Haphazard Linkages

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 ones stake off ones 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."

A Scary Scry?

2010-03-24T02:37:00.000+05:30

I feel much like the protagonist in Microsoft's Age of Empires game; at the beginning the only rays of light shine on me and my target at the other corner of the map. I need to get to the target but there's a problem. Everything is dark out there. I don't know the way. The darkness camouflages danger but also opportunities. I don't lose if I don't move, but I don't win either. As I start moving around feeling my way, the blanket of darkness lifts gradually, revealing reality. Sometimes I hit a dead end, forced to backtrack and embark on a new path, but at other times I get lucky and hit jackpot soon. There is a huge premium attached to action and adaptability to a dynamically evolving environment.

Investing is similar in many respects. The ghost of uncertainty lurks in the darkness at every turn in Investorville. But decisions have to be made. Often based on an incomplete, uncertain and biased perception of reality. As in the game, ones experiences are coloured by the paths one chooses over time.
Is the gilded past a harbinger of a bleak future?

In this post, I conjecture the prospects for US equities as an asset class, viewed through the lens of economic history.

Growth or Stability? Do investors pay for growth or stability? A combination of both determines the price investors are willing to pay for in the long run. Growth initially tends to fetch a premium and the basket of growth companies/economies that fail to take the step up fall by the wayside. The ones that do make the cut eventually see the pace of growth slowing but perceptions of stability emanating from size, market positions, moat etc. support premium valuations.

Turning to US real GDP growth rates over the past 40 years and thinking along similar lines for the economy, the present position seems weak on both fronts. GDP growth averaged ~3% over the 1970s up to 2000. The 30 years witnessed its share of recessions, battles with periods of high inflation and slow/negative growth. Growth has since slowed to average 1.6% in the past decade...and then the economy hit the dreaded iceberg.
While the worst may be behind us, the near term is unlikely to see a jump in recovery. If anything, the debt-fuelled growth of the past plus the debt to keep the economy afloat will call for years of austerity. Growth is likely to be muted over the next decade. How much will it be? I can't pluck a number out of the brain, but I suspect one would be content to see a repeat of the trendline growth of the past decade.

The Equity story?
thechartstore.com has an interesting chart plotting the Market Cap/GDP ratio for US equities over the past 85 years. The ratio saw a big jump in the 90s breaking away from trend, reacting to years of strong, sustained economic growth. The bubble popped in 2000 and the ratio has been on a downtrend since, but has remained above 100% for most part. The recession pushed the ratio down to 70% but has returned back to 100% levels.

When I think of the underlying factors that could support this ratio, I find myself soon running into a void. Sure the US economy is 3x its 1970 level. But the weights of debt, inflation and slowing growth have been gradually piling up on the other side of the value weigh-scale, almost unnoticed. A future of likely anemic growth and years of deleveraging makes me circumspect on the long-term prospect for equities.

I don't know if the ratio will fall to its long-run average of 60%. I would assign a low probability to that, given the structural changes to the global economy over the past century. But when I search for catalysts that could propel the ratio, I can't seem to see very many to get me scampering to hit the Buy button. On balance, I feel equities are in for a period of flat-to-down movement.

The 20-year itch

The past 110 years have seen alternating bull and bear cycles of roughly 20 years each. There is no law that demands adherence to the 20-year itch but the psychological aspect of history and the balance of odds seem to favour horizontal-down movement.

Gilded past...gilded future?

As gold levitated in the 1970s the ratio floated down eventually bottoming in 1980. Then as gold settled into a multi-decadel horizontal/down range and equities performed strongly in the 1990s, the ratio shot up towards the end of the 90s. The end of the equities party marked the beginning for gold's and the ratio collapsed again.

Two factors further strenghten my hypothesis for soft equity performance.

The alternating relative price movements for equities and gold leads me to think that its gold's time under the sun in the years ahead, relative to equities.
There is a good chance of the mountainous stimulus packages leading to a high inflation future. Japan's experience with re-inflating its economy over the past two decades failed and there could be a repeat in US' case. Given the structural differences in the economies, I would bet on a high inflation future...which is favourable for gold.

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.

The scary scry may not be scary after all!

The Pig's resurrection

2010-03-07T02:44:00.001+05:30

With many banks continuing to dance with death, there’s one bank that is smiling. The Pig’s.

The long period of declining savings rate – or an increase in consumer spending – was one of the reasons fuelling the boom that popped not-so-long ago. As over-indebted consumers look forward to an extended period of deleveraging, the US government hopes that with interest rates hovering close to 0%, consumers will be incentivized to borrow and jumpstart the Great Consumption story! Simultaneously, lending norms are gradually being tightened, stoking fears of rising defaults in the near term. The poor Fed can only encourage, but not compel, banks to lend. As consumers mend their profligate spending ways of the past, it looks difficult in the current environment to see either banks lining up to lend or consumers lining up to borrow.

Then there’s Bernanke-speak about keeping interest rates low for an ‘extended period’. With nominal rates close to 0% and inflation hovering around 2%, negative real rates of return do little to incentivize saving. The real return on US Treasury bills was >-2% in 2009. Consumers looking to save were penalized for indulging in frugality! The Fed desires consumers to spend at precisely the moment when they seem most ill-equipped to oblige.

So is current consumption a better option? Indeed the Fed and the economy would be happy if this were to happen. While the economic rationale for current spending sounds compelling, I don’t see it happening. High unemployment and the deleveraging cycle is likely to keep spending in check.

So if the consumption story is nearly dead and banks are unwilling to open their wallets, what will serve as the engine for future growth?

The Phoenix is not yet ready to rise from the ashes…

77th anniversary of the '1933 Bank Holiday'

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

Today is the 77th anniversary of the global Bank Shuttering that was initiated by President Roosevelt in reaction to the crisis that engulfed the system at that time. I thought today was an appropriate day to look back at events surrounding those dark days of 1933 for parallels today. What I see resonates eerily.

The Great Depression in 1929 triggered a series of events that had unintended global secondary and tertiary consequences. As always, the invisible hands of Haphazard Linkages and Reflexivity ensure that seemingly harmless stimuli set off a chain of rippling consequences that spread out rapidly. While circumstances, market characteristics and regimes shift over time, there is an element of temporal neutrality to man-made economic and financial disasters. Often, I have found practical lessons in economics, markets and human behavior residing in the treasure trove of history.

I turn first to similarities between the build-up of events through the 1920s and the 2000s decade. The table is mostly self-explanatory.

20s Smartie: We have the Gold Standard, inflation's dead and credit is easy. The war? Well, that's history. Long forgotten. We guys have a short memory. Its the age of booms; real estate, stocks, bonds...what are you doing Sir?

30s Realist: Apocalypse! Bailout! Bank runs! Debt did us apart...

00s Smartie: We have securitization, pack-n-sell products, move-em-risk products, CDO, CDO-squareds, CDS, trend following algorithms, inflation who?, credit is easy. Risk? Well, that's history. Long forgotten. We guys have a short memory. Its the age of booms; real estate, stocks, bonds, commodities, things-I-can't-remember-or-name...what are you doing Sir?

2010s Realist: Apocalypse! Bailout! Bank runs! Debt did us apart...

There was no securitization, no razmataz, no hedge fund quant demons thirsting after mispricing back in the 1930s and yet...the boom-bust cycle played out. Nearly 80 years down the line market sophistication (and the jargon) has increased manifold, engineering has been extended to the realm of finance and new products allow investors access to asset classes that a 30s charlatan could only dream about. But something is structurally and mentally constant in us human beings. The temporal overlap above may be coincidental but the behavioral pattern is perceptively self-evident. With the ever-so-faithful benefit of hindsight, it is easy to point a finger at the government back in the 1930s for acting too belatedly in tackling the crisis. It is important to recognize that the guys back then were uneducated in Depression history.

But this time its different, isn't it? It always seems like it is....but is it?

1930s: The Reconstruction Finance Corporation was setup, capitalized with $2 billion, to extend credit to lubricate the frozen markets. The government eventually took stakes in institutions, infusing money to invigorate the sickly economy. President Roosevelt's rousing swearing in seemed to do the trick as far as emotional will was concerned. As the economy rebounded, the government exited through stake sales to private investors and/or banks. Best estimates point to a break-even on this trade for the government. Adjusted for inflation, tax-payers lost a bundle. The 1930s was characterized by the rise of economic nationalism, bloc economies, trade protectionism and a move towards unilateral policy setting, factors that are absent today.

2010s?: A slew of stimulus packages, within kissing distance of $1 trillion, instituted to stimulate the economy. The governments - learning from history - acted speedily and decisively in concerted action to arrest the downturn.

A few observations before rounding out.

While it looks very likely that the pattern of exit will resemble the 1930s, timing is the uncertain variable. Exit too early and you jeopardize a nascent recovery. Exit too late and you stoke monsters (hyperinflation, credit glut, asset price bubbles etc.).
Inflation behavior was a divergence between the 1920s and 2000s. Inflation back then was rather benign and on a gradual downtrend. Contrastingly, inflation was generally rising through the past decade and the massive monetary infusions almost certainly will stoke inflation in the near/medium term.
Some of the biggest problems confounding global politics today is the interconnected problems experienced by peripheral countries in the Euro zone. Should Greece (and others?) be bailed out? What are the omens for the Euro? Indeed, can it survive as a currency? If yes, would this necessitate massive structural changes to the very fabric of the EU system?

The big lessons from history is that while regimes change and markets evolve, certain things remain timelessly constant. It is impossible to predict the next bubble-pop with any degree of accuracy. But it is fallible human beings who make policies, economies and it is fallible human beings who participate in the markets. Contrary to opinion, I think trend-following algorithms are fallible too.

In a paradoxical way, the only thing that can be predicted with conviction is the repeat of emotional excesses that has afflicted human beings through centuries. The low interest rates of today are very likely to sow the seeds of a bubble in one or more asset classes, which will pop at some point in the future. It would be folly to blame the causes of that bust to 'low interest rates'. The low interest rate environment is a necessity today given the present state of the economy. If it sets off a bubble elsewhere, it is haphazard linkages at work.

The more things look different, the more they look the same...and the more things look the same, the more they look different.

I part with a 1933 quote:
"As a group, bankers have demonstrated repeatedly their incapacity and greed, and yet in their hands has rested the decision to say who shall have credit, what manufacturer or merchant shall control goods and how much. They have misued that power, they have shown that banking should no longer be left in the hands of irresponsible private groups. The emission of credit, to be constant and sound, must be supervised from the standpoint of its public welfare rather than of private profit."
- Bernhard Ostrolenk

Sounds familiar?
We live through interesting times.

Happy birthday Black Thursday!

2009-10-24T18:38:00.000+05:30

Today is the 80th anniversary of the Stock Market Crash of 1929. Its an interesting time to reflect back on the 80 long years that have passed by to see if things have changed. Have they? The more boom/bust cycles look different the more they look the same.

So what lessons have we learnt?

- That hope has driven - and will always drive - people to monetary dope.
- That lending schools eventually end up bending rules.
- That a borrowing binge frequently ends in a harrowing cringe.
- That in a boom...greed goes up, fear down.
- That after the bust, greed dies and fear gains renown.
- That in a boom...an allusion to delusion is dismissed as an illusion.
- That after a bust...the delusion of an illusion leads to reclusion.
- That people buy when they should sell, ignoring the alarm bell.
- That people sell when they should buy, ignoring the market's sigh.
- That when we hear things get cheaper as they rise and dearer as they fall, its time for Cindrella to leave the ball.
- That the 'smart money' ain't that smart after all.
- That after a market chasm, capitalism gives way to socialism.
- That the prudent end up paying, while the indulgent end up staying.

...That history is doomed to repeat itself...

Long Volatility theme follow-up

2009-07-12T11:27:00.000+05:30

One cannot prove an investment idea or theme 'right'. A better way is to take an idea and try to falsify it as much as possible. The 'best' investment idea/theme then is the one that best withstands the test of falsification. Lets see how the "Long-Volatility-Around-Elections" trade played out....

Volatility exploded and how! Through the election months of April and May-2009, market participants grew increasingly nervous on the election outcome, resulting in a volatility spike.

Volatility nearly doubled in the space of around two months. Long-volatility trades (straddles/strangles) worked out beautifully. Indeed some Long Straddles/Strangles nearly trebled in two months. While it is nearly impossible to time entry and exits to perfection, this theme would have resulted in an indecent return anyway!

Another addition to my Investment History notebook!

Time to stick my neck out. Where do we go from here? I can't see any significant volatility-expansion/compression story in the horizon. Is it time to go home? Not necessarily. Trending markets offer their own set of opportunities. But I have always found it tougher to take a call on market direction than to take a call on volatility.
...While its extremely tempting to do an "I-told-you-so", I see every investment idea/theme as a hypothesis that retains its credence till a structural shift renders the hypothesis obsolete. Then its time to formulate a new hypothesis and put it to the test!

Cautionary statement: There is immense risk of capital erosion in options trading. I strongly urge readers to steer clear of speculative activity.

Insights from the Options Pit: 'Vix'y 'Volcone'o

2009-03-28T10:41:00.000+05:30

My posts seem to have a direct relationship with liquidity and credit availability in the markets...both have dried up!

In this post I draw insights from the beautiful, non-linear world of Options. The title is a grammatical mess but it captures the central idea behind this post. I make a case for increasing volatility over the next two months in the Indian markets and possible ways for investors to play this. I'm amazed at the near-term thinking manifesting even in the options world. The markets are so riveted on the near month expiry that they forget there's a next month...and a month after that. India will go to elections starting mid-April and the spectacle will be for everyone to see over a 1 month period.

As always, this time will most likely see tugs-of-word wars and plenty of ego-massages as one party tried to outdo the other in gaining the coveted majority number. Pre-election opinions point to a fractured mandate and there's a very high probability of frenetic post-poll activity. We are nearly in April but what are the markets saying?

...the markets seem to be pricing in a 'normal' situation. I define 'normal' as a period where the Nifty index volatility is around the long-run range (which roughly is the 25%-30% band). Volatility (or vols, for short) started picking up over last week and are currently in the 30%-35% band. Is there a possible opportunity?

Lets take a look at history for pointers on the possible way forward for the market over the next couple months.

Elections and Nifty behavior: Part I (Apr-May 1999)

The chart captures the Nifty index and the 30, 60 and 90-day volatility surrounding the election period in Apr-May 1999.

The period leading up to the election months witnessed quiet activity on the vols front and the Nifty was essentially flat...And then something beautiful happened...

Suddenly the markets took cognizance of the upcoming elections and uncertainty increased, manifesting in increased volatility. Vols shot up from the 25%-30% band to the 40%-50% range through the election months of April and May 1999. The Nifty rose 6% over this two-month period.

Vols settled back to the long-run range over the subsequent months and the Nifty continued its rise, along with the general euphoria surrounding global equities around the internet bubble.

So far so good...what happened in 2004?

Elections and Nifty behavior: Part II (Apr-May 2004)
Similar pattern?

Vols were chugging along unspectacularly in the months leading up to the elections while the Nifty was in a gradual downtrend. Interestingly, through much of April 2004 Vols were flat...and then they jumped...

Once again, increased uncertainty coupled with post-poll dash for forming alliances resulted in Vols jumping from around the 20%-25% band to the 40%+ region. The 30-day vol shot up to the 60% range...

The Nifty, however, dropped 18% over the two-month period...too bad for naked Call buyers.

Vols remained elevated for a while before reverting back to the long-run range.

Elections and Nifty behavior: Part III (Apr-May 2009)?
...hmm... probably there's something here. Nifty Vols over March were around the 30% mark. The past week saw the Nifty mimicking the rise in global markets. And vols started rising, but they are still in the 30%-35% range. Elections begin in mid-April and run for a month leading me to make a case for increasing vols over the next couple months.

Comfort from the 'VolCone'
The VolCone is a chart of volatility over varying time periods (30/60/90/250 days) for the Nifty over the past one year. The chart captures the Maximum, Minimum, Median, the 25th and 75th percentile for the Nifty volatility over the past one year.

The solid Black line is the current volatility. We see that the 30 and 60-day current vols overlap the 25th percentile line. What does this mean? The way to interpret this is that one can reasonably expect 30-day Nifty volatility to be lower than 30% (current levels) about 25% of the time. Put another way, there's a 75% chance it will be higher than 30%. How high? I have no answer to that. This, combined with the closeness to elections, leads me to think that options are not being priced for this event. Increase in Vols generally lead to higher option prices.

Conclusion
The (confusing?) conclusion from the 'VolCone' chart combined with historical performance leads me to think that Vols could increase over the next couple months. Options are not pricing in the election event and once they do, there could be reasonable upside for an investor willing to bet on this occurance. Given the current conditions, I would be buying Volatility...(in option jargon, I would be 'Long Vega').

So would I do naked positions? I don't think so. I have never been able to predict market direction and find more comfort in playing my Volatility friend. I have no view on market direction but I have a reasonably strong view of increasing volatility. In this scenario, I would be inclined to putting on Strangles or Straddles, that allow me to play volatility without taking a view on market direction.

Why aren't the markets pricing it in then? I don't know. Vols have indeed starting moving up over the past week...so one of two things could happen. Either me or the markets are getting this wrong...

If new information compels me to alter my stance...I would do what John Maynard Keynes once said, "When facts change, I change my mind. What do you do Sir?"
Cautionary statement: There is immense risk of loss of capital in options trading. Readers are strongly encouraged to counter my views and base their decisions on independent due diligence.

A Tale of Two Companies

2008-10-18T19:27:00.001+05:30

The frequency of my posts have dropped drastically. I am at a loss to decide whether this is attributable to market conditions, or me not having anything significantly intelligent to say...I am tempted to vote for the latter.

After months of contemplating what to write, I settled for an exposition on something that I term "beautiful". Capital structure is something that does not get as much importance as it should by investors, analysts and management in general. What is the optimal capital structure? I wish someone knew the answer. In this post, I take a look at how the markets treat two companies that are similar in most respects except for their capital structures. I then take a look at a case of possible mis-pricing and how often, even 'good' companies never seem to get their due.

Capital Structure irrelevant? Hmm... I consider Chambal Fertilizers and GNFC (fertilizers again!) for this post.

Most finance experts and academics advocate having 'some' debt in a firm's capital structure. "You get a tax-deduction...debt is cheaper..." are some of the reasons cited. Not wrong in my opinion. What is the right mix? That's a question that doesn't really have one right answer. For the moment, even if we assume the company's management knows the 'right' mix, the broad market participants are mostly unaware of the 'right' mix. What do they do in such cases?

The example exemplifies the point beautifully.

Lets start with margins. Both companies generated about the same EBITDA margin for fiscal year ended Mar-08. However, GNFC topped at the net income margin level. It generated a good 3 percentage points more than Chambal.

Turning our attention to the capital side introduces a fresh perspective to these numbers. GNFC managed to generate 100% more profit for common shareholders, while employing 30% less capital and only 62% more equity compared to Chambal. Impressive? Very...in my opinion.

So what did the markets do? They rewarded GNFC's superior performance by ascribing a 50% less equity value, and 70% less enterprise valuation, compared to Chambal. In terms of multiples, Chambal is currently valued at ~4x more than GNFC on the EBITDA multiple and 3.5x more on the P/E multiple. What could possibly explain this wide discrepancy? Is it a sign of terrible mis-pricing or is there something else at play?

Traditionally, apart from the arguments put forward for assuming debt, common equity holders like debt as it bolsters Return on Equity. Taking on debt gives a firm leverage, which is a double edged sword. Take on too much and the management risks destroying enterprise value, take on too little and again there is a risk of firm value not being maximized. The optimal funding structure is, in my opinion, like a moving target. One cannot get it right all the time, but one can try and get as close as possible to the 'right' number.
When analyzing two companies within the same industry, the investor faces the tough prospect of forming an opinion on whether a company is over/under-priced compared to the other company.The statement seems innocuous, but is one of the most important factors for an investor to answer, in my opinion.

In the above case, assuming other things being more or less equal, it seems a bit intriguing to me that the markets are valuing GNFC only at 0.5x book value of equity and valuing Chambal at 1.5x book value of equity. Especially considering that GNFC scores on all other operational metrics. To some extent, the differences in capital structure could explain the difference in market values for the two firms. Firms with some debt in their capital structure get rewarded with a greater enterprise value, compared to an all-stock firm. The other explanation that comes close to rationalizing the huge discrepancy is that the markets are probably expecting far better growth rates in Chambal's case compared to GNFC. But in a lollipop business, most companies face similar growth prospects, give or take a couple points.

Maybe Chambal has a better history compared to GNFC?
Lessons from the past
A look at history reveals some very interesting insights into the two companies. The comparison is so striking that commentary is mostly unnecessary. GNFC's growth rate over 4 years on almost every operational metric is better than Chambal's. Notably, GNFC has managed to grow Net Income at 34% CAGR with only 12% CAGR on Total Capital employed. This compares very favorably with Chambal's performance (13% Net Income CAGR, 10% Total Capital CAGR).

GNFC has also managed to grow dividends at 3x Chambal's rate. Dividends are important, as shareholders typically put a premium to companies that not only pay dividends but also manage to grow them at a good rate.

Turning to averages, its clear that GNFC beats Chambal hands down on every metric. It uses debt sparingly compared to Chambal and has turned in better return ratios.

However, the market and enterprise values, and valuation paint a very different and interesting story! The market value of both companies have grown at about the same rate over the past 4 years. Turning finally to valuations, one can see that GNFC has historically traded at a discount to Chambal.
Over/Under/Rational-pricing? Why should a company that is larger in size (in terms of revenues), has demonstrated a history of better operating metrics, grown dividends at a much faster rate and is comparatively conservatively capitalized, trade at a big discount to its peer?

A look at 1H2009 results for both companies show that there has been a significant dip in operational performance. Since Mar-2008 Chambal's stock has corrected 20%, while GNFC's stock has fallen 58%. The latter had a production disruption for 3 weeks in July related to a plant shut-down, but how much will this materially impact results 5-year out? Not too much in my opinion. GNFC will most likely post a pretty bad 2Q2009 result, however, a long-term investor shouldn't be too bothered with a on quarter dip.

The stock action reveals something striking about the markets. Yet again it demonstrates the short-term thinking that determines the actions of market players. The markets conveniently forget the long history of superior performance and beat down the stock only on the back of short-term negative news. Rational?

While the past, admittedly, cannot be used to linearly extrapolate into the future, it does reveal some important clues about companies. If I were to take a 5-year view - and was forced to buy a fertilizer stock - I would choose GNFC. The likelihood of management continuing to do the good things it did over the last 5 years is far more in GNFC's case than in Chambal's.
Conclusion So is GNFC under-priced or is Chambal over-priced? Tough call to make, on a standalone basis. However, in my opinion, it's far easier to form an opinion on GNFC than Chambal. A company with a demonstrated history of superior performance trading at 1.5x last year's EBITDA and 2x last year's earnings merits a close look, even if it isn't a screaming buy.

The comparison reveals the market's implicit appraisal of difference in capital structures of two firms in the same industry. The markets, on balance, prefer firms which have some debt to no debt. What is the ideal 'some' is an open question.

More importantly, the comparison reveals a beautiful insight into the way the markets think and act. Sadly, holding on to a 'strong' company for around 4 years, did not guarantee proportional outperformance over an inferior peer in GNFC's case. It is an interesting lesson. While in lots of cases, the long term is a good judge of true value, the markets don't seem to get it right in some cases. The long term investor in this case loses out.

This, however, does not undermine the importance of numbers in the investing decision. While numbers are important, it is far more important to try and think far ahead. Thinking five years or more makes the investing decision that much more easier than predicting two quarters ahead. Most times, the key to a good investing decision lies outside the cosy world of multiples...

Every day its in the nature of this business to force people to take decisions on imperfect and incomplete information. However, over time, some get better at it as they develop a 'feel' for the numbers.

At the end of the day, the guy who keeps his head when everyone around him are busy losing theirs, is the one who takes home the biggest prize...

Delinquent Future?

2008-04-07T19:03:00.000+05:30

My brain requested me to let it go on a vacation...So I listened and went on a sabbatical. I hope you missed me!

Much has changed - both in India and globally - since my last post. Markets around the globe seem to have caught a collective cold. I am probably feeling happy after quite a while in the markets, with so much pessimism going around. The markets have now tuned their radars to pick up the slightest of negative news flows to go on a free fall.

In this post, I take a look at some interesting developments in delinquency rates related to real estate and the response of the equity markets (S&P 500). Admittedly there are number of factors that have a bearing on the movement of the S&P 500 and one cannot see the causal effect of one on another in isolation. But as they say…sometimes the part is better than the whole…especially when trying to get a sense of how things fit together to form the larger picture!

Delinquency rates – to put it crudely – measures how many loans default as a proportion of total loans outstanding. The more people default higher is the delinquency rate. Why would people default? Simple, an economy goes into a tailspin --> people lose jobs --> low or no income --> can’t meet monthly loan payments --> increase in defaults --> higher delinquency rates.

What could be the relationship between delinquency rates and equity markets? One line of reasoning goes this way. Increase in delinquency rates --> people have less money to spend --> decrease in consumer spending --> liquidating of investments to meet important outflows --> collective negativity leads to slowdown in corporate earnings --> decreased stock prices.

Again, what is the cause and what is the effect is a debatable issue here. Here is a chart depicting the movement of the S&P 500 and movement in delinquency rates for real estate, residential and commercial properties.

Back in 2000, delinquency rates had just begun to rise and peaked in early 2001. What happened to equities? The S&P peaked just as delinquency rates started rising and then went into a free fall. The excessive froth that built up during the internet bubble took quite some time to settle down and the S&P continued its down trend till mid-2002.

Post 2001, delinquency rates started falling as the Fed intervened and cut interest rates. Interest rate cuts stimulate the economy, leading to a virtuous cycle of positive things resulting to a bull run in equities.

Looking at the low interest rates several players entered the real estate market with dollar signs in their eyes. They thought that the only way home prices could move was up and they leveraged themselves…well almost…to buy their dream home! But as they say all good things come to an end and this housing bubble too…

…The uptrend in the S&P which began in mid-2002 continued over the next five years. However interest rates were continuously rising during this time as the Fed worried about several things, not in the least among these being the build up of a possible housing bubble. Somebody had finally arrived to spoil the party. The continuously rising interest rates gradually led to a rise in defaults as people started feeling the pinch of costlier money. But somehow the equity markets were still oblivious to this development and continued rising…

Then suddenly – as always – the markets woke up and saw the above chart. Delinquency rates were at 8/9 year highs and everyone started wondering why on earth they were loading up on equities…

And the S&P started dropping...

2008 has been a forgettable year for most global markets. The fall in the S&P has triggered a fall in equity markets around the globe due to the coupling effect. What remains an unanswered question is whether the end 2007 peak will mark a repeat of the 2000 peak. Because if it does then those unfortunate people who correctly picked the top are in for a one way ride. Everyone says equities are one of the best asset classes in the long run. Ask a guy who picked the 2000 peak and see if you get the same answer. There is nothing that makes an asset class inherently good. Price paid is everything…

Delinquency rates have never been higher in the past 8/9 years but the S&P touched about the same level seen in 2000. The housing trouble seems far from over and a recession is almost the grim consensus currently. So till that time equity markets could be in for a choppy ride with an increased inclination to moving south rather than north. But there will be pockets of value waiting to be picked. One just needs to be patient and keep looking…

In the complex web of interconnected linkages, it is extremely tough to isolate one factor as the cause that leads to A, then B and then C. However, certain ‘indicators’ stick out like a sore thumb when overlapped with another. Delinquency rates and equities is one example. Credit spreads and equities are another. (For the curious: Check out this earlier post where I first played Dr. Doom. The S&P was at ~1520 then, its at 1380 now.)

I am fascinated and interested in unearthing these relationships. My other idol, the physicist Richard Feynman used to say this about physics – and something that is true in investing too –

“It’s all about asking the right questions and to keep looking. You do an experiment not with the intention of proving your prophecy but to learn about reality. This integrity will lead you to ask questions that you would have never thought of asking otherwise. In the process you unearth something about the way Nature works…it is fascinating!”

I totally agree.

I will never claim to ‘predicting’ market levels. I cannot do that. I don’t know how to do that. But by continuously looking at things that might have a bearing on each other I maximize my chances of staying out of big trouble.

As my guru, Warren Buffett says,

“I have made money by staying out of trouble.”

Pearls of wisdom from God himself.

Inefficiency and the Perils of Inaction

2007-11-09T12:17:00.000+05:30

A lazy afternoon opened my eyes to the perils of inaction in the investments business. When going through some of my old files, I came across a company that I had identified about a year ago (October 06). I had done all the hard work, done the numbers, saw the opportunity…and did not do anything. I share some valuable lessons in this post with the company as the protagonist. This story is about Gujarat Narmada Valley Fertilizers Company (GNFC)

Inefficiency manifests itself
GNFC is engaged in the Fertilizers business. What was so special about a company operating in a regulated, commodity business where no one player seemed to enjoy a strong ‘moat’? There were better investment opportunities elsewhere in other industries. I don’t disagree. As a Buffett follower, I wouldn’t have touched this company, never mind the price…But as a part believer in Benjamin Graham’s ‘cigar butt’ type stocks, I couldn’t pass this company over after what I saw…

Cigar Butt stocks: A discarded cigar butt allows the smoker one last puff…but the last puff doesn’t cost much. Cigar butt stocks are those where there isn’t much steam left…but the prevailing price makes the proposition an ‘easy picking’.

The thing that drew me most to GNFC was its strong fundamentals. The operational performance stood out glaringly when juxtaposed with its similar sized peers. GNFC had seen 4 consecutive years of expanding margins and was steadily repaying debt. A very good sign. The glorious fallouts of this were gradually showing up in the numbers. A company was getting stronger…and nobody seemed to be looking…Table time..

Prices are as of October 20, 2006; the day I carried out my analysis.

In the table, I have compared GNFC with two of its similar sized peers in terms of revenue. Starting from the top, the difference in profit margins is self-evident. Strike 1. Moving on to the balance sheet, one can see that GNFC had the strongest balance sheet in the group. Its debt/capital ratio was very comfortable, while the other two had as much debt as equity. Strike 2.

GNFC had the best Return on Capital in the group. (ROC is my favorite metric. Personally, I spend more time on it than on any other metric when analyzing businesses. ROC tells you how much return a company is able to generate out of all the capital that it takes in (in the form of Debt and Equity. I look for companies that have enjoyed high returns on capital over long periods). What I saw warmed my heart. In an industry where most players were struggling to get into the early teens, here was a company that was achieving ROC in the high teens. Strike 3. GNFC came out tops on Return on Equity (too!). Strike 4.

While Chambal Fertilizers enjoyed a higher dividend yield, GNFC wasn’t too far behind. Now, I turn my attention to one of those beauties of the market. Mispricing.

To give a little background about the trend leading up to 2006, GNFC had expanded margins fron around 5% in 2002 to 14% in 2006. It was also consistently reducing debt and expanded its ROC. All positive signs. The other two in the meanwhile had increased debt and saw their margins either staying flat (Coromandel) or heading southward (Chambal). Both negative signs.

Given this background and GNFC’s current standing, one would have been rewarded for asserting that GNFC ought to trade at a premium to its lesser peers. Hmm…And one would have been wrong. The ‘efficient’ markets had apparently forgotten GNFC’s existence and shunned it to hell. And so an anomaly was born…waiting to be exploited.

Did the anomaly correct itself?
One year is a reasonable time frame to expect these glaring anomalies to correct themselves. Did it? Let’s take a look.

To give a 1-year perspective, prices for the above table are as of October 22, 2007. Prices in INR.

The markets had recognized their folly after all! Suddenly GNFC was in the limelight, and the other two were shunned. (Well not really, they did appreciate too!). But the Atlas had won…after all! The margin of return was more than twice the other competitors. A classic value pick.

BUT I HAD SOMEHOW MANAGED TO MISS IT…

Cut to 2007
Below I present figures for the same companies, for the same metrics…but for fiscal year 2007.

To give a 1-year perspective, prices for the above table are as of October 22, 2007.

Hmm, the industry seemed to have made life tough for all companies, GNFC included. All the companies witnessed a drop in margins from 2006. But the relative levels were unchanged. GNFC still Struck! Strike 1. After 4 years of debt reduction, the company increased debt in 2007. But so did the others. In Chambal’s case, debt had now become twice as much as equity. Strike 2 to GNFC.

Not surprisingly, the return ratios fell for the group as a whole, as most had to grapple with an increasingly alien business environment. While Chambal and Coromandel slipped into single digits, my friend GNFC still continued in the high teens. Strike 3.

This time around, one would have been rewarded even more handsomely for stating that GNFC now ought to trade at a premium to its brethren. Hmm…And one would have been wrong. Again. While the P/E and P/B for the group has expanded, GNFC still seems cheap relative to its peers. The other two seem overpriced considering their current operational health. So if somebody put a gun to my forehead and forced me to buy one company’s stock in the fertilizers business, I would pick my friend. But…

The line between ‘Relative’ and ‘Absolute’ valuation
This is where an investor needs to weigh carefully the approaches of relative valuation and absolute valuation. While a stock may look attractive relative to its peers within the industry, it may very well be expensive when compared to other businesses. Ultimately the underlying economics of the business ought to take precedence over standalone valuation. Faced with the prospect of choosing between two equally strong companies, I would choose the one which operates in the ‘stronger’ business. By ‘strong’ business, I mean a moat that keeps competition at bay. Where a new fellow coming in would find himself running into Atlases, not Lollipops.

GNFC is an example of an Atlas company operating in a mostly Lollipop business. So there may well be better opportunities elsewhere.

Conclusion
One question that may be linger in your minds is, “If this guy really saw all this, what did he do sitting on his...well..?” Answer: I take full responsibility for inaction. This brings me to the second part of the title of this article.

The losses from inaction far exceed the losses from wrong investment decisions.

It’s far easier to eat ones ego and reverse a bad decision than watch an identified easy pick go through the roof. In GNFC’s case, I was somehow not convinced of the then prevailing price. It still seemed a tad over-priced to me. I made a mental note of buying into it if it ever came to INR 90…and I kept waiting. (The price did come close to 90 once…but I was caught napping…)

In my experience, in the long run, I have seen stocks of Atlas-like businesses return far more than Lollipops. Very often though in a Bull Run, the Lollipops tend to trade at a premium to Atlases. The observant value investor has the world at his feet, literally, for there are Atlases for the picking…at a fair discount to their true worth!

I vow NEVER to ‘nap’ again!!!

Disclaimer:
I do not hold GNFC or the competitors mentioned above. The article should not be viewed as a solicitation to buy, sell or trade any of the stocks mentioned. There is immense risk of loss in blind-man-buff investing.

Blast from the Past

2007-10-29T14:16:00.000+05:30

Two unrelated cases happened over the past week that compelled me to pen down my thoughts on them. Both are, of course related to the markets, but they aren't related to one another. The common tether that binds them is investor psychology. Read on...

Black Monday

October 19, 2007 marked the 20th anniversary of the demonic 'Black Monday' crash that shook the markets exactly 2 decades ago. On Monday, October 19, 1987, the Dow remarkably dropped over 20% in one day's trade. Most global equity markets suffered declines of over 20% by the end of that fateful October month.

Experts continue to argue about the possible causes behind the collapse. Program trading, bulk selling, overpricing, illiquidity were all put forth as reasons behind the event. In this section, I will write about human psychology 2 decades since. Maybe there was some pattern somewhere?
The table shows 1-day price change for selected major world indices on three specific dates, beginning with 'Black Monday' of October 19, 1987.

A very interesting pattern comes out of the table. One can see that major world indices dropped quite a bit, on October 19, 1997, exactly 10 years after 'Black Monday'. The 1997 fall, although not major in terms of magnitude strikes a chord when seen in relation to the general sentiment surrounding equities in the late 90s. The internet frenzy had begun and equity markets around the world were mostly moving in one direction...UP...But on the fateful 10th anniversary, most major global markets chose to fell together. The 20th anniversary did not bring with it any cheer either! Again equity markets dropped together and this time the percentage decline was bigger than in 1997.

Did the underlying economic fundamentals driving the respective countries change in a day? Were world markets suddenly gripped with a bout of collective enlightenment, which forced them to pay respect to their past?

This is where investor behavior comes into the picture. Nothing had changed in a day. In fact, over the 2 decade period, prosperity had only increased globally. GDP, GDP per capita, science, technology had all advanced rapidly. But investor thinking didn't change much.

In my opinion - and I am venturing into the esoteric sounding area called 'cognitive psychology' - human beings take decisions with their eyes stuck to the rear view mirror. An unlikely event as a 20% fall was enough to fill people hearts with fear and uncertainty. Every time the dreaded date came up, investors around the globe chose to let go of their rationalities for a day and sold off...Sold off till Black Monday became a self-fulfilling prophecy.

Go-Go CEO (during a Bull Run)...and Go-Go CEO (after the bubble bursts!)
The second event is a classic in many ways. It occurs so often that investors have forgotten to even acknowledge them.

CEO joins the firm during the onset of a prosperous bull run --> Investors push the CEO towards making investments that enhances their return (and conveniently forget the risk involved) --> CEO obliges and invests in areas that probably he himself doesn't fully comprehend --> For sometime the good times continue --> CEO is King.

--> Bubble bursts --> Pain begins --> Company takes a write-down --> People hunt for a scapegoat --> Get one in the CEO --> Kick him out -- Bye bye CEO!

This is what happened with the CEO of Merrill Lynch, Stan O'Neil. The brokerage took a hit of close to $8 billion related to subprime mortgages, resulting in its biggest quarterly loss since its beginnings 93 years ago. Although the CEO is no saint, I find it intriguing that nobody thought of ousting him when he was busy investing in these risky assets. (Maybe they didn't because nobody understood or wanted to accept the risks involved). The CEO is shown the door when he accepts and rectifies his mistake. Hmm...

The CEO was known as a guy with a stomach for 'risks' and was seen by many as the one who directed Merrill's entry into the subprime mortgages segment. So to that extent the axe had fallen rightfully...But the stock went up 10%, coinciding with this bit of news!!!

Maybe the good times will begin once again...

Conclusion
Every day of watching the markets, makes me embrace the theory that ultimately the winner is the one who is able to control his behavior better than anybody else in the markets. Greed, expectation, euphoria and fear are emotions that co-exist in investors, sometimes unfortunately leading them to their downfall.

A Buffet adage is in place here.

"We simply attempt to be fearful when others are greed, and greedy when others are fearful."