Moivre.

On the exact day.

Probability had won. de Moivre had won too. But couldn’t hang around to celebrate.

(The story of his death may be apocryphal but one must not let such trivialities destroy a good expiry story).

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The buyin game shows that we desire a large share of outcomes with return prospects far higher than our required targets. We also desire to keep for ourselves a large share of outcomes even if we had little to contribute in achieving those outcomes.

How many of you are ready to play Abraham de Moivre and predict if such behaviour is greed, or folly, or (ir)rationality?

Halls of the Blind

2018-06-01T18:07:00.000+05:30

I can see what you see not

Vision milky, then eyes rot.

When you turn, they will be gone,

Whispering their hidden song.

Then you see what cannot be

Shadows move where light should be.

Out of darkness, out of mind,

Cast down into the Halls of the Blind.

- Diablo

I usually avoid referring to stuff from the 90s as the opening act. It risks giving away my vintage…

But the above words from one of the most successful role-playing games from the 90s – Diablo – (who remembers it?) is apt for this edition.

Auditor Problems.

It’s an opportune moment to dive into the Corporate Halls of the Blind.

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Indian markets have been beset by a sudden wave of auditor resignations from listed companies in recent times. Stock prices of the affected companies have taken a beating. Runaway auditors have caused market participants to speculate over the next defection, as alpha monkeys smell quick gains. Auditor issues have surfaced after a period of widespread price correction. Wounded consciences that were assuaged by the Band-Aid of rising stock prices have been violently peeled off as prices have turned down.

Rule of thumb: identification of ‘n’ frauds (real or otherwise) leads to 2^n fraud suspects, as sleuths scour the market for impending pockets of doom.

The problem highlights several aspects of investor behaviour that is worth noting. As always, history is the best place to look.

A throwback to the internet bubble era, with a special focus on a then market darling – Enron Corporation.

An excerpt from its then Annual Report, reprinted word-for-word. Friendly English commentary follows soon after.

Enron entered into a series of transactions involving a third party and the Related Party. The effect of the transactions was (i) Enron and the third party amended certain forward contracts to purchase shares of Enron common stock, resulting in Enron having forward contracts to purchase Enron common shares at the market price on that day, (ii) the Related Party received 6.8 million shares of Enron common stock subject to certain restrictions and (iii) Enron received a note receivable, which was repaid in December 1999, and certain financial instruments hedging an investment held by Enron. Enron recorded the assets received and equity issued at estimated fair value. In connection with the transactions, the Related Party agreed that the senior officer of Enron would have no pecuniary interest in such Enron common shares and would be restricted from voting on matters related to such shares. In 2000, Enron and the Related Party entered into an agreement to terminate certain financial instruments that had been entered into during 1999. In connection with this agreement, Enron received approximately 3.1 million shares of Enron common stock held by the Related Party. A put option, which was originally entered into in the first quarter of 2000 and gave the Related Party the right to sell shares of Enron common stock to Enron at a strike price of $71.31 per share, was terminated under this agreement. In return, Enron paid approximately $26.8 million to the Related Party.

English translation:

Enron transferred 6.8 MM stock to the related party; gets back only 3.1 MM shares. Net-net: Enron transferred 3.7 MM shares valued at $260 MM at that time + $27 MM for a total cash transfer of $300 MM to cancel a contract with the Entity controlled by a very interested party. A fictitious contract is created from thin air, then nullified, with a very real movement of hard cash.

This ‘gifting’ accounted for a quarter of Enron’s operating cash flow in 1999.

These should've been noticed by discerning investors. But not many did. Until it was too late.

In the internet boom as Enron’s stock price levitated, few took notice or reacted to such wondrous nonsense. A precipitous fall in the stock price triggered ‘auditor concerns’, then ‘scandal’.

Rest (in peace) is history.

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In bullish times, when a growing mass of believers coalesce around rapidly levitating stock prices, numbers and other such mundanities seldom matter. Until they do.

The recent auditor issues in India has dusted off questions that lurked in the shadows during normal (‘bullish’) times.

How can one be confident that the numbers that really count are being counted correctly?

Of what use is identifying a ‘fraud’ if nothing can be done about it (read: profitable exploitation)?

Faced with such difficulties, the market’s muscle memory kicks in for a rational Pascal’s Wager. ‘It wouldn’t hurt much if I believed in God and God didn’t exist. But I could benefit greatly if God existed. So let me believe in the numbers…until…’

Markets scrub their conscience on dodgy companies and selectively outrage against some when the tide turns.

Yet, many questions continue to be lost in the Halls of the Blind:

What about the Outsourced Diligence Model of investing? ‘A’ relies on an auditor, who relies on other auditors/managements, who rely on fuzzy estimates of unquantifiable aspects of businesses.

Markets do not exist as a torchbearer of collective morality. To the extent that the collective belief that markets discount future earnings potential is true, corporate governance issues shall be relegated to the shadows in the next cycle.

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Often get asked as to how investors can keep up with all this. It seems scary to many that such dangers lurk in the shadows.

It helps to remember that in the long timeline of history, failure is the norm, success the exception. A sceptical mind-set that assumes most things are likely to fail is a good place to begin. Since the pool of failures vastly outnumbers successes, a philosophy that rests on elimination is a strong weapon in an investor’s arsenal.

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"Our scars have the power to remind us that the past was real."

2018-01-31T13:38:00.001+05:30

Bonhomie.

So much of it wafts through the market air currently. Hannibal Lecter’s quote from Red Dragon in the subject line wells up in one’s head. (Though some would counsel against letting Dr. Lecter crawl into one’s brains.)

The past decade has seen a major change in the way market participants think about positioning. Like a responsible parent helping toddlers to get on their feet, central banks globally have held the market’s hands through periods of disquiet. We have learnt to walk, indeed. Conditioning has nudged us to presume the parent’s omnipresence during future periods of turmoil. Assorted naysayers, bear mongers have been shaken out. Converts and survivors from The Resistance have taken to trend following, along the path of least resistance. Up. Momentum plays on liquidity – the ETF brigade – have added to the crowd. The zigging and zagging of prices – Volatility – has progressively entered hibernation, as a result.

QUIETER...and QUIETER

Volatility tends to bear an inverse relationship with prices. It also tends to cluster together. As prices have gone up, volatility has gone to sleep. The low volatility regime of the present day is a result of several factors. Low interest rate regimes globally, central bank parenting, rise of ETFs. Conditioning has pushed some of the adventurous to making open bets against market downturn. Underlying presumption being a continued upward trend in prices. Helpful global central banks are in U-turn mode from their easy money stance. Interest rates have U-turned as well. The rise of the volatility sphinx has been proclaimed before. But central banks have repeatedly drowned out callers’ tunes. Though low by historical standards, a lift-off of interest rates from the zero bound has the potential to trigger quick price reversals. With no real experience with this ogre over the past decade, we may have occasion to remember Hannibal Lecter soon.

INDIA: THIS TIME IS DIFFERENT…..ISN’T IT?

There is little to not like here. Financial savings wave, systemic clean up, and a government that plays the adoring parent’s role. Demonetisation categorically resolved the debate around competing investment avenues. Real estate and gold has receded from minds. Falling bond yields pushed fixed income out of market mindshare. Leaving the only game in town: equities. Indians have latched on and how. Domestic investors poured more capital into equity than the 2006-16 period combined. Many of these are first-timers entering the equity market in a meaningful manner. With a preference for smaller-sized companies. This group has had little experience with either volatility, or a large market drawdown. Meanwhile, interest rates have been quietly inching higher.

THERE IS PLENTY OF ROOM AT THE BOTTOM

The average small cap index drawdown over a 1-year period has been -30% historically. The post-DeMo new investor group has never had to confront deep valleys before. A low volatility world combined with no drawdown experience makes this group particularly vulnerable to sharp downturns.

…which, one is led to believe, will be bid into with confidence.

The easy money of 2017 is likely history. Scars could remind us, yet again, that the past was real.

Napoleon’s Lucky Generals: "I know he's a good general, but is he lucky?"

2018-01-14T11:55:00.000+05:30

With most market participants making money this year, the timeless quote by Napoleon in the subject line rears its head, once again. Regular non-readers know the wonderment I have on the impact of luck on investment outcomes.

The markets have been on a tear (sure you didn’t notice), and my mailbox/chat is seeing two polarized stances. On one side is the Bullish Apology. Where market participants pre-emptively share justifications for continued strong markets everywhere. This group exhibits hyper optimism, using recent history as the periscope through which to peer at and gauge the future.

The second, and potentially, the more interesting group, is the Bubble Babble crowd. This group looks askance at the rallies, and deems things a bubble. This year has given this group a great polarizer. Bitcoin. A tiny bit know much about it. Most know a bit about it; yet there is a growing supply of those sharing their two coins, calling Bitcoin a bubble.

Both groups share certain characteristics. They are tenanted with folks that have ridden the high tide and exhibit a sense of triumph. Both exude high conviction; in their own, and others’, interpretation of reality. Rather than reality itself.

Both have vociferous voices. Of those that missed out on the rally and/or entered belatedly. Many suffer from bouts of ignorance, which is quickly anesthetised with conviction in their own, and others’, interpretation of reality.

This belief inhibits both groups from acknowledging the charms of Lady Luck in influencing investment outcomes.

India Equity Universe: Falling strike rates of Napoleon’s Lucky Generals.

The experience illustrates why a probabilistic psyche and a healthy prescription of humility are such useful attributes in investing.

The optimal strategy is to participate in games where one has reason to genuinely believe that they:

1) understand the game.

2) have favourable long-term odds.

Here’s my bullish apology at bursting the CAGR bubble.

Most of us are unlikely to ever be Napoleon’s Lucky Generals over long periods. Positing investment decisions on being one is fraught with the risk of ending with globules in one’s bank accounts.

Where Are The Fundamentals?

2013-11-25T12:45:00.000+05:30

The following charts are useful in appreciating the previous bull market in India.

Improving interest coverage ratios and uptick in growth in the first half of the previous decade created a favourable environment for assuming a long equities posture. The acceleration in equities post 2005 coincided with a down tick in debt service capacity. This is in tune with behavioural characteristic of investor attention reacting belatedly to fundamentals. Cut to the present, coverage ratio is at 12-year lows and yet the equity index is at levels similar to 2007, when coverage ratios and economic growth were vastly better.

Improving balance sheet health also reflected in a down tick in interest expenses relative to revenue until 2006. Post 2006, this metric has evolved on a deteriorating trend, and bank gross NPAs have grown at an accelerated pace. Both are at 12-year highs. The broad economic slowdown is partly to blame; however, blame ought to be apportioned to bull markets as well, as falling diligence levels incentivise easy access to capital, even to companies ill equipped to handle debt burdens. The gross NPA excludes recast loans, which form a good chunk of advances (10% of loans are NPA + restructured). What could lead to a reversal in this situation? Growth and a stable inflation environment would offer good starting points. How have these been panning out?

Two other broad conditions created a supportive environment for equities post 2003. GDP growth picked up and stayed above long-term trend, while CPI ducked and stayed below trend until 2008/09. Since then, these lines have gone in the wrong directions. Achievement of GDP growth forecasts for 2014 & 2015 would still see growth running at 25% below trend, while inflation would be 30% above trend. Economic slowdown has also reflected in earnings. The RBI is focused on reining in inflation (the right thing to do), leaving the reins of economic growth in the hands of the government. As things stand today, stagflation is the path of least resistance over the medium term.

Given impending elections next year, reforms momentum has been waning, or being stalled completely. Political will to reform is low and unlikely to materialise until elections. In relative terms, China outlined a reform-oriented plan in its Third Plenum. China's pro-reform agenda contrasts sharply with the stalemated reforms process in India. With the former's economy expected to grow at a faster pace, capital is likely to prefer China to India in the medium term.

In sum, earnings and economic growth have slowed down inexorably, while inflation is stubbornly high. Things continue to deteriorate on the balance sheet front. Reversal catalysts are nowhere in sight. In such a scenario, it is hard to justify the equity market rally on the basis of either fundamentals or possible electoral outcomes; sentiment and hope - shaky foundations - are the pillars on which the rally (if sustained) is built.

'Can We Have Some (More) Obama Please?'

2012-11-21T18:43:00.000+05:30

The US election is history. The dust has settled and life reverts to the dreariness of the usual. It is an appropriate time to pause awhile and look at some intriguing outcomes of the election.

Voting is perceived as an activity centred around individual voter self-interest. Well-balanced, informed voter base is an assumption that is considered unworthy of a re-examination. While the self-interest angle is quite palpable, the gamut of reasons put forth by voters on picking a certain candidate are often mired in vagueness.

The following is an edited excerpt of an recent email exchange with a friend. HaLin wasn't eligible for voting, but under the garb of a market participant, had much practical interest in the outcome. This post is a summary of events as they happened.

Does individual rational behaviour lead to collective rational outcome? It is time to dive in to the world of individual definitions, nomenclature and qualitative perceptions.

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Quote:

...turning to the economy.

Since Obama came to power in 2008, the running money spigots added about $2.6 trillion to the system through multiple Quantitative Easing (QE) programs. From the end of 2008 to end 2011, US GDP increased by $800 billion. c.$3.3 of fresh money printing corresponded to $1 increase in GDP. Some may argue, as indeed they do, that absent this QE, the danger of economic contraction was real, considering how much credit markets and confidence had frozen up. With the latest QE (Sep 13, 2012) the Fed is empowered to print money in unlimited amounts, dressed up in novel nomenclature, and they stand ready to do whatever it takes to revive the economy and until the labour market 'improves substantially'. This is essentially euphemism for more digging into the bottomless money pit to create new forms of debt. However, viewed against the grave counterfactual, one may put forward a case for Obama, supporting the money printing exercise. Benefit of doubt.

Employment picture

Considering government numbers, the unemployment rate was essentially unchanged over Obama's term. It went up, then went down, quite coincidentally close to the election. Depending on how one looks at the numbers and who one peruses, figures vary but overall, it may be summed up that Obama's first stint wasn't a job-fuelling term. Again, one may argue that in the absence of QE, unemployment might have been worse. Benefit of doubt.

Debt situation, and the inertia of acceleration

All newly created money is essentially debt, which has balooned over Obama's term.

Household Debt as a % of disposable income peaked at 130% of income in 07/8, has reduced somewhat since; and now runs at 110-115% of income. Deleveraging? A chunk of this reduction has come thanks to bad debt written off by banks, many of whom were receipients of Obama's QE handouts. Never mind the circle. Benefit of doubt.

A tidbit about US debt is insightful. It took the US 193 years to ratchet up the first $1 trillion to its sovereign debt. It then took 20 years to add the next $5 trillion, then just 10 years to add $10 trillion. Building inertia of acceleration.

Obama administration opened the bottomless money pit in an attempt at reviving the economy/creating jobs, put money in the hands of those already sinking in debt, grappling with restructuring...so they could spend more. On the first two counts one may extend the benefit of doubt (Obama inherited a busted economy at the onset of the crisis), on the last, benefit of doubt may be sought under the refuge of 'time will tell'. Ask Japan.

New debt is being created (an expenditure), in order to kick start spending (another expenditure), while increases in revenue is mired in a haze. Piling on debt when overall debt is a fraction of GDP is different from piling on debt while sitting atop a debt mountain.

Obama re-election, by voter group

Hispanics and African-Americans strongly preferred Obama. This followed a repeat in 2008.

Source: http://www.census.gov/people/wealth/

Low net worth + home repossession concerns + uncertain job scenario + pro-common man's presence + assumed familiarity + easy money policies, is a strong premise pointing to where this vote was most likely headed.

Financial market performance, under Obama I

Source: FT, Kitco, et al

This kind of extreme performance in financial markets in the backdrop of a flaccid economy may strike one as paradoxical. Much of it is thanks to the near costless, easy money programs that Obama administration championed.

If one turns next to the investor base that would benefit from this kind of performance, one would notice something interesting.

Source: http://www.census.gov/people/wealth/

The 1% figure prominently.

In summary, a Left-leaning President's pro-common man policies was the best thing to have happened to the pro-market, pro-wealthy 1% (Right leaners, mainly); while having a soft impact on reviving the economy/creating jobs. Even if Obama increased taxes, the 1% would breathe easy, thanks to the windfall gains they made in the financial market.

In the present world, the 'Left' is the new Right...

Much of the developed world's problems is thanks to spending more than their revenue and borrowing to fund the gap. The Republicans' plan, while vague (one cannot spell out everything), clunky, and with visible loose ends and gaps, would draw the curtains on QE, and easy money.

The 1% benefited under Obama (thanks to QE). Prospective Occupy Wall Street groups and haters of the wealthy might do well to pause awhile before re-training their guns on the 1%. Romney would have been quite the party spoiler.

Unquote:

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The herd directs its ire on the 1%, while the strongest catalyst that helped the 1% (Obama) is loved and voted back in power. But it is fair to expect that the 1% will continue to be vilified, even as perceptions towards Obama rise concomitantly.

The Right would rather sit well with the Left candidate. Kicking the can down the road is the in thing with no reversal in sight.

Oddities are the order of the day.

Problem of the counterfactual

Would the Republican plan of deficit balancing work? Could a gaffe-ridden, politically gauche Romney have turned out a better candidate? Would Obama be able to translate oratorical elan and gallery-playing into addressing deep-rooted issues facing the economy? What of foreign policy? Climate change? Healthcare reform?

Many have articulated views on some, or all, these topics without really knowing whose policies might really work. A mental anchor is sought and the first available anchor, howsoever a Chimaera, is embraced.

The Art of Voting, and Closing comments

Humans exhibit a ready tendency for optimism. The murkiness hierarchy typically runs from the present, past, to the future; in increasing order. When standing in the present, with a cursory picture of the past record, and little or no anchor to depend on for the future, humans innately lean towards a mix of preferring the status quo and optimism.

To expect an entire voter base to express an opinion considering all factors, and assigning appropriate weights to each, is a Holy Grail expectation. Individual self-interest frequently leads to sub-optimal collective outcomes.

The anti-Romney brigade tend to project their immediate self-interests and belief systems, frequently using these as a yardstick against which to judge the rest of the electorate. The anti-Obama camp reciprocate.

Voting one's self-interest is an individually rational choice, aimed at leading to a workable outcome, even if far from ideal. However, the process of interaction of individual actions frequently leads to sub-optimal outcomes. As an ancillary consequence, the opposite emotions of ire and exuberance that follow, turn out to be frequently misplaced too.

The prevalent dogma is feel-good, hear-good, and perennial can kicking. Voters get what they look for, not what is in the collective best interest. In a clash of propaganda, the camp with the strongest conviction prevails.

Long feel-good, short reality; continues to remain the flavour of the season.

Mind Of The Market II: All-Is-Well Syndrome, A Habit Of Misplaced Hope

2012-06-28T18:27:00.000+05:30

In a chaotic world, a barrage of mirages can, sometimes, be confused for reality. In an environment of sustained negative developments and events, it seems somewhat paradoxical for misplaced hope to find an audience.

The second part in the Mind Of The Market series (Part I, here) will focus on recent elections in Greece and France, and the culture of all-is-well and misplaced hope that pervades market participant positioning. Paradoxically even as mainstream media resonates with negative undertones, participant actions paint another story.

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Greeks came, voted a second time, and all seemed well. Again. For a disaster seemed averted. Greeks avoided Tspirageddon and offered the reins to a pro-bailout coalition led by New Democracy and PASOK, to steer them through the new phase in a never-ending saga.

The flight of deposits that had begun from Greek coffers into banks in stronger EU countries (run-rate approx. EUR 800 mm per day) seemed like a costly hedge to those that prudently went through the process. Money started trickling back into Greek banks, post elections and 'clarity'.

All is well.

Or, is it?

When The Mouse Garnered More Attention Than The Elephant

June 17, 2012 was a big day for voters. While global media and market participants were transfixed on developments in Greece, fretting about the possible victory of Tspiras' Left; a potentially far more important election transpired in France. Surprisingly, few seemed to notice, or care.

30-day search volume, a rough proxy for 'mindspace':

There was a collective sigh of relief when Left-centric Alexis Tspiras' Syriza lost to Right-leaning opponents in Greece. Over at France, the Socialists, under Francois Hollande, managed to achieve an absolute majority. Unlike Greece, where New Democracy had to jostle with PASOK to put together a government, France achieved a significant Socialist-dominated leadership, unlikely to face major opposition in implementation of policy.

In another queer development, a Party promising anti-austerity was voted to power (France), and a Party promising anti-austerity was shown the door (Greece).

The Promise Of The Impossible...

A quick summary of Francois Hollande's election campaign agenda is insightfully oxymoronic.

Anti-austerity and growth-stimulating platform
Reduce French budget deficit to 3% next year (current deficit: 4.5%) and eliminating it by 2017, although no clear road-map was enunciated. The Finance Minister insisted that targets would be met 'without austerity'
Reduce retirement age from 62 to 60 years
Creation of 60,000 new teaching jobs over the next 5 years
Raise minimum wage by more than inflation and make it tougher for businesses to lay off workers

New jobs shall be created, working hours slashed, wages raised, lay-offs are tougher, pro-spending policies figure prominently; and yet, budget deficit is expected to be on the way down. Market participants seem to be placing an inordinate amount of faith in Hollande's ability in pulling off this Supermanesque feat of reconciling mutually exclusive objectives.

Hollande's pro-spending/stimulus stance is more likely to increase deficits than to decrease it. Especially, when the levers that would contribute to slashing the deficit are weakly understood. The whispering debt meter is likely to grow louder with time.

...Yet Hope Runs High: France, A 'Safe' Haven

A look at market participant attitudes towards France over June is illuminating. Despite the slew of dark clouds on the horizon, largely thanks to the political impossibilities propounded by Hollande, market participants gleefully lapped up new bond issues by France. Reuters news runs:

French bond yields hit record low at auction - Jun 7, 2012

French yields fall at debt auction, demand firm - Jun 21, 2012

Yield on France's 50-year bond, due in 2060, fell to 3.27%. This was down from 3.34% in Nov '10, when the EU crisis was less intense than the present day. In the first bond auction after Hollande's Socialists assumed power, market participants accumulated new French bond issues. Bid-to-cover (a measure of participant demand) ran at close to 2.5x.

Yields began touching new lows (bond prices and yields move in opposite directions) and new issue appetite was healthy. When little had changed for the better and with the path of least resistance still pointing to more pain.

Hope floats eternal.

All is well.

Greece: The Lair Of Liars & Wonders Of Short-Term Memory

While slightly dated, the chart captures the pre- and post- Euro situation in Greece. The (susiciously) reducing deficits leading up to Euro adoption reversed post-adoption. Much of this could be attributed to the benefits of cheaper sources of financing (common currency). Debt piled on and Cindrella had a ball. Until the party ended.

Rumbles From The Past: Greece, 1990s
Barring a brief interlude in the early 1990s, PASOK - a Party associated with unbridled populism, a love for spending and tolerance for corruption - was at the helm of affairs throughout much of the 1990s and early 2000s, a critical time as Greece proceeded to adopt the common currency. In 2004, Greece admitted that it had fudged accounts to gain access to the Euro. Of course, that PASOK had presided over Greece when this activity was underway was deemed unworthy of mention.

Voters exhibit an odd sense of history. Few remember, or question, the true reasons for their present quagmire but selectively remember the PASOK-promoted pay rises that they were beneficiaries of. Self-interested, rational beings indeed. Unsurprisingly, now, this same group is expected to lend support to their decades-old rivals - New Democracy - in forming a government and in steering Greece through trying times.

The Greece stock market roared its approval on pre-election rumours of pro-bailout faction assuming power.

Inertia Of Lying
Ahead of the critical EU Summit over the next few days, the Greek Prime Minister miraculously goes down with an eye problem, while nausea incapacitates the Finance Minister. Replacements shall make their way to the Summit, requesting renewed assistance from the EU powers-that-be.

The health 'issues' are likely to recur, at appropriate moments in this dynamic drama.

But, all is well.

A Habit Of Misplaced Hope

Time to gauge the pulse of the market. One would be forgiven for thinking all was indeed, hale and well. For a major disaster (Euro-imperilling government in Greece) was averted. All was/is, of course, well with France.

Cross-asset class behaviour leading up to Greece and France elections:

Risk-off sentiment prevailed generally, as market participants dived for cover in US Treasuries and bought protection to hedge against events in Europe (widening European CDS). Risk-off posturing continued with equity markets around the globe sauntering flat-to-down. Commodities reflected the sentiment, with dual-personality Gold being bid, even as Oil and Copper were shunned.

Post elections?

Built-in pessimism morphed into hope. The unwind began, as participants cycled out of US Treasuries, European CDS tightened and equities were bid. Oil and Copper continued to signal something amiss but few paused to ponder. The most significant change manifested in Volatility, which compressed materially post the weekend election events, a sign of return to 'normalcy'.

To sum up, little has changed for the better in the weeks post-elections. If anything, woes of varied character and intensity continue to confound Spain, Italy, Greece, France and Germany. This union is in disunion; on banking union, fiscal union, political union. The form of the Euro-wide bailout fund, European Stability Mechanism (ESM), remains shrouded in indecision and no clear path exists. Meanwhile, voices for Euro-defection and bailout requests (classic Game Theory responses) have picked up.

Market participants learnt all about tail-risks in the aftermath of the subprime crisis and Lehman Brothers. Few years since, tail-risks do not seem like tails anymore. The Black Swan event now would be a miraculous cure to the world's ills, or, the more likely outcome; the emergence of a new Order.

Until then, all is well. ?

Mind Of The Market - I : Pavlovian Conditioning, Paradoxes & The Psychology Of Herding

2012-06-11T18:46:00.001+05:30

In what should evolve into a multi-part series, Mind of the Market will endeavour to peer under the hood of the largest laboratory of human psychology in the world; the financial markets. Where frigid numbers and emotive participants spar enthusiastically in an elaborate and often bewildering drama-in-motion. Where apparitions and reality merge so finely as to be mostly indistinguishable. Where paradoxes and circular relationships reign supreme, frequently, and fervently, questioning the very essence of rationality and cause-and-effect.

Part I addresses the dynamics of Pavlovian Conditioning and market participant response to stimuli in investment decision-making. Intriguing paradoxes and the behaviour of asset prices - a cause (and consequence) of market participant response - is considered concomitantly. Finally, the psychology of herding closes Part I.

Pavlovian Conditioning and Asset Price Behaviour

When Ivan Pavlov discovered his lasting contribution to humanity - Classical Conditioning experiment on dogs - humankind was probably offering years of daily corroboration of the phenomena of Conditioning. An excerpt of the key theme of his study:

Conditioning is usually done by pairing the two stimuli, as in Pavlov’s classic experiments. Pavlov presented dogs with a ringing bell followed by food. The food elicited salivation, and after repeated bell-food pairings the bell also caused the dogs to salivate.

The table below broadly aggregates typical market participant response to event stimuli (information, emotional state and expectations):

Equities and commodities chime along lock-in-step, while sovereign credits adorn the character of a recession/bad news asset class ('safe' havens). Gold appears a near all-weather choice that is spurned during good times. The broad matrix, by no means sacrosanct, reasonably captures market participant psychology to macro stimuli.

Some Intriguing Paradoxes

The Psychology Of Buying - Sovereign Credit

Mountain of Debt + New Debt = Increasing Debts-appeal

Amidst the ebb and flow of the financial crisis, new debt issued by USA, with a burden already as big as its GDP (and rising), has found enthusiastic buyers. Over the past two decades and change years, US’ debt grew 6-fold even as GDP grew 3-fold. Debt is now nearly 100% of GDP versus 50% in 1987. Back in 1987, US 10-year Treasury yielded 9.5% and inflation (CPI) was 4.5%, for a real return of +5%. Cut to the present, US 10-year Treasury yields were close to multi-century lows (c.1.5%) recently, while inflation (CPI) was c.2.5%, for a real return of -1.0%.

Despite mounting debt burden and negative real yields, market participants gravitated towards US Treasuries. Negative real yields can be somewhat tolerated if there is a reasonable chance of greater depreciation in the currency of the marginal foreign buyer (if, say, a foreign investor makes (!) -1% by way of real yield and the US$ appreciates 6% relative to her currency, she would make 5%).

Foreigners added ~$650 billion to their US Treasury holdings between Mar-11 and Mar-12 for negative real yields and since they hold close to half of US Public Debt ($11 trillion Public Debt, $15.7 trillion Total Debt, at last count), it is instructive to enter the mind of a foreign buyer, to discern their thinking.

Foreign holders of US Treasuries are exposed to risks on two fronts, (a) asset risk (risk of principal repayment and negative real yield) and (b) currency risk (US$ depreciation). The two largest foreign holders of US Treasuries - China and Japan - suffer from low/no real coupon and a gaping abyss if and when the US$ depreciates relative to their currencies (ignoring US insolveny risk, to keep things sane). The JPY is already feeling the heat thanks to JPY appreciation; while the Yuan, owing to the managed peg, has managed to stave off the eventuality, for now. But a gradual appreciation looks likely, for various reasons, and were it to materialise, these foreign buyers will be minus some big notes from their Treasury chests.

In the past, at the first signs of 'risk', the JPY, CHF, Gold and sovereign credits found many seeking shelter. In a vastly changed world today, similar protection is being sought. Ironically, in the shelter with the weakest foundation.

Classic Pavlovian Reaction overlaying rationality.

The Psychology Of Selling - Equities

Beneath the macro stimuli lie camouflaged several layers of micro stimuli that impinge on participant emotions and asset prices. Daily/Weekly/Monthly economic data releases, quarterly earnings reports and a host of other information trigger Pavlovian Responses in market participants; who, akin to Pavlov's mongrels that were befuddled by cause and effect; cause gyrations in asset prices bearing little relevance to actual intensity of the stimulus.

A quarterly earnings report below expectations often triggers selling in the company stock, even if the quarterly timescale bears little relevance, either to the longer timescale, or to the long-term dynamics of the underlying business. Among the higher order reactions to this earnings miss might be sympathy selling of companies in the same business (extrapolation of the reasons behind Company X's woes to Company Y), and a bump up in price gyrations.

Fed with data minutiae, often by the minute, market participants feel a compelling urge to act out (disseminate) incoming information. A quarterly GDP growth, or a quarterly earnings, print coming above/below market expectations gnaws at participants, and sightings of their emotional response can be found in the behaviour of prices. That these numbers, highly questionable in some markets, and subject to ex-post revisions, trigger multi-order reactions is intriguing.

Instances of Pavlovian Reactions often trouncing rationality.

The Psychology Of Multiple Personality Disorder - Gold

For a wonderfully insightful example of rapidly altering human risk perceptions, it is illuminating to cast some light on the behaviour of Gold over 2011. Grave signs of multiple personality disorder was witnessed in Gold, which was one of the few asset classes that closed the year on a celebratory note.

1H 2011: Gold rose as sovereign debt worries escalated

2H 2011: Gold fell as sovereign debt worries escalated…further

Even as fear escalated over August through December 2011 on resurgence of EU sovereign crisis, Gold suddenly seemed to have fallen out of favour. What was being hoarded on the premise of fear was now being sold, when the same reasons were available in greater supply.

It was roughly a year in two halves for the Yellow Metal. The first half, where it held allure to market participants as an inflation hedge/doomsday investment; while in the second half, this relationship broke down as Gold began tracking market expectations of Central Bank Quantitative Easing (a.k.a money printing).

At some point in the flowing continuum of emotional reactions, perceptions tipped; the stimuli had changed. Expectations of, or the absence of, quantitative easing began guiding market participant perceptions towards the yellow metal. As expectations for further rounds waned, so did interest in Gold. Recently, possible reopening of monetary spigots instilled some vigour in Gold.

The Psychology Of Herding

From being conditioned to dive into the seemingly soothing arms of sovereign bonds in time of duress, to selling earnings misses (and buying earnings beats) in equities, to flipping commodities on the near-term prospects of economies; herding represents one of the most innate characteristics in market participants inhabiting the financial landscape.

Being social animals, the evolutionary urge for tacit acceptance by the majority is a compellingly strong force. Apart from acceptance, the social fallout of being in the wrong while in minority further assists in the building of crowds. The prospect of quick profits while chugging along with the many instills a sense of comfort. Pavlovian Responses are, sometimes, a necessary appendage in this scheme of things.

Trend-followers, algorithms or otherwise, attuned to picking up these developments seek to exploit the power of the herd, before everybody else. Being alone, as a trend-follower, is a wondrously alluring prospect but, unfortunately, a mutually exclusive possibility. The trend follower, additionally, is an implicit Long on the persistence of the prevailing bias.

The enthusiastic herding into sovereign credit today, as a reaction to fear, has driven real yields in several geographies into negative territory. A few years down the line, when the world appears a little different from today, where interest rates would have likely ticked up from today's historically low levels; a host of market participants might awaken to the true meaning of the word 'safety'.

Another typical Pavlovian Response in the face of catastrophe would be likely at this point - denial.

…Thus, at the court, both great and small
Behave alike, for all ape all.

– Jonathan Swift, Excerpt from The Logicians Refuted

The Correction (& Persistence) Of Anomalies

2012-06-03T12:18:00.001+05:30

During dreary journeys across the market landscape scouring for interesting opportunities, the investor occasionally stumbles upon an oasis. Of extreme anomaly. The sighting is generally a mirage, a ray of false hope; but in some instances, the manifestation is very real and extremely intriguing, especially so when the anomaly manifests across companies operating in the same business.

The anomaly was first highlighted here ('Over-priced anomalies in bear markets'), when discussing One Life Capital Advisors (Bloomberg: OCAP IN). Extreme pricing is generally either an outcome of mass euphoria/fear, or a flock of informed market participant presence. OCAP IN seemed to be in the latter category. The post also highlighted the case of peer, Brescon Corporate Advisors (Bloomberg: BFS IN), as an example of under-appreciation.

For brevity, the scheme of things as on the date of writing (Dec '11) is reproduced:

Such cases of extreme pricing always pique my interest. The situation seemed too far removed from reality. Diligence corroborated my hunch on OCAP IN's ridiculous pricing, and it corroborated my hunch of under-pricing in the case of BFS IN.

A mid-market focused investment banking, debt restructuring franchise with a reasonably long history of operations and respectable brand value seemed to be completely unloved. The company small size ($3.5 mm market value) and low liquidity were partly the reasons. Competition from investors scouring this market segment is limited and severe anomalies sometimes manifest, as a result.

BFS IN was available for far less than its cash and liquid investments (including equities), even after allowing for diminution in carrying value of these investments. Essentially, market participants were assigning no value to the business, a relatively reasonable operating history; a clear anomaly.

As sentiment picked up in the first quarter of 2012 on the back of renewed FII inflows, stocks of under-appreciated companies come under the spotlight. BFS IN benefited from this surge in sentiment and currently trades at a market value of c.$7 mm, a 100% gain in a few months. The current market value is equal to its cash and liquid securities. Market participants continue to assign little value to either the business or its franchise, which is reasonably strong in its focus area. The margin-of-safety has since compressed but the example illustrates the minimal force that is sometimes required to effect a meaningful correction in anomalies.

On the other hand, the persistence of over-pricing is another intriguing aspect. OCAP IN continues to enjoy a market value of c.$70 mm - 10x BFS IN's market value - which, given its competitive standing, operational history, franchise value, business size, makes for an Alice in Wonderland situation. Shorting isn't the easiest in India but even if one could, the wait and weight of pain would be excruciating.

The principal risk in unloved companies is (1) questionable numbers/management, (2) the absence of a catalyst that could allow restorative forces to act with rigour. (1) is within the realm of known-unknowns and can be tackled to a reasonable degree. (2) is more sketchy. Sometimes, the catalyst takes so long materialising as to be virtually useless for value emergence. The catalyst in this case was an uptick in sentiment. But insisting on fat discounts to true worth allows leeway for unknown-unknowns that might afflict the company under consideration.

I'm watching this one closely, as I continue on my journey across the market landscape.

Natural Gas Implied Volatility: Drift Back To Normalcy

2012-04-14T16:55:00.001+05:30

Event-specific circumstances, sometimes, create interesting situations for deploying capital. The Indian Natural Gas sector presented one such instance; in Equities and Implied Volatility, this week.

Background note here.

IVs popped across the board, principally manifesting in Indraprastha Gas (Bloomberg: IGL IN, NSE: IGL), which was the chief victim in the melee. Reacting to the adverse regulatory pronouncement, other companies in the Natural Gas space too came under fire from investors, IVs spiked as stock prices swooned. IGL stock fell over 40% within minutes and other companies shed double digit percent. Petronet LNG (Bloomberg: PLNG IN, NSE: PETRONET), however, should have escaped relatively unscathed, as the ruling is expected to have little impact on its earnings power. But fear is a pervasive force, which divorces with rationality in time of duress. Time eventually acts as an arbiter in the estrangement but the process is gradual and fraught with roadblocks.

Panic-induced selling traces a typical cycle. An event acts as a stimulus, triggering ripple reactions (and over-reactions) in several directions. The magnitude and length of time of the selling is contingent on the gravity and expected persistence of the negative information. Once the initial wave of selling abates, traces of value can often be found in several pockets.

The PNGRB ruling was directed towards gas transportation and compression operations. Regasified LNG, PETRONET's core business, did not fall under the purview of the regulator. To this extent, PETRONET's earnings power was insulated against the adverse regulatory development. The stock, however, shed about 12% minutes after the stimulus triggered widespread selling. The magnitude of correction was overdone, taking PETRONET's valuation to levels (sub-10x P/E, 5-year historical P/E = 14x), which offered an attractive value proposition for long-term oriented investors. PETRONET's per share earnings have grown at over 30% annually over 2006-Dec 2011. Turning to India's natural gas fundamentals, the favourable demand-supply gap is unlikely to reverse in the near future. The natural gas deficit situation is likely to persist over the medium-term and PETRONET is likely to realise above-average prospective growth in per share earnings. As market participants absorbed the impact of the regulatory development, Longs moved in to PETRONET and the stock recovered most of its losses by the close of the day.

IVs had been hovering in the early 30s in late-march/early-April. The event stimulus resulted in PETRONET IVs popping across the board, with strong skew emergence as participants scrambled to buy downside protection. IVs increased to rich levels relative to history and Short Volatility postures offered attractive risk-reward.

The following chart captures the evolution of Implied Volatility and PETRONET Put Option Greeks, across strikes, in the few days post-event.

As normalcy returns gradually, IV and Vega (sensitivity of Option prices to changes in Volatility) are gradually drifting lower. For an option insurer, shorting Volatility at higher-than-normal levels improves risk-reward materially, offering a reasonable margin-of-safety. Subsequent IV compression leads to value realisation. The compression is most prominent in close-to-money strikes, with deep OTM strikes exhibiting lower sensitivity but working wonderfully, nonetheless.

Classic value emergence across the equity piece in the capital structure and in volatility, a less-widely viewed asset class.

Disclosure: Expressed & unwound profitable Short Volatility positions. Continue to hold certain positions, as of this writing.

Disclaimer: This is not a solicitation to buy/sell any instrument discussed here. Views are contingent on future circumstances and may change without notice. There is immense risk of loss in Options investing. Please consult your adviser, and more importantly your judgement, before making investment decisions.

Ruckus, Volatility Skews & Gap Risk

2012-04-10T14:59:00.001+05:30

It has been quite an eventful day for the Indian Natural Gas pack, which are quite effervescent as I write.

The ruckus was triggered by a ruling by the Petroleum and Natural Gas Regulatory Board (PNGRB), fixing new tariffs for natural gas players. The PNGRB lowered gas network tariffs and compression charges by over 60% each. This prompted a free fall in stock prices of Natural Gas companies, with Indraprastha Gas (Bloomberg: IGL IN, NSE: IGL) caving in 40% within minutes of market open, on the back of rampant selling, as sell-side analysts rapidly scaled down forecasts. Other stocks shed between 5-15%.

A ruckus is generally kind to Volatility. Natural Gas Implied Volatility, which was quite tepid since mid-March '12, spiked reacting to the adverse newsflow. IV skews, which were flattish around the long weekend (April 4, 2012), have now turned into smirks as Puts have come into focus. The scramble for buying protection has pushed up Put prices. Spiking IVs offer attractive possibilities to deploying capital. Petronet LNG (Bloomberg: PLNG IN, NSE: PETRONET) & GAIL (Bloomberg: GAIL IN, NSE: GAIL) IV skews paint an insightful picture.

Though IVs have picked up across the board, OTM Put IVs particularly, have bumped up neatly and now offer a reasonable risk-reward.

Queerly, skew was inverted going into the long weekend. Generally, lower liquidity in OTM strikes should impel Option Writers to demand higher compensation for assuming Gap Risk. Writers, however, seemed happy to assume risk for low, flattish skews.

A long weekend brings its own advantages and disadvantages. The advantages gained through a Long Theta posture needs to be weighed against the possibility of Gap Risk, after the long weekend. As market participants process and assimilate developments materialising over the weekend, the chances of a Gap Open (up or down) becomes likely. One way of somewhat mitigating this risk while enjoying the benefits of time decay is to demand higher IVs. The other is to own cheap protection at low IV.

The Natural Gas pack is hounding the Longs today. The next few days will be interesting indeed.

A Resurrection In Sentiment?

2012-04-08T13:37:00.003+05:30

The Day of Resurrection is probably an opportune moment to pause and gauge the pulse of the market.

After the forgettable dalliance with 2011, risk assets seem to have found an amenable ally in 2012 so far. Tepid interest from FII towards India in 2011 has been replaced by renewed fervour ($9 billion net inflows in 1Q2012 v/s -c.$1 billion net outflow in 2011).

Interestingly, very little has changed fundamentally. The March budget was a damn squib, with the Finance Minister hoping to walk the tight rope between taming inflation, curbing a burgeoning fiscal deficit, without fettering growth. The Budget was, however, low on major reforms and irksome issues continue to make their presence felt. Yet, FII continue to pile in.

One of the intriguing things about human behaviour is its stickiness in altering the status quo prevailing bias. After a prolonged period of bull market, bearishness/pessimism is a rarity; likewise, after a bearish period, bullishness/optimism is a rarity. Bull markets are fuelled by optimism, which is confidence's child. The circular relationship seems to portend that confidence is a necessary prerequisite to bull markets. This needn't always be the case.

When much bearishness is already imputed in prices, a minor dose of optimism is enough to take prices higher (converse is true around market tops). In temporal terms, optimism is a short-term phenomena, while confidence is more structural. Tangible on-the-ground improvement in business environment is a necessary catalyst to support sustained confidence.

Quick glimpse of the thermometers that I keep an eye on to gauge sentiment.

Is the bull market here? Or, is this a temporary oasis of optimism?

Commodities, except Crude Oil, had a stellar January '12, as the risk-on trade gained backers on the possibility of QE3 favouring risk assets. February was quieter and March proved to be speed-breaker to budding optimism.

The price performance of Healthy v/s Weak companies is a useful indicator of market participant focus of interest. 'Healthy' contains debt-free/net cash balance sheet companies, 'Weak' contains the most indebted ones.

After a spell of negative price performance, a spell of optimism generally favours the indebted over the conservative. The debt-heavy tend to fall so greatly in a bearish environment that a temporary reversal in sentiment is enough to propel these pockets higher, as participants cycle out of defensives. As always, sustenance is key to gauge a structural shift.

January '12 was very favourable to the Weak companies in my index but follow through has been stolid. February saw the Healthy beating the Weak and March turned out to be inglorious for both, more so for the Weak. One of the companies in my Weak pack is Kingfisher Airlines (Bloomberg: KAIR IN, NSE: KFA), which is sparring with possible bankruptcy.

Gauging behaviour is one of the most challenging aspects in investing. Numbers convey a picture and they have their utility as communicators of market sentiment. But they cannot conquer uncertainty. Just as a good doctor, with experience, is able to ascertain much about a patient's health by inspection and smell (yes), a market practitioner does the same with the market.

With the likelihood of QE3 remaining shrouded in speculation, commodities are likely to experience bouts of volatility, driven by the vicissitudes of QE3 banter. India, meanwhile, may track developments on the interest-rate front, with a rate cut fuelling optimism. For now, optimism needs a pair of strong legs, something that seems in short supply, to morph into confidence.

Till then, Happy Easter!

'Prediction is very difficult, especially about the future.'

- Neils Bohr, Physicist

Dear SEBI. Can We Short Please?

2011-12-29T09:53:00.001+05:30

The catalyst that turns fantasies into realities came in the form of this SEBI order for OneLife Capital Advisors (covered here).

SEBI (Indian market watchdog) barred this company, several others and the merchant bankers to these initial public issues from accessing the securities markets. SEBI accused them of diverting IPO proceeds, performing shoddy due diligence and aiding promoters to prop up prices post-listing.

Unsurprisingly, in the beginning of the end scene, OCAP IN is down 15% as of this writing. A pummelling, rightly deserved. The end would be interesting. HaLin rued their inability to initiate Shorts on such cases, in the previous post.

The Shorts are common whipping lads when markets and companies come under fire. The chorus against Shorts is inversely related to (1) market levels/stock prices, and (2) the acceleration of the fall from grace. Shorts are blamed for disrupting markets, for acting on misplaced rumours, for cornering poor and genteel companies looking to create employment in a socially responsible manner, and for generally being Evil.

Few derive satisfaction from seeing others go bust and the Shorts aren't St. Good Guys at all times. But in certain instances, measured corrective forces in markets (provisions for single-stock shorts, for example) are a necessary counter-weight to the (sometimes questionable) actions of companies and issuers. A Long-only market character leads to a one-sided world, loaded in favour of companies. Frauds, historical and prospective, find a fertile setting to grow unabated in such an environment.

Shorts impose a certain discipline on company managements, inducing them to contemplate the ill-effects of their actions, if exposed. Since the effect would directly be experienced by insiders through a drop in value of ESOPs/insider holdings, the Short-brigade bring some semblance of sanity to markets (its another matter that the Shorts themselves go insane occasionally!).

The purging exercise brought about by the Shorts is a case of Darwinian survival of the fittest in business. By shorting dodgy companies into extinction, Shorts ensure that capital eventually finds its way to places where it is most welcome. (Social fallouts of capital re-allocation, a touchy subject, is left for another day).

The SEBI has a fine balancing act. If it raises minimum qualifying criteria, there's a risk of keeping public markets off-limits for fledgling companies reliant on capital for growth. This would impel them to seek capital from private sources, which come with their associated pros and cons. Relaxing qualifying criteria would attract shady companies. It is a tough problem which is, like so many things in life, without a black or white framework for a solution.

It is in such situations that Shorts serve a useful purpose.

Is the SEBI listening?

Over-priced Anomalies In Bear Markets

2011-12-21T20:27:00.000+05:30

One of the alluring things about investing is the prospect of rare sightings of anomalies. In a torrid market, typically, the universe of value Longs tends to expand relative to bull times. The opposite - an anomalous over-pricing in certain pockets - is rarer.

One such example is OneLife Capital Advisors Ltd (Bloomberg: OCAP IN; "OCAL" or "Company"), a recently listed Indian company engaged in providing financial intermediary services, an aspiring equity broking franchise and portfolio management services company.

'Aspiring' is the operative word, as OCAL was incorporated in 2007 and commenced business in September 2009. As the Company admitted, there is little to look at in their limited operating history. Nevertheless, market participants enthusiastically bought into the Company's prospective story. Overall IPO was subscribed 1.53x, with retail participation at 2.5x allotted portion and Institutional interest at 1.02x.

Investment Banking franchise dynamics

People are an investment banking franchise's key source of competitive advantage. Superior deal sourcing, well-entrenched network of corporate relationships and deal history help differentiate one player from another in this competitive industry. Moat can also be derived by specialising in niche pockets (e.g., debt restructuring/resolution, mezzanine financing). A generalist investment banking franchise with limited history of operations, promoter pedigree and key employees (there were 11 employees as of the IPO filing) competes from a rather weak position. OCAL has all the ingredients of this eclectic combination.

Broking franchise dynamics

Broking is a fiercely competitive business, bearing a natural correlation with the capital markets. Except for instances where a broker serves an underpopulated segment in the market, pricing power is low and players compete fiercely in a race to the bottom of the price pyramid. Other means of building a moat is timely and best execution, low slippages, pre-trade investment research, post-trade execution services and attractive terms on margin funding.

Revenues are primarily a function of volumes. As a result, waning volumes in a weak/sideways moving market has a negative impact on business. Well-entrenched incumbents tend to buy growth or rely on ancillary activities to drive revenues. A new, small-sized entrant would run into a gladiatorial arena full of competitors. OCAL is in such a position.

Portfolio Management Services dynamics

This is a typical hedge fund structure, with respect to fees, that is. Performance-wise, there isn't much to be said about this group as a whole, in both absolute or relative terms.

Revenues can form a good annuity stream (upfront yearly management fee) with optionality driven by Carry (a cut of profits). Recurring revenues are contingent on assets under management, which encourages management to embark on asset-gathering exhibitions to support revenue growth, sometimes to the detriment of investment performance.

Differentiation is largely a function of investment performance than fee structures. Long history of superior performance under (hopefully) the same investment manager lends much credibility and strong competitive positioning. OCAL neither has the track record nor the personnel to guide this operation. A majority of its recent IPO proceeds (~35%) was earmarked for this venture, which hitherto contributed nothing to its topline. Attracting the right talent for this venture would not only prove difficult, given its history, it would also entail a large capital outlay; which will likely keep expenses on a rapid growth trajectory relative to revenues. It is difficult to envision OCAL achieving sustainable profitability, let alone cash flow, in the medium-term, given the scheme of affairs.

With this background, it is insightful to glance at a quick comparison, contrasting OCAL with a competitor, Brescon Corporate Advisors Ltd (Bloomberg: BFS IN). BFS IN is an investment banking franchise specialising in debt syndication, restructuring and resolution services. It is also involved in real estate and private equity financing.

OCAP IN has doubled since listing in mid-October.

An all-in bet on a perfect future

My interactions with the lead manager to the issue were illuminating. OCAL's current investment banking mandates = $95 mm (have to rely on the weight of words of the management). The revenue stream is a fraction of this value and payments are received based on achievement of milestones.

Working with a rather liberal 50% p.a. growth rate in mandates over the next 3 years and a 5% fee arrangement (typical, 1%-2%), the mandates would translate into revenues of ~$15 mm, which would accrue to OCAL over a period.

Moving on to Portfolio Management Services. $2.5 mm is the initial funding received from IPO proceeds. Let's assume Management manages to grow assets under management (alliteration unintended) to $200 mm over the next few years and can charge 3% of AUM as fixed-management fee (typical, 1.5-2.5%). This would translate into revenues of $6 mm.

Equity broking is a function of volumes. The largest company, Religare Enterprises managed volumes of $800 mm / day in 2010-11. Assuming OCAL manages 10% of this and using an average brokerage rate, this business would add ~$10 mm to OCAL's revenues. One of the ways of running a low-cost brokerage operation is to focus solely on execution, without adding ancillaries such as research (which add to costs). It was unclear, from my interactions, whether OCAL intended to take this route.

Summing the three revenue streams up, one arrives at around $30 mm (cumulative, over a 3-year period). The largest integrated financial intermediaries currently trade at a Market value / revenue of ~2x, which is the multiple OCAL is discounting based on its prevailing market value. We haven't even touched upon profitability...

Parting thoughts

For a company with minuscule revenue, limited history and anything-but-upbeat business prospects, the stock enjoys good short-term momentum trading interests (daily traded value = $8 mm). The run enjoyed by companies like OCAL is a characteristic generally commonplace in bull markets.

Market participants are expecting a stupendous show from OCAP IN over the next few years. With a drop in trading volumes and slowing investment banking mandates, the environment has been tough for players like BFS IN and indeed, for many players in the financial intermediation services industry. A situation that is likely to persist over the near-term. Another possibility behind the strong stock performance 2 months post-listing could be a take-over attempt by a larger rival, which appears remote.

These are the sort of occasions when one misses the ability to initiate a short.

Disclosure: No position

Disclaimer: This is not meant to be an invitation to indulge in speculative activity. Please consult your adviser, and more importantly, your judgement, before making investment decisions.

The Bungee Jumping Indian Rupee

2011-12-16T22:16:00.000+05:30

Of the many interesting events occupying market participants' attention in India in recent times, few have been more riveting than the rapid slide of the INR, which has depreciated > 20% against the US$, since the end of July 2011.

The pace of depreciation appears to have caught policy makers and market participants by surprise. Hedge funds focused on India, who did a reasonably good job of arresting capital erosion until July, saw their returns plunging into the red, thanks largely to the INR's free fall. An economy on the fringes of diverging negatively from historical growth rates and a political climate dominated by corruption issues and policy flip-flopping aren't doing much to assuage negative sentiment either.

If one traces India's macroeconomic developments over the past few years, the INR's fall-off-the-cliff show would be seen as a delayed reaction to realities. What is surprising is the lateness of the reaction, not the event itself.

In simple terms, if country A purchased more than what they sold to country B, A would stare at a trade deficit and B would enjoy a surplus. If this process continued over time, A's cumulative deficit would grow, mirrored by B's cumulative surpluses. A would have to continually rely on external capital to continue with the status quo. B, with its accumulated capital over the years, might agree to lend to A, so both continue to trade happily...

A's persistent borrowing to finance the deficit would lead to increasing indebtedness. Beyond a point, its financial health might begin to cause B some concern who, worried about repayment, might curtail lending. At this point, much-needed capital dries up and as confidence in A's financial well-being erodes progressively, investors would begin pulling out capital, leading to depreciation in A's home currency.

To prevent continued depreciation and lend support to its currency, A could (1) utilise foreign currency reserves and/or (2) borrow. (2) is not a good option in situations similar to those in the above paragraphs (would lead to further erosion of investor confidence). Many countries through history have resorted to (1), and then (2); before complete erosion in confidence led to obliteration.

Worsening Trade Balance...

Working off this (highly) simplified example, we turn to India's Trade situation.

Source: RBI

The flat INR helped buoy imports, which grew 25% p.a., over the past 7 years. Exports, during the same period, grew 21% p.a. The progressive deterioration in trade balance necessitates a counter-weight through inflows of capital. Unlike its Asian peers, India does not enjoy surpluses on its current account, thereby exposing it to the vagaries of capital flows.

...funded by Capital inflows, so far

Source: RBI

In the past, India has been somewhat heavily reliant on foreign portfolio flows, followed by credit, to fund the current account deficit. In 2008-09 when net portfolio investment was negative and credit dried up following the credit crunch, India had to dip into its foreign currency reserves to make good the shortfall. Part of the hypothesis behind the INR's prospective weakness is centred around this possibility.

For the first 6 months of the current fiscal, net capital inflows were $40 billion, with FDI contributing over 50%, followed by External Commercial Borrowings (ECB). The more volatile foreign portfolio investment has been negligible this year, largely a reflection of the global macro environment, flight-to-safety and eventually, flight-to-cash.

The influx of longer-term FDI capital is a welcome development. In this backdrop, the recent backlash on FDI in multi-brand retail comes at an inopportune moment. Superimposed on a political environment characterised by credibility deficit triggered by corruption issues and frequent policy flip-flops, tapping the ECB route for funding seems the path of least action, going forward.

INR History: An artificially high level?

India snapshot (source: RBI)

The growth in M3 - a money supply measure - over the long-run has been an important carrier of information on inflation (evidence from around the world: here, here, here). Over time, inflation chips away at the purchasing power of currency. Given the divergence in India's true inflation and those in developed market economies, the INR should have trended down over the years. While it wiggled up and down, the INR stayed flat over Dec-03 - Jun-11, even as money supply and credit expanded strongly.

Viewed in this context, a combination of foreign portfolio capital flight due to jittery global markets and persistently high inflation, have finally managed to trigger a long-overdue correction in the INR.

External Debt situation

India's current total external debt = $316 billion. $68.5 billion of this amount is short-term, making up 43% of residual maturity (historical levels). Foreign currency reserves cover ~8 months of imports. Assuming that the maturing short-term debt is fully rolled over and the trade deficit at the end of fiscal '11-12 = $150 billion, India's incremental capital requirement through Mar-12 is likely to range between $20-30 billion. With external debt at < 20% of GDP and debt service coverage ratio at 4.5x, solvency is not a central issue. Refinancing could largely be contingent on the EU situation. Any deterioration on that front could put some pressure on debt roll-overs, by way of availability of refinance and/or cost. In the worst scenario, India's foreign reserves should be able to cover the maturing short-term debt comfortably.

What could support the INR?
Broad factors:

Interest rate hikes
Foreign capital inflows
EU debt resolution
RBI intervention

The strong pace of economic growth over the years has stoked inflationary pressures, which is persistently above the RBI's comfort zone. Prioritising inflation combating over growth, the RBI embarked on a rate-tightening regime over 2010-11. This interest-rate stance has been one of the factors supporting the INR, so far. As the world dipped into recession and interest rates headed towards the zero bound, investors hungry for yield found succour in high-interest rate markets such as India.

Economic growth and investment activity are exhibiting signs of slow down, while industry and consumer expectation surveys paint a gloomy picture. The continuing issues in the EU is likely to persist into 2012. In this backdrop, rate hikes by RBI, going forward, appear low probability. If anything, should economic growth slow down, a reversal of RBI's interest-rate stance is highly likely, which would reduce the INR's allure. -1.

Given the negative real interest rates and political gridlocks repeatedly scuttling policy initiatives, the prospect of foreign portfolio investors returning to India with gusto appears grim. ECB seems the most likely route to be tapped, weakening INR notwithstanding. -2.

The evolving EU situation could have interesting repercussions for the INR. In the best case, a complete resolution that infuses a sense of bonhomie among investors could see capital flows into India, which would be positive for the INR. This, it must be admitted, is very low probability. The only other plausible options seem; (1) band-aiding of the EU continues, which would be neutral to the INR, due to investor risk aversion, or, (2) The extreme scenario: A Euro breakdown. This would mean curtains for the INR. -3

Enter RBI?

There's a growing chorus of voices urging intervention from the RBI to stem depreciation. The RBI's few attempts so far hasn't had the intended effect on market participants. Unlike its Asian peers, which may recycle trade surpluses to support their currencies, India's deficit situation reduces its room for manoeuvre. The RBI has voiced its intention of resorting to Open Market Operations and tapping other levers should push come to shove (jigging the Cash Reserve Ratio/Statutory Liquidity Reserve).

Parting comments

A turn in RBI's hard interest-rate stance seems likely, going forward. Continued reliance on foreign currency borrowings appears to be the most likely outcome. In the best case (low probability), the INR is likely to wiggle sideways, while progressively introducing hurdles in the form of domestic and global macro issues (higher probability) quickly weakens the case for a long INR.

Kiss From A Rose: Scenting Karuturi Global

2011-11-23T12:10:00.001+05:30

US$1 million = रु.5 Crore
Country: India
Home currency: INR

This post focuses on Karuturi Global ("the Company"), the world's largest producer of cut roses and an aspiring agriculture company with a presence across India, Kenya and Ethiopia.

Before getting acquainted with the Company, it is worthwhile to get introduced, briefly, to the business of rose production.

The Business: A thorny process to a rosy end

The birth of a rose involves the following:

Land and Equipment: The major fixed-cost components. The quantity of roses produced is a function of yield, which tends to vary depending on a slew of factors
Planting
Harvesting and Picking: It takes about a year for full production, from the time of planting. Picking is a critical activity that influences rose quality and prices. Trained personnel are a critical requirement here
Packing and Transport: Once the roses are picked, off they go into a bucket of bacteria-enhanced water for preservation. From here on, they enter the safe confines of a Cold Storage Unit. Stems aggregate into bunches, then boxed and ultimately get transported to end user markets across the globe

Growing roses is a complex operation. For the pain that goes into the production and the pleasure they grant to consumers, roses are reasonably resistant to recessions. The arenas where they are commonly found; weddings, funerals, home/office adornment, image building, expressions of love et al are typically unaffected by the mood swings of recessions.

Pricing is a function of rose variety; which ranges from small stems (Sweethearts, how apt!), medium stems (Intermediates) and large stems (Hybrid Teas)

Over the past couple decades, trade volumes of cut flowers have grown in the high teens. Pricing, however, has largely remained tepid. Roses enjoy relatively stable long-term demand, generate good margins and above-average returns on invested capital. Europe is the largest consumer market, accounting for over 50% of global cut-flower consumption. Other major markets include USA, UK, Russia and Japan.

Pegged at over $40 bn (source: US Department of Commerce), the global cut-flower business has been a steady grower.

Rose Production: Economics

A farmer owning 1 hectare of land and contemplating growing roses might look at the following picture.

For illustrative purposes only

Key levers that influence operational performance are yield, pricing and costs. Historically, it has proved difficult to exercise the Pricing lever consistently. Yield tends to vary and is dependent on a variety of factors such as geographic location, water/irrigation facilities, soil dynamics.

A hold over costs and benefits of size become a critical factor in developing a strong moat. As the world's largest producer of cut roses, Karuturi enjoys admirable competitive positioning. Roses are a fragmented market and competition, of any reasonable size to pose a threat to the Company, is low. On the costs front, Africa compares favourably with Europe, where high costs of production are driving producers to convert their floriculture bases to holiday villas. Another critical aspect is proximity to end user markets. Africa's proximity to Europe and India's to Japan bestows distinct advantages on the Company in catering to two of the largest markets in a cost-effective manner.

Roses reach end consumers through various channels. Primarily, the auction markets in Netherlands witness frenetic activity and account for ~40% of roses moving in Europe. Roses are also sold to bulk distributors, retail chains and bouquet makers.

Company History

An insight into the company's evolutionary history makes interesting reading.

Karuturi entered the floriculture business as Karuturi Floritech in 1994 in India, with an annual cut-roses production capacity of 7 mm near the city of Bangalore.

Late 90s and early 2000s: Changed its name to Karuturi.com in 1999. In 2001, it obtained an internet service provider license and rechristened itself as Karuturi Networks. Operational performance was anything but boast-worthy with the company swinging from profits to losses and vice versa. Though revenues grew at a compounded rate in excess of 90%, after-tax profits flip-flopped between Red and Black. Free cash generation was lacklustre.

c.2002-2007: Grew as a floriculture company focused on rose production. Roses were produced in India and exported to Europe, Japan and Russia. Revenue grew from रु.10 Cr in 2002 to रु.45 Cr in 2006. Net income swung from losses to रु.15 Cr, achieved on a capital base of रु.45 Cr funded with negligible debt. Operational performance was noteworthy during this phase, with strong growth being achieved with improving profitability and returns on capital (>40% ROIC). Revenues CAGR was 60% while EBITDA CAGR outran revenues, growing close to 100%. Capital base grew at 75%, as incremental capital was invested profitably. Enterprise value reflected this improvement, growing >40x over this period. Cash burn progressively increased, concomitantly. The Company was morphing into a growth machine.

2007-present: It enhanced its footprint in rose production with the acquisition of Sher Agencies, a Dutch rose producer (500 - 550 mm roses production) with operations in Kenya in Oct-2007. Purchase price was around $70 mm and Karuturi paid about 6-7x profits for the acquisition, which has turned out well. Through acquisition and expansion, the Company is now the world's largest cut-rose producer.

It has since embarked on a flower-to-food transformation. Karuturi is evolving into a global company with a growing presence in Africa (Ethiopia, Kenya). About 600 million rose stems are produced and sold each year across Kenya, Ethiopia and India (small contributor), which find their way into Europe and other export markets. In addition to floriculture, it aims to evolve into an agriculture company over time. The latter business is focused on producing food crops; maize, wheat, rice, sugar, palm oil and soybean. In due course, agriculture is expected to be the mainstay business. Corn and rice produced currently are bought by South Sudan.

Revenue CAGR over this period was 60%, EBITDA grew at ~50%. Unlike the previous stage, growth has been achieved on a capital base that has expanded faster, at 70%.

Revenues in the most recent year were रु.640 Cr, EBITDA of रु.240 Cr, net income रु.155 Cr, achieved on a capital base of रु.1,900 Cr with debt at रु.560 Cr. Over this period, enterprise value grew to रु.2,300 Cr. Stock price currently is lower than in 2007 but market cap has grown 2.5x, as this period was accompanied by significant equity dilution.

The expansionary third phase has witnessed massive capital outlays (about रु.1,500 Cr) as the company acquired land in Africa. The next 3-5 years should see operations expanding to Tanzania with investment outlays of $500 mm.

In 2006 (when I first invested in the Company), I was attracted to its high ROIC, lean balance sheet, attractive dividend yield (5%), inexpensive valuation (2x trailing earnings) and growth profile.

An unknown company back in 2006, its sheer pace of expansion over the next two years attracted investors like Soros Fund Management, IL&FS Investment Managers and a slew of others, who rode with the stock on its journey from mid-single digits through the early 40s. It also smartly sold convertible bonds (foreign currency convertible bonds, as they are called in India) in two tranches totalling $75 mm at the height of the bull market. c.$39 mm is currently outstanding.

It isn’t surprising that investors (foreign investors hold 35%) adore this company. The agriculture premise strikes a chord, especially as Karuturi is essentially an India-domiciled company with operations heavily weighted to Africa, the next expected growth frontier.

Over time I have been pruning exposure, though. This is largely attributable to strong share price movement post purchase (8-10x rise), historical (and prospective) equity dilution, compressing ROIC and management.

Promoter holding is a little over 18%. There are numerous instances of Indian promoters with relatively minor stakes in their listed Indian entity routing cash to fund overseas projects. Painful experience investing in Indian convertible bonds has impelled me to view such instances with a healthy dose of suspicion. As a mitigating factor, the promoter recently made a preferential warrant issue at रु.21.6/share (5x current share price) which, if fully converted, would take his stake to over 20%.

African Sojourn

The recent trend of Indian promoters venturing into Africa has been greeted with approval but question marks remain. Overseas companies have been cutting deals with local governments to lease land at throw-away rates. Karuturi has signed a 50-year renewable lease on 100,000 hectares in Ethiopia where its rentals are $1.2 / hectare / year. The Company claims that it managed to cut competitive (extremely) deals as it enjoyed first-mover advantage. Subject to the Ethiopian government’s satisfaction on Karuturi’s execution record in developing the first 100,000 hectares, it would have rights to develop an additional 200,000 hectares.

A recent deal by a US company in South Sudan was annulled after a pressure-group activist exposed the one-sided deal. Karuturi has so far remained unscathed but given the low payment rate, the limelight could fall on it in the future. Further, the contract allows the lessor to amend rents at its discretion and includes an exit clause, allowing the lessor to terminate the contact post a 6 months written notice. Even though the Company is in dialogue with World Bank to insure against political risk in Africa, this remains one of the key risks to the business.

Thoughts on Convertible Bond: Debty Matters
Some thoughts on the unappreciated piece in the capital structure is in order.

Companies in India carry convertible bonds at book value on the balance sheet. When stock prices fall so much as to make the convertible bond's conversion option practically worthless, the convertible needs to be perceived as debt. When redemption comes calling, the book values morph into redemption values (which, in some cases, are far higher than stated balance sheet numbers). Several companies in India (and many unfortunate investors) have had a gut-wrenching experience with this phenomenon in the aftermath of 2008.

The Company issued the following FCCBs in 2007:

Feb-2007: $25 mm, 0%, 5-year maturity. Current outstanding = $0 - 3 mm (FCCB I)
Oct-2007: $50 mm, 0%, 5-year maturity. Current outstanding = $39 mm (FCCB II)

Total debt outstanding, Sep-2011 = $120 mm, with FCCB making up $39 mm.
Split isn't available; as FCCB I is a small amount, it is best to assume all outstanding as FCCB II.

Redemption falls due in Oct-2012. Conversion price on FCCB II is nearly 5x current share price. Thus, conversion into equity is a remote likelihood. In this scenario, focus shifts on ability to repay the convertible bond, either through internal cash flow or refinancing.

Including the YTM (Yield to Maturity) of 7% p.a on the FCCB II, total amount payable at maturity = रु.270 Cr. Credit situation, next year, should be comfortable with Total debt / EBITDA ~3x and Debt / Equity = 0.5.

EBITDA may be ~रु.250 Cr and operating cash flow रु.150 - 180 Cr, next year. Total credit limits available with the Company = $200 mm, leaving undrawn credit lines at $80 mm, or ~रु.400 Cr. A combination of cash flow and refinancing should be able to fully cover FCCB redemption.

At current indicated bid/asks, the convertible could fetch a YTM between 32% - 40% for a holding period less than a year. Considering the above repayment scenario and Karuturi's equation with foreign investors in the past, full repayment may be reasonably expected, in the event of non-conversion. Given the weak prevailing sentiment towards equities, an investment in the convertible bond instead of common equity affords a more favourable risk-reward (but is limited to only certain classes of investors).

...that is to say, ability to pay should not pose a problem. Willingness, however, may be another matter altogether.

Thoughts on Valuation

Current share price = रु.4/share, Common equity @ market = रु.340 Cr, Enterprise Value = रु.810 Cr, P/E (last year earnings) = 2x

A useful way of thinking about Karuturi's value is to think through individual business.

Floriculture: Using an after-tax profit / stem of c.4 cents (above illustration) and rose production at 500 mm stems (2011 production = 600 mm), profits = $20 mm. Rolling 3-year average multiple over the past 8 years = 7x. Using a 4x multiple, market value of the equity = $80 mm, or रु.400 Cr for the stable floriculture business.

Agriculture: This business is in nascent stages currently. Beginning with maize and paddy, production of palm oil and sugar is expected over a 3 year time-frame. This year 12,000 hectares of maize and paddy were planted but a flood decimated the entire crop. Hopefully, this will be a non-recurring event. It competes with the likes of Bunge and Cargill in this business, as a result, competitive positioning is weak compared to its strong positioning in the floriculture business.

A hectare yields between 1.5 - 5 tonne of crop. Using 2.5 tonne / hectare, 5% after-tax margin and 25,000 hectares under crops over the next 3 years (Company is eyeing 100,000 hectares), this business could generate after-tax profits in the region of रु.15 - 20 Cr, on a conservative basis. At 4x earnings (global agriculture companies trade between 8-10x), this business would be worth रु.60 - 80 Cr.

Floriculture + Agriculture = रु.400 Cr + रु.60 - 80 Cr = c.रु.460 - 500 Cr, a broad range of value for Karuturi's equity on a conservative basis.

Considering that floriculture capacity is slated to grow 30% over the next couple years (probably sooner) and relaxing some of the assumptions for the agriculture business, intrinsic value has the potential to be far higher than indicated above.

Dwelling on the two primary drivers of business, the stable floriculture business is likely to continue ticking at a reasonable rate, while the agriculture business will drive optionality over the intermediate-to-long term.

Headwinds to the business are:

Africa pressure group activists. Most do not seem to share my concerns but this is something worth watching closely
Sustained cash burn, leading to equity dilution/increasing indebtedness. This is likely to offset the positive effects of revenue growth
Exchange rate movement. With exports making up a significant chunk of business, a hardening of the INR would affect the Company negatively. The probability of this, however, is low. The high inflation environment compared to the developed nations and a slew of other macro-related issues is likely to keep the INR weak

Extend the investment horizon longer to 5 years and above, strong sustained revenue growth is needed (c.20% CAGR) to support stock price. Allowing for compression in margins and pencilling in expected capital outlays, cash burn rate is likely to be high and the Company would be hard-pressed to generate free cash flow. In this setting, as debt burden mounts progressively, further rounds of equity dilution may be warranted (a recently planned GDR issue was shelved due to adverse market conditions). A convertible security offering might enter the picture (speak purely from experience, no mention from the Company).

Concluding remarks
Growth in the pie (business value) looks highly likely, but if there are more claimants on the pie, value of each pie (share price) could languish. Equity holders would be loath to bear the weight of prospective equity dilution (shares outstanding have grown 14x in the past 6 years). A convertible instrument - preferential warrants/preferred shares/convertible bond - seems the best mode of financing prospective growth.

In sum, market participant interest (and other interests) in the Company could lead to wild swings in prices. For those who admire momentum, relying on an eager soul to whisk one's stake off one's hands at a higher price in the near-term is likely to be a profitable affair. For those who perceive those pieces of paper as a stake in a business, the rosy road could be strewn with thorns.

Position disclosure: Long common equity.

Disclaimer: This is not a recommendation or a solicitation of interest in the Company. History is rich with examples of losses triggered from speculative activity in financial markets. Please consult your advisor, and more importantly, your judgement, before investing.

Schizophrenic Markets

2011-09-25T21:58:00.000+05:30

An abrupt market drop causes a rally in gloom-n-doom hypotheses. More than a few that landed in my inbox recently focused on the relationship between corporate profits and GDP. The core theme was this: corporate profits as a percentage of GDP exhibit a mean-reverting characteristic. Whenever they overshoot too far from the mean, they fall back; and this isn’t good for long-term equity returns. Current levels are close to historical highs, so equity bears invoke the above to build a bear case. Historical references cite the peaks hit in 1965/66 and 2006 as strong evidence for weak subsequent equity performance.

History provides some insights. The following exhibit uses after-tax corporate profits from NIPA and uses the Dow Jones Industrial Average as a barometer of equity performance. The DJIA was chosen as a longish history of prices was readily available. For comparative purposes, a similar exhibit for the S&P 500 is appended later.

Only 2 out of the previous 9 occasions have been dreadful for long-term equities. The 1965/66 peak (the so-called Kennedy-Johnson peak) was followed by a long period of negative equity market returns. Something had changed on this particular occasion compared to previous instances. The 2006 peak seems to be (so far) tracing the 1965 pattern. Indeed, in terms of performance, the latest instance is unprecedented.

The S&P 500 shows a similar pattern, except that the 1965 peak exhibited some divergence with the DJIA’s performance over the 2 and 3 year time frames. The 1997 peak preceded a decent show by equities over the typical time frames that a majority of market participants inhabit (1-3 years).

Given the above, the equity-bears’ argument for selling equities on the premise of historically high corporate profits/GDP necessitates a closer look.

One went about searching for the missing pieces that could complete this jigsaw puzzle somewhat, and zeroed in on some metrics that to have a bearing on equity performance. Metrics included Robert Shiller’s cyclically-adjusted P/E ratio (CAPE; real S&P 500 price divided by last 10-year average real earnings), 10-year US Treasury yield, AAA corporate bond yields and inflation (CPI).

Ceteris paribus, a high starting CAPE accompanying peaks might be posited to set the stage for weak subsequent returns. High valuations and high profits relative to GDP would imply that most of the positives were already priced in by market participants; and slip-ups on profitability would be perceived unkindly.

A closer look at history

In investing, very often, the path taken to arrive at a signpost has a strong influence on future course of events. The exhibit below presents a 10 year picture; 5 years prior to the peak year and 5 years subsequent to the peak year.

Cut to 1965: At the cusp of 1965, the market came off a period of low inflation and general prosperity in the 50s and 60s. Optimism buoyed by President Kennedy’s election in the early 60s, and followed by President Johnson’s Great Society program, stoked a rally in equities. And then the Vietnam War escalated, degenerating into a deadlock, ultimately entering the history books as a costly indulgence. Johnson’s Great Society dream would remain a dream and inflation worries increased as a result of the war, puncturing investor confidence. Proving market participants’ right, inflation inched up through the 60s and 70s. 10-year Treasury yields inched up through the same period.

It appears that a high starting P/E + corporate profits / GDP peak + high inflation + rising bond yields in the post-peak period set the stage for weak equity performance.

Some caution is warranted, however, before forming a provisional conjecture. Post-1941 performance dents this hypothesis. The World War II peak was followed by a rise in inflation. Through 1941, average P/E was reasonably high and inflation was low, similar to 1965. Ensuing equity performance was strong, however. High valuation + peak + high inflation had not succeeded in keeping equity returns in check. The outcome is interesting considering that average inflation was higher post-1941 v/s post-1965.

The post-1974 performance was similar in behaviour to post-1941. Things get more intriguing here as average inflation was high both before and after the peak year and bond yields were well on their way to multi-decade highs. Yet, equities did okay.

By 1997 investor optimism was running high again and the CAPE was at elevated levels relative to history. Inflation was low and bond yields had been trending down over the past 15 years. This peak, however, was followed by a tepid show for equities over the medium/long-term.

Cut to 2006. CAPE was high, inflation and bond yields were reasonable. But ensuing equities performance has given no cheer whatsoever (so far anyway).

In a nutshell, equities do not bear a consistent static relationship with inflation or bond yields at all times. Valuation levels, however, are a different matter. But writing equities off because corporate profits / GDP are at peak is a little simplistic, in my opinion. Another important factor that these periods share is investor sentiment. Psychology plays a pivotal role in determining future outcomes and is, unfortunately, the least considered variable. The character of investor sentiment changed post-1965 due to a multitude of factors (Vietnam War inflation, Cold War etc.), resulting in bearishness, and was probably a contributory influence in keeping returns down. The vicissitudes of the human mind has trumped cold reality repeatedly through history.

Could this time be different?

A summary of the present: Corporate profits / GDP are presently at elevated levels relative to history, inflation is reasonably high considering the recessionary backdrop and bond yields are at historically low levels with little room to fall further. Are equities doomed, or does this represent an attractive entry point? Considering the above exposition one is reluctant to proffer a conjecture.

At 20x, the S&P CAPE is high relative to the past and broad interest rates are expected to stay low over the foreseeable future. Given the repeatedly unsuccessful attempts at band-aiding the global economy, few believe the present downturn to saunter into history books anytime soon. The difference between buying and selling the broad index is essentially a bet on the future pattern of investor sentiment. If the latter does not turn up, a purchase now is likely to face an unsatisfactory outcome. In relative terms, however, Germany seems to offer better value. The current CAPE of ~12x is close to 30-year lows. Throw in reasonably attractive dividend yields (~4.5%), and the DAX looks like a better basket to be long in. There is, however, the real risk of low valuations morphing into value traps and the high dividend yields potentially signalling lower dividends in the future...well...

S&P 500: High CAPE + historically low bond yields + medium inflation + poor sentiment + mixed history = Trance

DAX: Low CAPE + attractive dividend yield + King Kong of the EUR + poor sentiment = (lesser) Trance

It seems a better proposition to dwell on individual businesses rather than participating in a broad index. High dividend yield equities combined with low dividend payout ratios in industries that are relatively recession-resistant is a theme that the mind is drawn to.

Sometimes, history accentuates an investor’s Uncertainty Quotient. It’s a bittersweet feeling.

Schizophrenic markets do not help either.

A closer look at NCDs - Is it worth perching high on the capital structure ladder?

2011-09-05T02:22:00.003+05:30

Indian non-banking financial companies (NBFCs) have been rather busy of late. July and August witnessed a slew of non-convertible debentures (NCDs) being offered to investors with a few on the way. It has helped that August was a washout for equities. Investors, repulsed by the downturn, have gleefully accepted the prospect of high yields offered on newly minted NCDs.

This post casts a bird's eye view on the NCD space, without treating any particular issuer specifically. The discourse is devoted to NCD investment appraisal and to ascertain the suitability of positioning in the senior pieces of the capital structure.

Central Hypothesis
Most primary issues, at offered yields, are unattractive on an after-tax basis relative to other available fixed-income options. Bank fixed-deposit rates over a 3-5 year tenor (the typical NCD maturity profile) compare well on risk-adjusted return. The other rationale for ignoring these issues in the primary market is the prospect of purchasing them at a discount to par, once they begin trading on the exchanges. This is predicated on a view on near-term future interest rates. The RBI is likely to bump key interest rates up in the forthcoming September meeting. As a consequence, many of these NCDs are likely to trade below par, offering the investor the opportunity of purchasing some of the higher-quality securities at a meaningful yield.

Disclosure: Apart from opportunistic interest in some of the issuers' common stock, no NCD holdings as of this writing.

NBFC Business model

Broadly, NBFCs are engaged in the business of providing capital to various sectors (auto, gold, capital market margin funding, small-and-medium enterprise financing, infrastructure financing etc.). NBFCs borrow from a combination of sources and lend onward at a higher rate (hopefully), making a spread in the process. In recent times, with regulatory changes making bank funding harder to come by, NBFCs have had to resort to alternative areas such as private equity and NCDs.

Key diligence factors to consider range from known knowns (company operating history, structure of loan book, non-performing loans, net interest margin and the rate of profit on invested capital relative to cost of funding), to the relative dangerous territory of known unknowns (how big are true bad loans?), to the most dangerous of them all, unknown unknowns (prospective regulatory environment, future macro-credit situation).

Factors contributing to business moat include promoter pedigree, long history of operations, size, clean credit history, access to low-cost funding, geographical presence and range of sectors serviced. Barriers to entry, in general, are low and NBFCs compete with banks that have access to lower cost capital and greater geographical penetration. As a result, NBFCs seek to differentiate themselves by offering better terms (speedy processing, rate of interest charged and other loan terms) to borrowers. Overarching these factors is the 'R' word. The prevailing Regulatory environment has a significant bearing on business and earnings power.

Recent NCDs

$1 = INR 45.7

A few things stand out. Bid-to-covers (a measure of investor demand) have been strong but investor appetite seems to be waning gradually. Yields to Maturity are inching higher with a corresponding descent in issuer credit rating, in a pattern reminiscent of credit issuance cycles in the past. Of the recent issues, Manappuram Finance pre-closed its NCD issue prior to scheduled close date after mopping up INR 470 Cr ($103MM). Its larger rival Muthoot Finance's ongoing NCD could possibly have been one reason. Other factors prompting the early close are India Infoline Investment Services' NCD, which promptly dropped below par on listing and broker routs in the grey market.

Key operating metrics

The table lists prominent operating metrics of NBFC issuers (by no means an exhaustive list). The ROIC - WACC spread is a measure of the excess return earned by an NBFC on its total capital funds (debt + equity funding). The Implied Growth Rate has been arrived at using the Price/Book model for financial institutions.

Bond investing is a negative art, as Ben Graham called it, and it is sound practise to follow a process of exclusion in security selection.

Past growth for the group has been extremely strong, especially for the gold loan companies. The high debt-to-equity ratios reflect the nature of the NBFC business. Persistent growth is a function of continued and cheap access to external capital. Turning to the interest coverage ratio, a high number is preferable but there are no quantitative axioms with respect to what this ratio ought to be in order to be considered 'reasonable'. I prefer using 2x as a starting point, with a lower limit of 1.7x.

An NBFC's loan book often is the largest component in current assets. Provisions for stale loans are made but almost always pander to 'provisioning norms' set out in the rule Bible. One way to think about this is to imagine a scenario if 10% of the loan book goes 'bad'. This could well be an outlier event but a remote probability, nevertheless, worthy of consideration. In a liquidation scenario (for e.g., all loans called in), only a fraction of book value is what is likely to be realised and hence, a cover of over 1x total debt is a reasonable standard to work with. Lower cover warrants close attention and needn't necessarily be the cause of complete exclusion.

Shriram Transport Finance (Bloomberg: SHTF IN) and Manappuram Finance (Bloomberg: MGFL IN) look good on these standards. Their comfortable Capital Adequacy Ratios and positive return spreads (ROIC - WACC) are other attractions. Macro drivers for the latter in the form of low gold loan penetration and a gradual shift in attitudes towards gold pledging should be supportive of prospective growth.

The recent NCDs are secured obligations ranking on par with other existing secured obligations. "Security" usually takes the form of a charge on receivables and/or immovable property. An asset cover might also be insisted upon, in some instances. (Whether the security is enforceable is another matter...).

Interest-rate cycle: A case for extending Duration
The RBI seems to be heading towards hitting the pause button on broad interest rate hikes. The frenetic pace of hikes over the past year in a bid to tame inflation could possibly be close to plateauing (at least, temporarily). The September meeting could see a rate hike but the prognostications for the remainder of 2011 and early 2012 lean towards the 'pause' camp. Renewed global economic slowdown lies at the crux of this view.

The near-term hike could likely lead to a few NCDs trading below par (recently listed ones are already below par). However, craning the eyes out over a 3-year horizon, the path of least resistance for future interest rates is likely to be flattish-to-down; the latter gaining in probability should the slowdown persist through 2013. In such a scenario, extending duration by purchasing longer-dated bonds could be attractive.

Risks: Explicit (and Implicit) Issuer Call Option
A word of caution deserves mention. SHTF's 5-year NCD carries a Call Option at the end of 4 years. Were interest rates to follow the path posited above, it is likely that the issuer would Call the bonds and refinance it with lower rate debt. Capital appreciation on this bond will be capped due to the Call feature.

The other NCDs do not have an explicit Call Option but the indenture allows the issuer to call the bonds in, under certain circumstances. Sardar Sarovar's deep-discount bond story in 2004/5 is a good example from history that highlights the risks faced by investors holding bonds issued at high interest rates. When interest rates fall subsequently, it is in the issuer's interest to replace high-cost debt with low-cost debt.

From my enlightening experience investing in convertible bonds (junior, unsecured debt in the capital structure), I have learned to make an allowance for wilful defaults. This refers to the situation when an issuer has the ability but not the willingness to honour debt obligations. The NCD's security acts as a reasonable mitigant but in my experience, enforcing the security is often a harbinger of a wild goose ride.

High yields are sometimes no compensation for deficient safety.

Risks: The 'R' Word
NBFCs are subject to close regulatory scrutiny. Over the past few years, capital adequacy norms have been tightened and so is a realignment in non-performing loan classifications. Any clampdown on bank lending to NBFCs is a significant source of risk and could dent earnings power. The Gold Loan financing companies, additionally, are subject to state laws that could cap interest rates charged to customers. Any imposition of rate caps by RBI could further erode earnings power.

The Tax Angle
Unlike infrastructure bonds which allow tax benefits to the investor, NBFC NCDs offer no such moolah candy. The interest income is taxed at an investor's normal income-tax rate and so are short-term capital gains (gains realised within 1 year). Long-term capital gains (realised after 1 year) are taxed at 10% without cost indexation.

As an illustrative example, a 3-year annual-pay NCD carrying a 12% coupon would return the investor an after-tax yield of 8.4%, if held through maturity and sold at par value. IRRs increase if the investor's exit price is at premium to par.

These after-tax IRRs lose their sheen on a risk-adjusted basis, when compared to bank fixed-deposit rates over similar tenors (I am not particularly keen on interest income). After-tax interest rates on fixed-deposits, while lower, carry little default risk and come attached with a (near) assurance on principal repayment.

Past NCD issue price behaviour: L&T Finance, 8.4% semi-annual pay, 2013 maturity
The security's 52-week low price of 78% of par value afforded an investor an after-tax yield in the 20%s. A decent return for secured senior debt, on a reasonably well-capitalised, pedigreed name. I am keeping an eye on high-quality issues when they are available at meaningful discounts to par value, ideally close to maturity.

Perhaps my history with issuer debt behaviour impels me to seek a wider-than-normal margin-of-safety. But I have learnt the hard way that in bond investing - as with recreational fornication - it is better to be safe than to be sorry!

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The above write-up is not a solicitation to invest in the securities discussed. It is meant for a readership that is interested in the practise of investing. Comments/counter-views are welcome.

Crisis and asset price behaviour

2011-08-13T13:28:00.001+05:30

The previous post was squeezed in-between trades (to have a standing record of my thoughts-in-motion). I spared myself a rather longish exposition on history and behaviour. Now that the gyrations have played out (somewhat; and I have unwound my panic trades), I have time for a breather.

The US debt downgrade was greeted with knee-jerk reactions followed by various voices crying hoarse, expressing solidarity in Uncle Sam’s debt. The Risk switch snapped from ‘On’ to ‘Off’ and capital duly forsake equities, fleeing into US Treasuries, Gold and CHF (Swiss Franc). The flight into Gold was understandable, given its current-flavour-of-the-season status as a safe-haven. The CHF and US Treasuries' behaviour were queer, to say the least.

Crisis moments in history always provide good food for the curious brain.

1987 stock market crash

The 1987 stock market crash triggered a bout of risk-aversion. Panicking investors pulled out of equities to seek refuge in Treasury bonds. Gold was sold. The prevailing rationale for dumping the latter centred around two basic arguments. 1) A depression would likely follow the crash, in which case inflation would be a non-event. As Gold was seen as a hedge against inflation, it wouldn’t be in demand, 2) Gold was being sold to meet margin calls on other asset classes that were being pounded in the battering.

Equities – DOWN, Gold – DOWN, Treasury Bonds – UP

Gulf War

The onset of the Gulf War triggered a rise in crude oil prices (which was reasonable, considering the battleground was atop mountains of oil). The US$ weakened as investors fretted about likely future budget deficits caused by Gulf War spending. Equities and US Treasuries sold off; on the rationale that war-induced inflation would hurt the economy. As inflation is stocks and bonds’ nemesis, both sold off. It is pertinent to note that US 10-year Treasuries were yielding 8.75% and the Fed had much leeway in slashing interest rates, if needed. Another quirk was the behaviour of the Japanese Yen (JPY). Even though Japan was more dependent on Middle East oil than USA and was still coming to terms with the fallouts of the Nikkei bubble, investors embraced the JPY!

Equities – DOWN, Gold – UP, Treasury Bonds – DOWN

Internet bubble

The dot-com bubble that popped in 2000 was chiefly led by technology and internet stocks that were heralded as the game-changers of the 21^st century. When the bubble eventually popped, investors swapped equities for bonds. 2000 turned out to be a good year for bonds that were up about 13%. The tech wrecks dragged down equities, with the S&P500 ending the year -10%. Minus the tech jocks, the S&P ended the year marginally positive, indicative of the ring-fenced tech space power outage.

The crash, once again, prompted fears of an economic slowdown. Overlapped on US’ fiscal situation (budget surpluses, which minimized the need for debt financing), this created a happy situation for bonds. Bonds were in vogue as people positioned themselves for a slowdown. Gold had a good year too.

This might seem a bit odd. If inflation was a big concern, Gold’s rally would seem rational, given that it was seen as an inflation hedge. However, this should have caused bonds to sell-off. But as both gold and bonds rallied, did this point to an anomaly? An irrationality? Some caution is called for before forming an opinion on supposed irrationality. Because, sometimes, people see Gold as an inflation hedge and at other times, they perceive it as a safe-haven. In this event, Gold was christened as a safe-haven buy. When perceptions change is difficult to predict and is one of the many things that make a market practitioner’s job interestingly challenging.

Equities – DOWN, Gold – UP, Treasury Bonds – UP

These events highlight divergences in investor behaviour at various points in history. The illustration is useful for more than its behavioural value. It highlights the pitfalls of betting blindly on past patterns repeating in the future. Firstly, crisis events have no clear pattern repetition. While events rhyme, each event is unique in character and the test is one of right interpretation. Secondly - and yet - it hurts to not peer into history to learn the lessons of past folly.

Gauging prevailing investor psychology (the Hypothesis) at various points in time is probably the toughest and the most important aspect of an investment practitioner’s job. It is akin to a doctor checking a patient’s pulse as the first stage of a diagnosis. In 1987 the Hypothesis was an era of economic growth slowdown where inflation was not expected to be much of a concern. In the aftermath of the Gulf War, the Hypothesis was a period of economic growth slack where inflation was the chief concern. Post the 2000 bubble, the Hypothesis was a period of growth slack but where inflation was not a priority concern. Recession was posited in the first and the third instances, while stagflation was the prognosis in the second. The common thread in all three was the repetitive passing out of equities. Paradoxically, even though equity sell-offs have often triggered fear, usually they are reactive to broader rumblings elsewhere in the economy.

A ‘barmy’ world?

A quick look at US’ financial situation in 1987 compared to today. Compared to 1987, US national debt has risen 6-fold while GDP has increased about 3-fold. US national debt is now nearly 100% of GDP versus 50% in 1987. Back in 1987, US 10-year Treasury yielded 9.5% and inflation (CPI) was 4.5%, implying a real return of +5%. For investors flooding into US Treasuries in 1987, this was a tempting prospect. Cut to 2011, US 10-year Treasury yields 2.5% (and trending lower) while inflation (CPI) is 3.5%, for a real return of -1%.

Yet, capital flooded US Treasuries. The CHF is bid even as real rates on it are negative.

Even as European peripheral weaklings spar with bankruptcy and US scrambles to extend its honeymoon period with borrowed capital, corporate financial health seems to be healthier than in 2008. Net debt/EBITDAs, in general, are lower than in the crisis, interest-rates are at multi-decade lows and valuations seem reasonable. Yet, bidders are rare.

The world looks thus: Negative real-rates trade seems to be well and truly pumping. An asset that has never had a recorded account of throwing out cash, which is painstakingly (and expensively) dug out of the earth only to be stored in vaults (at an expense), is bid up enthusiastically. While businesses that are healthier now than in the recent past (and throw out real cash) are ignored.

Will Alice come out of Wonderland?

Stags-flation

2011-08-06T13:09:00.001+05:30

So S&P downgraded the US one notch to AA+ with a ‘negative’ outlook. Given the downgrade, escalation in the debt limit and promised spending cuts spread over the next decade; one would be forgiven for thinking Treasuries would have sold off with money flowing into safe-haven favourites (CHF, JPY, Gold..). Treasuries rallied reacting to this news, showing that in times of duress, psychology trumps everything else as investors pile into an asset class for its perceived safety value. Never mind if the expected return is not commensurate with the risk assumed. Actually, few think in terms of 'return' when it is apocalypse time. Treasury rally in the face of a downgrade also indicates that few probably believe in the rating agencies' opinions. With the Swiss bank slashing rates to curb the CHF's rise and the BoJ intervening to prevent a rise in the JPY, the world resembles the stage in the 1930s when everyone scampered to be the first to hit the currency bottom in a bid to boost exports.

Given the above, it looks likely that Monday market open will be greeted with $ weakening, more Treasury buying, and money flow into Gold, the ultimate (perceived) safe-haven. Disclosure: Long yellow metal.

Stepping back a bit and looking at the globe as a developed/emerging markets matrix, one observes:

1) The developed world struggling with solvency and liquidity issues, with politics upstaging economics by a huge margin. The politics trade is a tricky one, giving few asset classes or trading themes time to take shape. Growth continues to be anaemic while inflation seems just a corner away from ambush. The devil is on leash for now but for how much longer? The path of least resistance seems to be a period of stolid economic growth amidst a backdrop of low-to-moderate inflation. Stagflation = +1.

2) The emerging world is grappling with a central banker's ultimate nemesis; above-target inflation and below-trend (and slowing) economic growth. The path of least resistance here too, like the developed world, seems to be a period of stagflation. Stagflation = +2.

Lessons from history are a little dodgy here. The (anti-inflationary) Gold Standard was still in vogue in the 30s, so inflation wasn't an issue for economies till they defected or were forced to defect from the Gold Standard. Economic growth took a knock collectively but inflation did not pose as much a threat as a collective issue as it does now.

Given this central hypothesis of stagflation, hard-asset plays and businesses with annuity characteristics with some degree of freedom to raise prices without a corresponding increase in cost, are themes worthy of consideration. In a period of anaemic growth, investors have historically not been loath to paying a premium for sustainable growth, explaining lofty valuations of some of the consumer plays like Nestle, Colgate, Gillette, P&G. As long as the central hypothesis holds, these consumer plays will continue to blink on investor radars, high valuations notwithstanding. Another theme is companies with strong balance sheets and low dividend-payout ratios. Cigarettes, toll-roads, water/waste-water treatment, sections of the natural gas value chain, battery makers...The fixed-income asset class provides some interesting plays, given the high interest rate environment, by way of NCDs that offer an attractive risk-reward in senior pieces of the capital structure.

The Phoenix bursts into flames before perishing, followed by a rise-from-the ashes moment. Though the flames aren’t visible yet, a burning smell wafts into my nostrils.

Amen.

A Bonded future?

2010-08-08T16:01:00.000+05:30

Quick rallies make me a little more skeptical than usual. The bond markets seem to tickle the skeptic in me. In times of doubt, I turn to history for a new perspective through which to view the present moment. As I browsed through the past, I chanced upon this article on the Great Bond Massacre of 1994. As with almost all instances, the 1994 bond market episode is instructive as much for the parallels with the present moment as for the uniqueness. Back then, as today, bond yields were at historic lows and inflation was muted. Wages were subdued and companies were struggling to raise prices. At the same time, idiosyncrasies exist, making the comparison an interesting and instructive exercise.

In 1994, euphoria ran high and the big spread between short and long rates saw speculators loading in on the carry trade (borrow short, invest long). The Fed kept rates low as the Clinton administration contemplated ways of slashing the deficit and Mr. Greenspan worried about inflation. Then Mexico sneezed, setting off a bout of contagion that quickly spread across the globe. US responded to a strengthening economy by bumping up short rates. Bulk selling of bonds began, pushing rates up, causing a death spiral for leveraged, long-duration longs. And as with the current crisis, hedge funds were promptly blamed. Some things are timeless indeed...

Cut to the present. Bond issuances have picked up strongly. July was the strongest month on record for global high-yield issuances ($24 bn). Companies sold $90 bn of U.S. corporate bonds in July, the most since 1999. Average yields on the securities fell to 5.01% on July 31, the lowest since April 2004. Bonds have outperformed equities YTD and Purchasing Manager's Indices have beaten expectations in several regions (barring China). The consensus seems to discount a low interest rate environment in the near-term and deflation seems to be at the top of the agenda. A sustained uptick on the indices could see GDP growth expectations headed in a direction that would make the deflation argument less forceful as time passes by. Could a surprise rate hike see a repeat of 1994?

Here's a quick capture of economic data from 1994 compared to the present.

Budget deficit was $200 bn back then. It is $1,500 bn today. Debt-to-GDP ratios have jumped sharply over the years and average GDP growth rates were vastly different between then and now. Increasing indebtedness and an unprecedented economic slowdown have led to interest rates hovering at near-zero today. US consumers are emerging from a period of historically low savings rates. As they grapple with a sluggish economy and a period of personal balance sheet retrenchment, the government's stimulus/quantitative easing (QE) programs are likely to have only a limited effect in jump-starting consumer spending. The Fed wants consumers to spend at precisely the moment when they seem most ill-equipped to do so! Low rates notwithstanding, I think consumer spending will take longer to recover than in previous instances (1973/75 recession a good example). The QE could see inflation rearing its head in the future but the probability of this scenario playing out in 2011 seems remote.

This would imply two things; (1) interest rates will continue to be low for a longer period than in previous instances and, (2) there is a risk of the US getting stuck in a Japan-like deflation spiral. I believe the consensus is focusing on these two broad factors, explaining the rally in bonds YTD relative to equities.

However, a couple of things force me to consider the alternative hypothesis.

(1) The encouraging corporate profits as a % of GDP number compared to 1994. Since bottoming in 4Q2008 (~8%) , this metric has been on an uptrend.

(2) The room for maneuver of interest rates. Rates are at near-zero bound and the low rate/deflation hypotheses largely seem discounted in prices.

When the weigh balance of investor preferences tilts to one side, it is always useful to consider the other side of the weighing scale. Consensus seems to be firmly behind bonds currently. From the above exposition, and YTD outperformance of bonds over equities, I think risk-reward favours equities relative to bonds in the near-term. Bonds may not pop as in 1994, but the risks of a GDP spike increases the risk of a rate hike, which would impact bonds more negatively compared to equities.

Conjectures and reality

2010-08-07T03:23:00.000+05:30

I have always loved writing. Investing, it turns out, provides ample opportunities to pander to the writer's urge in me. Apart from serving as a repository of my misses (which have been way more instructive than the hits), the blog has been a storehouse of investment conjectures over time.
I strongly believe the best gauge of one's guessing ability is to periodically note down investment conjectures and test them against reality. This has helped me get better at guessing over time. One can never get everything right all the time (I have had the good fortune of numerous humbling experiences), but net-net if one's guessing right, I think things will be alright over the long run. Below are excerpts from my writings in the past. A check of predictions versus subsequent performance.

The following was written on July 31, 2007 when the S&P 500 index was ~1,500.

Credit spreads have widened sharply over the past few months after bottoming out at historic lows, but the equity markets, as usual, haven’t begun their reaction....On most occasions, equity markets have lagged developments in Credit Spreads and this time seems no different. If history repeats itself, it wouldn’t surprise me if the equity markets corrected in the short-to-medium term.

S&P topped couple weeks later and broke sharply soon after...down 27% through today.

And this is from earlier this year (Mar 23, 2010).

In sum, the divergence in market values from underlying GDP performance is unlikely to be sustained in the future, in the absence of strong catalysts. Positing a scenario of a high inflation future coupled with deleveraging and sluggish growth, gold (and other precious metals) as an asset class appear attractive relative to equities.

S&P fell 13% to its trough; has recovered since, down 5% through today. Gold is up 10%...

This exercise has helped me learn a great deal about my investing style, my comfort zone and my weaknesses. I believe the world is inter-linked, which means opportunities exist across geographies and asset classes. The natural skeptic in me feels a wee bit more comfortable scouting around for things that are ripe for corrections. Someone, somewhere, is going bust all the time! And as life is a zero-sum game, this implies there is a beneficiary lurking somewhere...

While the hits are encouraging, the markets ensure there are enough misses to prevent the unwanted growth of a big head. Capacity for objectivity is inversely related to head size.
The pleasure - quoting Richard Feynman - lies in finding things out!

Greece: A 2,500 year parallel

2010-03-27T23:23:00.000+05:30

Old habits die hard. So the adage goes. As the Greece bailout drama unfolds, the curious mind began prodding, 'Maybe its in their history?'. The questioning mind always seems to find a way to some provisional answers. Till more questions goad it on to continue the journey.

5th century BC Greece's economic history, interestingly, provides some thought-worthy parallels to Greece's present-day problems.

History

The discovery of gold and silver mines at Siphnos provided Greece access to easy revenues. As was the flavour of the day, once the Gods took their share the rest of the profits from the mines were distributed among the subjects. The Greek citizens abhorred direct taxes but approved taxing foreigners, taxing property and indirect taxes. The easy prosperity somewhat fuelled imperial ambitions and marked the beginning of a sense of entitlement among the subjects.

While rulers in Asia managed to impose a direct tax on their subjects, Greece continued living off its bounty of riches. Attempts to impose direct taxes by unfortunate rulers ended with the rulers being expelled from power. To fuel its 'defensive' ambitions, Greece resorted to relying on 'contributions' from its allies. Notably, Greece's citizens did not contribute to this effort. Propelled by the twin engines of mineral riches and 'debt' from allies, Athens went through a period of persistent budget deficits. The profligacy manifested in the erection of ornate structures and paying citizens to attend public festivals.

The Peloponnesian War provided an outlet to the build-up of military offensive power. But it also led to the destruction of Greece's accumulated wealth. Athens then underwent a laddered borrowing cycle that eventually ended in default. The War had destroyed Athens.

Subsequent attempts by Greek 'politicians' to cut back distributions generally ended in failure. The average Greek continued to feel entitled to riches that were now history. Athens lost much of its influence and never really regained its pre-war prosperity. The burden of the war fell largely on the wealthy through taxes and the visible destruction of a democratic Athens by an autocratic Sparta was perceived as a failure of democracy by the citizens.

A mountain of debt followed by default, imposition of taxes and pressures on wages caused Athens' gradual descent into a state of civil war and the decline of democracy.

Post the war, traces of ideas based on socialism/communism (equal share of wealth, land etc.) emerged (Plato's Republic). The Athenian economy subsequently went through years of painful adjustment that included among other things, focus on exports to fund imports of essential foodstuffs. Its main export engine - pottery - steadily waned in quality as competitive pressures built up from neighbouring nations. Athens' export competitiveness was blunted at precisely the moment when her import prices were rising. The resulting balance of payment problems continued to confound Athens several decades after the war. Revenues continued to be raised from liturgies (reliance on donations from the wealthy) and property taxes. Direct taxes were avoided as far as possible.

As Greece went about rebuilding her naval capacity, she relied on Persian finance to fund her 'defensive' ambitions. A jittery Persia ceased funding beyond a certain point and Greece was forced to rely on 'contributions' from its other allies to continue the rebuilding effort. This too failed beyond a point.

The war had had a debilitating effect on Greece and the economy went through several decades of painful adjustment. Reliance on direct taxes were minimal but the economy gradually limped back to a new normal, largely on the back of the engine of mining.

Present: The Parallels

Several centuries apart, the Euro gave Greece access to cheaper finance. The secular bullish wave of the global economy lifted Greece, leading to reliance on debt-funded growth. Things looked rosy and debts and budget deficits built up gradually...till the 2007/08 recession played the role of the Peloponessian War several thousand years earlier.

The recession has brought Greece to its knees, teetering on the brink of bankruptcy. As it looks forward to years of austerity to undo the damage, the government's proposal to raise taxes hasn't gone down well with the public. The move to impose a greater incidence of tax on the wealthy has had the same effect. Rioting, protests and bombings followed...civil unrest is increasing.

Greece now hopes for a bailout with Germany, France and the IMF playing the role of the Persian financier. As it finds itself in a position to forcibly increase exports to solve its balance of payments crisis, the Euro poses its own set of problems for Greece. Years of lost competitiveness which were masked during the boom years have resurfaced starkly. The traditional means of regaining competitiveness through cut in wages has proved unpopular so far and is likely to remain so in the future. Reducing the budget deficits through slashing expenditure, raising taxes, borrowing all look sketchy at the moment. As with 5th/4th century Greece post the war, there is a good chance that Greece is entering a period of sub-par growth.

Greece doesn't have many options on its plate as it braces up to meet the challenges that confront it today. It can either leave the Euro and face a step change currency devaluation which will boost exports, but will also hurt it badly as most of its fat debt is denominated in Euros. The defection will also raise its borrowing costs at precisely the moment when it looks desperately for ways to slash its interest servicing costs. But staying on the Euro will come at a heavy price. Germany is almost certain to demand strong austerity measures of Greece in return for a bailout, to prevent a recurrence in the future.

Through history, economically sound solutions (slashing wages, raising taxes, cutting spending) have often proved to be exceedingly difficult to implement politically. Greece almost certainly faces years of stodgy growth ahead. I can't help but question the sustainability of the Euro. Monetary dependence with fiscal independence serves to encourage profligate countries to indulge in excesses, protected by the safety of a bailout in an eventuality.

Book review: In the Long Run we are all Dead

2010-03-26T16:30:00.000+05:30

In the Long Run we are all Dead: A Macroeconomics murder mystery

The US economy faces a deep recession, raging inflation and an impending run on the dollar. President Wedik likes economics as much as a fish likes land. Should he listen to the Keynesians, who favour government intervention or the Monetarists, who favour market fundamentalism?

Unable to decide, he delegates the tough decision to his Chief of Staff, Admiral Harcourt Green. Green laboriously goes through the process of coming up with an economic policy package...only to be mysteriously murdered on D-day. Details of the economic package dies with him...

Something has to be done soon to avoid an economic collapse. What? How?

Who committed the murder? And why?

The murder story could probably have been constructed better but the crux of the book is economics! Recommend it to those looking for a light read on macroeconomics without running the risk of drowning in jargon.

In this delightfully light read, Wolfson & Buranelli, weave macroeconomics lessons around a murder mystery. One is led through the age-old tussle between Keynesians and Monetarists, but the writers manage to engage the reader's interest amid the backdrop of the mysterious murder. The authors beautifully present the contradictions and trade-offs that perennially confront economic policy makers. The key take-aways are that policy-makers often are in no better position than market participants to predict the future path of an economy, and there is a large reflexive element at work in economies that, sadly, economists choose to ignore. Should policy makers listen to short-run focused Keynesians or long-run focused Monetarists? How does one strike a balance between the short and the long-run? Indeed, what is the short-run and long-run? Life is full of trade-offs. What's good for the short-run may not be for the long-run and vice versa.

Economic policy decision making is akin to steering a ship. Ever so often one gets caught in a storm and the ship wobbles as it hits wave troughs and crests. If the skipper steers forcefully in the opposite direction as the ship wobbles to one side, he runs the risk of over-steering if the wobble is temporary. On the other hand, if he does nothing and the wobble lasts longer, he runs the risk of imperiling the ship with his inaction.

Economic policy setting is a scientific art and achieving equilibrium is an Utopian dream. A dynamically evolving system calls for flexible policies that frequently set off unintended effects. Indeed, certain policy actions have damaging and long-lasting effects on the economy. The period of adjustment that the economy has to subsequently go through to undo the damage is painful (think Japan). Finally, fortune and randomness play a bigger role than anyone is willing to allow or admit.

"Chaos...is certainty."