Tuesday, June 29, 2010

A Class Apart

(Published in Moneylife.in today)
At most seminars on stock markets I am struck by the fact that investor expectations always seem to border on greed. An interactive session on broader issues degenerates into stock specific questions. However, a recent seminar I was privileged to address was a refreshing change. The crowd had a large number of active stock market players and this was a gathering of what I would term as ‘wealthy’ people. All of them (barring the organisers, who were dressed in suits) were in casual daily attire. Clearly, comfort was more important than appearance.
Almost all of them were very well settled in life and were constantly on the lookout for more opportunities. Everyone in the crowd (which was more than five hundred strong) had spare cash to invest. They had substantial wealth in real estate, gold, diamonds, fixed income investments and shares. A few of them had chosen the mutual fund route as an additional avenue, but not as a first choice. They all seemed to prefer direct investment in to equities. Most of the questions did venture into stock specific questions, but they were more to do with provoking the men on the dais who included a couple of ‘talking heads’ on business channels.
The older among the crowd had seen ups and downs in the market, so they were more casual about losing money in stocks. Many of them had large core holdings in frontline stocks and a good mix of stocks that bordered on the speculative. Yes, they were all businessmen, from the trading community. Some of them had also put money in to the market through the Portfolio Management Schemes and had mixed reactions to the route.
I did a straw poll of the audience and found that none of them had ever entrusted their wealth to a financial planner or a ‘wealth manager’. Their view was that their financial assets are secrets which they do not wish to discuss with others. They were also upset by the fact that some of the private bankers sent their representatives to discuss financial investment opportunities with them. They were upset by the fact that someone in the bank, other than the branch manager or the relationship manager is privy to their financial data. They have learnt how to avoid these pests through some hard talking with their banks and a few of them have gone to the extent of just keeping an account alive with the bank in question, whilst moving most of the money to other banks.
A large majority of them were in to mid caps. Here their approach was well defined. They focused on industries they had good knowledge about. For instance, a steel trader would look at his customers and their financial behaviour, their off take of material etc would be a good base for him. There were a couple of people who focused very sharply on acquisition targets. In the latter case, the guys knew that they were placing bets on something other than company performance.
Most of them spend a couple of hours or so every day to devote to their portfolio. They talk to more than one broker, get his views and keep track of his views. They have a list of favourite brokers as well as ‘contra’ indicators (brokers whose views have consistently been wrong).
So, far, what is remarkable about them? Does it sound like a typical market participant? Well. One thing was noticeable. Almost each one of them stayed away from derivatives. They had no problem losing money in their stocks but none wanted to. In fact a younger member responded that derivative trading was stressful and after having lost money (in his words “three days positive, fourth day wipe out”) decided that it was not for him. He also said that it needed more study of the market and a need to be constantly monitoring the screen.
For me the gathering was revealing. Here was a group of people, for whom equity is another asset class and not the only one. None of them seemed to be unduly worried or impacted by the volatility in the market. And more important, they got in with a preparedness that they could lose their money. In fact, one of them was a late entrant in to equities, having got in at the peak of 2008, but still active and working his way through 2009 and 2010 to recoup all of his losses and emerge in positive territory.
The interesting thing was that someone tried to explain to them the merits of “Systemic Investment” in equities. They brushed it aside, saying that it may have its merits for someone who keeps worrying about wealth. For them, equities were clearly beyond asset allocation. It was one more way to try and experiment with money. Equities were not their first line of defence in their wealth basket. They entered the asset class only after exhausting other avenues.
Well, we may choose to disagree with their approach on the grounds of it not being the optimum strategy to ‘maximise’ wealth, but they are a class apart, who do not need to keep score. As someone said, if you have to count your assets, you are not rich enough!

R. Balakrishnan
May 31, 2010

Friday, June 25, 2010

Warren Buffett in India- What If?

As far as I am concerned, the Warren Buffet Graham Dodd School of investment is a complete education in stock picking. Having seen the Indian markets over the last few years, the one thought that comes to mind is that if WB were operating in the Indian markets today, he would perhaps find it difficult to find companies. However, if you take a cycle of twenty years, he would have found many opportunities to buy. WB is associated with ‘value’ investing. India is a ‘growth’ story. ‘Growth’ means buying in at prices that a ‘value’ investor may not buy.
If I look at WB/GD for inspiration, the key takeaway is the relevance of Return on Equity in conjunction with the ‘Margin of Safety’. If one uses these two financial measures, today’s markets are unlikely to throw up any investment worthy candidates. It is simply because our markets are today in an orbit that is being justified by the growth potential as well as the fact that when most of the world comprises of blind people, the one-eyed are looked upon with awe.
If I look at some of the key qualitative attributes that WB/GD has listed out as pre-requisites for being included in the short list, the following things stand out:
i) Find companies that have strong entry barriers and strengths that enable predictability of earnings. One of the examples in the WB domain is Coca Cola. In India, I have not come across an Indian company that has this attribute. It is only some of the multinationals operating in India that has this attribute. Clearly, India is not a business pioneer even in its homeland, forget globally. Companies like a L&T / HDFC come close, but one will have to search hard to find many more;
ii) Management quality: Here again, most Indian companies suffer due to management being a family affair. Father passes it to son and so on. The best person for the job is not chosen. So, here again, the list of Indian companies is rather small.;
iii) Forever companies: WB says that he would like to stay invested in a company forever. Here most Indian companies fail the test. Where are the Century’s / Nirlons’/ Mafatlals/Singhanias of the yesteryears? They were the blue chips then. Again, one has to stay content with an HDFC or most of the MNC’s who will be there a hundred years from today. You cannot bet on the longevity of an Indian company or management or family. Their capacity to surprise is immense.
Apart from the key differences, the other issue is a WB approach may simply fail because we have two classes of shareholders, whose returns are different. The promoter shareholder gets his returns from many sources whereas the non promoter shareholder gets incidental benefits. Corporate governance and capital market regulations notwithstanding, the promoter only lets you see what he wants to let you see.
SO, to gain from a WB approach, we need to have the ability to understand the management and take a call on what the odds are of riding his coat tails. The other most important thing, to my mind, is that we have to learn when to sell. The volatility in our markets (illiquid and shallow by characteristic) gives great opportunities. I like to make a shortlist of companies that I like and put against them, prices that I am comfortable paying. And then wait. Surely, in a person’s investment life span, anything from three to five opportunities will come. And the returns will be great. Much better than market returns if I may say so. One must not have the compulsion to invest everything in one go, like a fund manager.

(R. Balakrishnan)
May 24th, 2010

(The above article was published in the June 2010 issue of "Wealth Insight", an excellent personal finance magazine published by my friend, Dhirendra Kumar)

Wednesday, June 23, 2010

Insider Trading- HDFC MFund in spotlight

(This incidence, involving the transgressions of a dealer with the high profile HDFC Mutual Fund, proves the old adage “Wall Street writes its own rules”. It also shows the dishonesty of the Indian media when it comes to covering news)

Insider trading is not uncommon. Almost every fund manager at some point has indulged in it. Often it could be for the fund he manages. In some cases, there are rogues who abuse their position for personal gains. SEBI has done well to document a case where a dealer of HDFC mutual fund (unfortunately, the fund with perhaps the highest level of trust in the public eye) has been caught in the act of ‘front’ running. ( See http://www.indianexpress.com/news/sebi-bars-hdfc-amc-exec-three-others-from-market/635317/0 for the story. Order copy can be had from SEBI website)
SEBI has ordered the Trustees of the HDFC Mutual Fund to conduct an inquiry in to this and ascertain whether such dubious practices were in continuance later and also to beef up the internal controls etc., Pending completion of the enquiry, SEBI order advises that:
“” i) HDFC Asset Management Company Limited shall not utilize the services of Mr. Nilesh Kapadia (the dealer in question) for the trading activities done on behalf of HDFC Asset Management Company Limited and shall institute an internal inquiry to be conducted by the trustees of HDFC Mutual Fund in the matter; and
ii) Mr. Nilesh Kapadia and HDFC Asset Management Company Limited shall jointly deposit the estimated losses identified so far as per Annexure-A of this order, to the Trustees of HDFC Mutual Fund. This amount shall be held by the Trustees in an account segregated for this purpose, till further orders by Securities and Exchange Board of India in this matter. “”

In the beginning of the order, there is a statement that reads as under:
“However, no apparent connections were noted by the stock exchanges. The preliminary findings of SEBI in respect of the said references are given in the following paragraphs. “
I leave it to the reader to figure out why SEBI is so circumspect. On going through the order, it is obvious that there is foul play and the parties who have actually indulged in front running, have links with the accused dealer. See the latter part of the order which reads as under:
“The investigation conducted so far in the matter had revealed 38 instances over 24 scrip days spread across BSE and NSE during April to July 2007. In these instances, Mr. Rajiv Ramniklal Sanghvi/Mr. Chandrakant P. Mehta/Mrs. Dipti Paras Mehta were placing buy/sell orders ahead of substantial buy/sell orders of HDFC AMC. The buy/sell by the abovementioned persons were successively followed by the buy/sell by HDFC AMC till finally, the aforesaid persons could square off their trades within the same trading session, substantially against the orders of HDFC AMC that were still coming in. In the investigated instances, the volumes accumulated by the said individuals were also found to be significantly large. Thus, the instances apparently represented front running. In the 38 instances mentioned in the following tables, Mr. Rajiv Ramniklal Sanghvi, Mr. Chandrakant P. Mehta and Mrs. Dipti P. Mehta have made substantial intra day profits by front running the orders of HDFC AMC. “
In spite of the above, there is hesitation to make a guilty pronouncement!

The incidents documented by SEBI happened in 2007! The amount of gain they have calculated to the gentleman in question is around Rs.23 million.

Some things about the order stare you in the face:

i) The amounts were with reference to three years ago. Surely, the question of interest and penalty seems to have been forgotten by SEB (One thought is that hopefully, SEBI will do something once the Trustees submit their report to SEBI)I;
ii) The deals narrated in the SEBI order relate to a three month period in 2007. Does it mean that the dealer became honest after this?
iii) The SEBI order merely asks the AMC to conduct an ‘inquiry”! Technically, the dealer can get away scot free! All he has to do is to pay up some amount! He can continue to work with the AMC in some other capacity.
iv) The front running done here is far more crooked than plain and simple insider trading. The guy had the wherewithal to transfer the gains on the illicit trades by screwing the fund investors;
v) Why is not SEBI forcing a full inquiry by an independent audit firm (rather than leave it to the Trustees) in to the fund’s entire history when the said gentleman was in the same position? Everyone knows that the Trustees do not have detailed knowledge about the working and most of them are there because of the name and prestige attached to being on a panel for HDFC family?;

To my mind, this seems like a serious case of fraud and needs to be probed further. HDFC Fund has to come out in to the open and make the outcome of the inquiry public. Disgorgement of the gain has to be done, at some cost.

Another thing is that this incident clearly shows the absence of checks and balances at the fund house. These are incidents that normal prudence ought to have immediately. Every fund house has a recording system and if the compliance officer had only bothered, this would have been caught.
I also wonder why there is no penalty levied on either the dealer or the fund house.
This incident proves several things:

i) HDFC as a fund house has good clout with the media. Few newspapers carried this and the TV channels, which normally go to town with any frivolous news, remained quiet;
ii) If there is no punishment, then there is no deterrent to this crime. That, to me is the biggest failure of the legal system, when it comes to things financia;
iii) SEBI is being very indulgent in this case.

Tuesday, June 8, 2010

The broker and the banker

Once upon a time, a bank started a life insurance venture. The bank was astute in its cost management and accordingly, it outsourced marketing (for some region/s)of the life insurance to a known broker. The understanding was that the broker would be reimbursed cost plus a percentage to cover him for providing the 'cover'.
All was well. One fine day, a few employees left the broker. And went and told the banker that whilst they were reimbursing the broker for over a thousand 'employees', in reality there were fewer than half the number.
The banker got annoyed and then went to check the facts. Alas. The broker was billing for twice the actual manpower deployed! And the broker was a clever fellow. The excess billing was not passed on to the broking entity, which also happened to be a listed company. He quietly put the difference in his own pocket.
Of course, the arrangement was disontinued. The banker, however was in a dilemma. To lose face or not ? He preferred to remain quiet and continued a 'broking' arrangement with the broker.
Our broker was a street smart guy. He knew his goose was cooked. But, being a responsible promoter of a listed broking entity, he promptly terminated the services of the entire gang that was selling the insurance policies. He informed them that henceforth, they could keep ninety percent of the commissions earned on the policies sold by them. However, the company would not pay them a fixed salary. The broker was kind enough to offer the use of office premises, computers etc to the group of 'ex' employees.
Now, the bank pretends that the incident never happened. The broker goes about his business as usual, looking for the next banker to con.
So much for corporate governance..

Monday, June 7, 2010

Free Float.. The fumble of the Regulator..

Indian capital markets have always been a joke. Anyone can list. All you need is a business plan or a friendly merchant banker. And you start with a ten percent dilution at stage one and after a few years, the promoter holding can be zero. No one will know. Our stock exchanges have absolutely no gate-keeping, with regulators generally not having a clue about anything. It is a travesty that companies like NMDC/MMTC are given the status of ‘listed’ companies, with a handful of shareholders. Our stock exchanges are a great place for raising venture capital and have been the principal reason that venture capitalists find it tough to get decent deals in India. Anyone can list at any price on the stock exchanges. And the processes are designed to hide things from the investors and also make sure that the investor never gets time to read anything about an IPO. Hence, one fails to understand why the FM wants to tinker with the stock markets? Surely, the stock markets are supposed to serve the interests of the issuers and the bankers. The investors do not mind manipulated prices nor do they care a fig about it.
Our octogenarian Finance Minister mentions that the move to increase public shareholding to 25% will deter price manipulation. There, he is mistaken. Any share price can be manipulated, if one has enough money. There are many listed companies which on paper have more than 25% holding with ‘non-promoters’ and included in ‘public’ category, but in reality happen to have benami holdings which are included in the public category. So, this move, in no way will put an end to manipulation of share prices.
The latest dictat of having a 25% holding is one more joke. It is a rule that cannot be complied with and if a company or promoter does not want to comply with it, SEBI cannot do a damn about it. Yes, they can threaten to not give permits to new entrants, but soon they will relax these, with several catches. The first demand will come from the PSU undertakings. When the regulator does not understand what the markets are all about, he is but a tool in the hands of industry and investment bankers. After having debased the concept of ‘listing’ it does not make any sense to put in new entry barriers. After you have given permission to companies to list with minimal free float, SEBI cannot deny the continuance of listing by executive action.
I would rather urge a carrot and stick policy to encourage broader public participation in businesses. For instance, one or more of the following steps could have been looked at:
i) Shifting of companies with less than 25% public holding to the OTC exchange. This will preserve some sanctity for a stock exchange ( this will also give some life to the OTC exchange);
ii) To start with, ensure that stocks where the public holding is below 25%, cannot be traded in F&O;
iii) Deny inclusion of such illiquid stocks in to any sort of Index;
iv) Increase the fees payable to the exchanges/regulator by such companies;
v) Restrict trade in these stocks on cash basis only.
vi) Permit open market sale of promoter holdings through block deals, with institutional buyers (in fact this is the typical route that has been used by many promoters to dump their shares);
vii) Instead of 25% non public, a better thing would be to insist on a minimum of 100,000 shareholders with a minimum holding of 1000 shares each, for permission to be listed on the main board of an exchange. Otherwise, the OTC is always there for the illiquid companies. In fact, I recall that the NYSE used to have this criterion.;
viii) Have a higher rate of taxation for companies that do not have 25% non-promoter holding. However controversial it sounds, it is the only way to ensure compliance. Once this is done, suddenly promoters will cease to worry about market timings for dilution of equity;

The idea is that these companies are encouraged to dilute. SEBI is foolish in prescribing a 5% per year dose of dilution. That simply will not work. A promoter will sell only when he gets a price that he is happy with. Market conditions do not remain stable for any length of period. Hence, you cannot force disgorgement.
An interesting fall out will be what happens where the promoter has gone in for increasing his shareholding and reduced free float. Similarly companies have gone in for buy back and reduced the free float. Many MNC’s have gone in for buyback with a view to delist. How can a regulator force them to disgorge once again?
The other fall out will be the argument of experts that the markets cannot absorb so much. It will nail the argument that India has a vibrant investor community, when the truth is that it is a shrinking universe. Listing has become a joke with the permission of this anachronism called ‘QIP’ issuances, warrants to promoters, preferential issues etc.,
It is interesting that the regulators find a way of cutting their own noses to spite their faces, time and again!

Sunday, June 6, 2010

Throw the dice... Let the stocks roll


The corporate scorecard for the year ended March 2010 passed off uneventfully. No surprises on the upside. Coming out of a bad year, results were along expected lines. If there were any pockets of disappointment, it was, for me, the public sector units. Across industries, the PSU units showed some tiredness in their performance. It is unlikely that they can do anything spectacular, given the fact that making profits itself is seen to be a kind of ‘mission accomplished’ for the PSU’s. The other takeaway as far as I am concerned is the worry that most of India’s engineering giants are running out of steam. In spite of bulging order books, execution seems to be fumbling. One last worry is the high rates of attrition in the services sector. Whether banking or IT, the attrition rates are getting higher.
I met with a few companies in the IT sector as well as the finance sector. It is a challenge for them to hold on to people long enough, especially at the entry and middle levels. A friend of mine runs a head hunting firm focused on senior hiring. The main driver for change is money (no surprises). But what was sickening was the chase. Mediocre quality rules the roost and has highly inflated egos, apart from expecting fancy salaries. At the entry level, it is clear. A couple of thousand rupees more per month is reason enough for change. In one IT co, they worry after every pay day. Some employees simply do not turn up. They are not bothered about any letter of release or certificates! Here, I do not blame the employees. The employers are the root cause. In difficult times, they let go of people. An easier option would have been to let go of few seniors who are superfluous and take an across the board pay cut. Instead of that, they sacked youngsters, who now give it back to them likewise. And I also see madness returning in the hiring area. Start up cos and cos planning their IPO’s or fund raising want to adorn their payrolls with names. In this hurry, they are willing to pay fancy ‘sign on’ bonuses and ridiculous salaries. Of course, the people joining realise what is happening and they take advantage of the need (greed) of these companies. Net net, I am seeing unsustainable cost structures getting built in the services industries. The senior fellow wants to pay a fancy salary to the junior, simply because it ensures that he will get a higher salary! The biggest take away from the recently ended fiscal year is not in the balance sheet, but will make itself felt in the profits in the years to come.
The other thing that, to me, is worrying is the failure of companies to add to supply. Not much spending on capital expenditure, not many new facilities coming up, infrastructure not getting the desirable momentum portends difficult times ahead. Add to this domestic inflation which is quite stubborn, I find it difficult to see the road ahead for most of the large companies. At some stage, supply will come in and normalise the profits. The present levels of profits are clearly not a sustainable thing. Companies will have to give up on the bottom line when the top line accelerates. Add to this, in sectors like FMCG,competition from unorganised sector, local and regional players is very evident from looking at the stagnation in businesses of companies like HLL ‘s They seem to be enjoying growthless profits.
And the moment the markets get better, companies are in a mad rush to increase the supply of equity. And regulator relaxes the rules to create more illiquid stocks.
These are the times when I feel that our markets lack an instrument where one can go short on a stock over an extended period. In the old badla system, one could do this. Alas, today there are no derivatives which will let you short a stock over a long period. The monthly or quarterly rollover system is no substitute for the old system. And this brings me to a point that was raised by a good friend, Nalin Moniz (he runs a PMS company) in response to an article of mine on evaluation of PMS. He maintained that when one cannot short a stock effectively, it is not fair to insist on absolute returns. The stock market is structurally skewed in favour of the bulls.
So, to make money in the stock markets, one has to get lucky in the minefield of small cap companies. The other thing is to keep money handy and pray for a decent fall in the market (say by around thirty or forty percent from here) and then buy. Timing is everything in today’s markets, where there is too much money chasing limited investment options. The good thing is that this money exhibits a herd mentality. If they all panic together, it gives a good buying opportunity.