70) Let it be

RBI should not rush towards an interest rate cut right now.

The Reserve Bank of India (RBI) governor Y.V. Reddy has to take one of his most complex decisions today, when he announces the new monetary policy. Will he cut interest rates or not?

Crafting monetary policy in an open economy is a far more difficult task than it was in the days of closed borders and minimal global capital flows. And the new monetary policy is to be announced at a time when global markets have been unsettled by recession fears—when open economy issues will be in the forefront, in other words.

From a purely domestic viewpoint, there is hardly any case for a cut in interest rates. Sure, economic growth is likely to slow in the next four quarters, perhaps to around 8.5%.

There are already early signs of a slowdown in industrial growth, in the demand for some types of consumer goods and growth of bank credit.

Though the strong rupee has not yet dented exports, it is quite likely that an appreciating currency will be a deflationary influence over the medium term. These bits of data have led to renewed calls for lower interest rates. But what those making these demands seem to forget is that RBI should be quite comfortable with this situation.
The central bank has been saying for quite some time— correctly, in our opinion—that India can sustain a long-term growth rate of around 8.5% a year, given the current rates of savings and investment. Sustained growth above this level is likely to spark off inflation —as it did about a year ago when there were concerns that the Indian economy had started overheating.

It is also argued that the central bank should take a risk and cut interest rates, since inflation is still within the comfort zone of below 4%. But the inflation rate in India is understated. First, consumer prices are rising at a far faster pace than the headlines about the wholesale price index suggest. Two, the government has not raised domestic fuel prices and hence artificially capped the inflation rate.

RBI is likely to look beyond the published inflation numbers and see what its consumer surveys show. Our guess is that they will reveal that inflation expectations have grown in recent quarters. And central bankers should ideally pay close attention to inflation expectations since they directly affect decisions to consume, save and invest.

So, it is not surprising that the consensus till recently was that RBI should not cut interest rates right now. But that consensus crumbled after the recent bout of global stock market volatility and the US Federal Reserve’s subsequent 75 basis points cut in the target federal funds rate. That was a panic reaction and uncalled for. But it has left the financial markets thirsting for more. Traders are now betting on a further 50 basis points cut in the federal funds target rate. That has widened the difference between the Indian and the US interest rates, and a wider differential is usually a catalyst for higher capital inflows into India.

But that depends on the global risk climate. A dramatic repricing of risk amid a slowing global economy could lead to a flight of capital from emerging markets such as India, despite higher interest rates here. Investors are jittery right now, and a flight to safety could send money into safe havens such as gold.

There is no doubt that the economic balance has changed over these past few weeks the world over, with recession risk and financial instability getting more attention than inflation pressures. India has been no exception to this attitudinal shift. But the inflation risk has not gone away just because people are looking in another direction.

However, we believe that the Fed fired its gun in a bout of panic. There is no reason why the cooler heads in RBI should follow suit.

Courtesy- Livemint editorial views

69) Towards a painful climax

The message for investors is clear: Run for safety. And safety lies in precious metals and cash under the mattress.

If you are a believer, then you could feel proud about the way your god is playing dice with financial markets. Not only does God have a sense of humour, but he (or she) appears to be a good story teller, too.

An exaggerated swoon in global stock markets forces the US Federal Reserve to fire precious interest rate bullets. Then, it is revealed that a rogue trader in a French bank had run up losses amounting to more than $7 billion. The Bank of France knew about it, but it did not inform the Federal Reserve. The Federal Reserve is said to be unhappy that it reacted to the stock market swoon that was amplified by the French bank cleaning up its trader’s positions.

As a result, 75 basis points of the federal funds rate have been too easily used up.

In spite of this, the market expects the Federal Reserve to cut interest rates again on Wednesday. If the Fed does not, the market would swoon once again, underscoring the Fed’s poor judgement in cutting rates last week. If it does, then it would have injected far too much monetary stimulus into the economy than it intended. The price of crude oil is back above $90 per barrel.

Unquestionably, this is a fascinating script. The climax is bound to be thrilling, but it is not guaranteed to be pleasant. In fact, the opposite is more likely.

The slide in the global stock markets in the first two days of last week was matched by the dramatic recovery over the next two days. The ostensible reason for the recovery was that the New York insurance regulator had organized a meeting to discuss recapitalization of companies that insured bonds. Without insurance and the guarantee of payment when the issuer defaults, most of the debt instruments issued would lose their rating and hence their values would plummet. But, a solution is far from easy. Recapitalization is costly (some estimate it at $200 billion) and comes at a time when banks themselves are still raising capital to strengthen their balance sheets.

Crucially, neither the banks nor we know the extent of additional capital that they need. It depends on the extent of the likely further drop in American home prices. Merrill Lynch expects the cumulative decline to be around 30%. If so, the rout had just begun as the decline, as per the Case-Shiller national home price index in the US, is only around 6% so far.

Nonetheless, the message from the market action this week is clear. Equities were dropping even after the Fed cut rates. Only talk of recapitalization of the bond insurers helped to turn sentiment around.

Do not throw lower rates at the problem. Lower rates created it. There are only two solutions. Both are neither quick nor painless.

One is that banks have to assess all their current and potential losses and recapitalize themselves. The second solution is that prices of financial assets have to fall far and deep to draw investors back to the market. The process is under way in some asset classes, but barely in the case of equities. The big rebound in equities markets after every correction suggests that noise traders are dominating it. They prevent the market from forming a credible bottom and thus keep informed investors out of it.

Unfortunately, the Federal Reserve encourages such behaviour. By cutting rates in response to falling stock markets, it is not only delaying the inevitable in the US, but is also stoking asset price bubbles and consumer price inflation in developing countries. Core inflation was the highest in 16 years in Australia in the fourth quarter of 2007. Officially reported inflation in Singapore moved up to 4.5% in December.

Investors should watch for signs that central banks in Asia are alive to this threat. If they counteract the wall of liquidity flooding in from the US, then they would be doing the right thing by their economies. India has done that. Even there, a test is looming.

Pressure from politicians and industry to cut rates is mounting as the Reserve Bank of India (RBI) announces its policy review today. If RBI holds its nerve, Indian equities would deserve a higher market valuation for that reason alone.

Those who suggest that RBI should lower rates want to have their cake and eat it, too. On the one hand, they boast that the strength of the domestic demand in India would not allow America’s problems to derail India’s economic momentum. On the other hand, they want RBI to lower rates because the Federal Reserve has done so.

The gods are setting up policymakers to commit more errors on top of all that they had done up to now.
So, if you are a believer and an investor, the message is clear: Run for safety.

And safety lies in precious metals and cash under the mattress.

V. Anantha Nageswaran is head, investment research, Bank Julius Baer & Co. Ltd in Singapore. These are his personal views and do not represent those of his employer. Your comments are welcome at baretalk@livemint.com

68) The modern financial casino

Taking advantage of fleeting profit opportunities is beyond the reach of ordinary investors.

What do you make of this scenario? Mr You-and-me invests his hard-earned pension contributions in “Trust-Me” pension fund which, in turn, invests the same in high-yielding “Complexity Bonds”, rated AAA by “Safe Track” credit rating agency. But unknown to our protagonist and his pension fund, the high-profile “Securitization Bank”, which peddled these “Complexity Bonds”, was also shorting the same.

Then one day disaster strikes, the markets crash, and the hard- earned pension savings disappear, while the “Securitization Bank” makes a windfall.

Welcome to the spectacular world of modern financial markets, with its alphabet soup of exotic financial instruments, Nobel laureates, mathematicians and financial whizkids, and those wonderfully versatile off-balance sheet entities called structured investment vehicles.

Two rapidly emerging trends from the global financial markets are a cause for deep concern—a widening returns gap between categories of investors, and increasing difficulty in locating and pricing risk.

The extensive application of information and communication technology and the resultant integration of global financial markets have helped ordinary investors access real-time market information. With all available information being increasingly reflected in the prices of financial instruments, the major sources of profits are only twofold—arbitrage opportunities across markets and instruments; and multiplication of small margins by trading in volumes.

Such efficient markets trade away all the easy and obvious arbitrage options, leaving only the more latent and complex opportunities. Taking advantage of these fleeting profit opportunities requires deploying a battery of mathematics and finance wizards, armed with sophisticated software programs based on complex financial models and access to real-time information. And profiting from margin multiplication requires large investments, from either personal capital or debt.

All this is beyond the reach of ordinary investors. High net- worth individuals, hedge funds and private equity firms, being better positioned to locate and price risk, therefore tend to corner the lion’s share of profit opportunities, leaving but crumbs for small investors. With credit ratings providing inadequate and often misleading information about the levels of risk embedded in various financial instruments, and the price itself hardly revealing the inherent risks, ordinary investors are left vulnerable to be feasted on by larger investors.

Now let us explore the second trend. It has been claimed that two products of modern financial theory—portfolio diversification and securitization of liabilities— have helped diversify and transfer risk to make the financial system safe.

Securitization helps banks and other lending institutions pool their loans into asset-backed securities (ABSs), with or without structured tranches, so as to raise money in the capital markets for further lending, and also transfer credit risk from their books. It allows them to remain in the mortgage business as originators and intermediaries without taking too much of the interest rate, term and liquidity risks on to their own highly leveraged books.

But the reality has been somewhat different. Recent events have clearly shown that the complex ABSs have been “sold off by people who know best how to evaluate it, to people who don’t know what they’re in for.”

This turn of events can be traced back to a failure to address the two fundamental concerns that remain despite all the financial innovation of recent years— the quality of the underlying loan collateral and the pricing of its risk.

Unlike in the past when the extent of risk and its bearer was easy to identify, complex financial instruments such as collateralized debt obligations have dispersed risk deep and across the system, making identification and pricing difficult.

Further, the commonly used risk pricing models such as the value at risk contain the usual flaws and discrepancies, which get ignored or glossed over despite numerous bitter experiences to the contrary. The regular suspects of bell curve and capital asset pricing model apart, risk rating models assume that any credit defaults are independent of each other, thereby permitting the use of the “Law of Large Numbers”, to discount the probability of default of more than 20% of the principal. In the absence of any acceptable liquidity valuation method, the risk pricing models do not account for the risks associated with market liquidity. From hindsight, we realize that these omissions have been at great cost.

The complexity and sophistication of financial instruments has often been a convenient shield for skirting laws and accounting rules, besides obscuring risk and confusing unsuspecting investors. Besides, it also increases the difficulty of restructuring or rescheduling debt, thereby restricting one of the main levers of managing financial meltdowns.

There are numerous examples from the recent subprime mortgage crisis of how modern financial engineering actually gave only an illusion of risk transfer. The complex inter-relationship between hedge funds and others and the Wall Street banks often meant that the former borrowed money from the same banks that they were insuring against bond default by selling credit derivatives.

For the bigger investors, it is “heads I win, tails you lose!” For the rest of us, a blunt but accurate description of most of what passes on as financial innovation would be—gambling!

Gulzar Natrajan is a civil servant. These are his personal views. Comments are welcome at theirview@livemint.com

67) How do firms determine share price for an IPO?

The issuer companies have two options for fixing the price, they can either fix the price themselves or they can let the investors determine it.

In stock markets, numbers speak louder than words. Whether it is quarterly results of companies or price discovery mechanisms in an initial public offering (IPO), numbers are our trusted signposts. But numbers don’t fall from the sky. There are well-known price discovery mechanisms in case of an IPO. Our friend Johnny thinks that one should clearly understand these mechanisms before investing in IPOs. So let’s try to understand how the book-building price discovery method is different from the fixed-price method.

Johnny: How is the price discovered during IPOs?

Jinny: Well, discovery of price in an IPO is both a science and an art. The issuer companies have two options for fixing the price. They can either fix the price themselves or they can let the investors determine it. The first method, in which the company itself fixes the price, is known as the fixed-price method and the second, in which investors determine the price, is known as the book-building method. It is important to keep in mind that even in the fixed-price method, the prices are not determined randomly and the company has to disclose all the quantitative and qualitative factors that justify the fixed price.

The fixed-price method has one drawback. It does not take into account investor demand into price discovery. If you want to sell a piece of gold at its intrinsic value but there is no demand in the market, your piece of gold will not be able to fetch that price. Fixed-price issues also face a similar problem. The issuers arrive at the fixed price after taking into consideration the reasonable value of their company but if there is no demand in the market, the shares will fail to generate subscription. In the opposite scenario, if the demand in the market is high, the price fixed by the issuer may not reflect the true market value and the shares may get sold at a low price. To overcome these kinds of problems, issuers use the book-building method. It helps in matching the price of shares with the demand.

Johnny: How does the book-building method work?

Jinny: In the book-building method, the issuers indicate either a floor price or a price band within which the investors can place their bids. For executing the whole process, the issuers appoint the lead merchant banker as a book runner. The book runner appoints syndicate members who collect bids from investors. Both retail and institutional investors can take part in the bid. The bids received from investors are recorded in a book in electronic form. The book runner, in consultation with the issuer company, evaluates the bids and decides the final price, which is also known as the cut-off price. The cut-off price is the price at which the demand for the shares meets the price. In case your bid is below the cut-off price, you will not receive any allotment.

However, you can avoid this situation by submitting your bid without indicating any price. You have to simply indicate in your bid that you are ready to accept the offer of shares at whatever cut-off price the company fixes in the book-building process. This option is available only to retail investors and most of them submit their bid at the cut-off price.

Johnny: That’s interesting, Jinny. If all investors start submitting their bid at the cut-off price, the price discovery would become a discovery without surprise.

Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to them at realsimple@livemint.com.

66) The US Federal Reserve loves the credit bubble

In 2000, after the tech bubble burst in the early part of the year, it wasn’t until January 2001 that the Fed started cutting rates.

Is the US market poised for a sell-off? Not to worry, Ben Bernanke will reduce interest rates. Have US banks started to distrust each other? Not an issue, they can always borrow from the US Fed. Is a mortgage company on the brink of bankruptcy? Don’t worry, the Bank of England will nationalize it.

Could the US face a recession? Relax, the government is going to let the fiscal deficit go through the roof. Are bond insurers in danger of getting de-rated? No problem, the insurance regulator will ensure that banks put up money to bail them out. Are the markets not satisfied with the biggest rate cut in the last 25 years? Take it easy, Uncle Bernanke will give you some more.

The chairman of the US Federal Reserve is a student of the Great Depression of the 1930s, and he believes that one of the reasons it happened was because the Fed was too slow to cut interest rates. He once said that deflation could always be fought by dropping money from helicopters, if necessary, a remark that earned him the nickname “Helicopter Ben”. He now has a golden opportunity to put his beliefs to the test.

Will it work? It might. After all, rate cuts by Alan Greenspan laid the basis of the boom in the global economy from 2003-07, although the US wasn’t able to escape a recession. If we have a repeat of the same scenario, the US will go into recession for a year and global markets will recover in two years. But this time the rate cuts have been pre-emptive and deeper.

In 2000, after the tech bubble burst in the early part of the year, it wasn’t until January 2001 that the Fed started cutting rates. It was only in August 2001 that the Fed funds rate went down to 3.5%. In contrast, Bernanke has already cut rates to 3.5%. His being quick on the draw may pay off.

On the other hand, there’s no guarantee that it will.

Japanese example
Parallels are sometimes drawn with Japan in the early 1990s. After the Plaza Accord that revalued the yen against the dollar, the Japanese authorities, faced with lower exports, decided to stimulate the economy. Money supply shot through the roof, the Nikkei soared and land prices went to stratospheric levels. The central bank then raised interest rates to curb the absurd asset prices, which ended up bursting the bubble.

After that, despite a series of rate cuts and in spite of flooding the markets with money and driving interest rates to near zero, the Japanese market is nowhere near the peak it reached during that time, while the economy remains mired in stagnation.

Even if we don’t buy the Japanese example, it’s quite possible that rate cuts may not solve the problem. Even if the banks are recapitalized, the exotic derivatives market may be frozen for some time.

In the meantime, all sorts of frauds that were kept under wraps during the boom times will come to light, as they already have at Societe Generale SA.

Litigation will grow, as investors who were sold dud financial products sue for their rights. Banks may find it difficult to sell their collateral, because the law is unclear about the rights to securitized assets. Risk-taking will be subdued for some time and the banks may curtail their proclivity to create liquidity out of thin air. Perhaps this kind of a soft-landing is what Bernanke is aiming at.

Real dangers
On the other hand, there are also some very real dangers. For starters, markets and banks could now believe, not without justification, that Uncle Ben will always be there to bail them out. Banks may have little incentive to improve their lending practices and their fondness for mis-selling little-understood arcane financial derivatives to greedy investors could continue. The stage will have been set for the creation of another asset bubble as a result of a new wave of liquidity being unleashed. It was, after all, excess liquidity that created the problem in the first place—the bubble will only become bigger and when it bursts, it will do far more harm.

But maybe Bernanke is right. The credit bubble has become so vast that pricking it may lead to a huge depression.

Consumer credit is the lifeblood of economies today, allowing people to have tomorrow’s income today. US consumption buoys the world economy and it allows firms to increase sales and profits. Innovations like securitization have allowed banks to lend even more, because selling down loans frees up their capital for more lending. Derivatives increase leverage many times, allowing banks and speculators to create assets out of thin air.
For example, derivatives expert Satyajit Das makes the point that when General Motors Corp.’s debt was downgraded to junk status, it was found that the amount of credit default swaps on the debt was four times the value of the debt. That was then—with all kinds of exotic products such as CDO (collateralized debt obligations) squared and CDO cubed, the value of the financial assets created will now be many times the worth of the underlying real assets.

If this huge inverted pyramid collapses, it could bring down the entire economy with it. Perhaps the US economy has the bubble as its foundation.

Mint’s resident market expert Manas Chakravarty looks at trends and issues related to investing in general and Indian bourses in particular. Your comments are welcome at capitalaccount@livemint.com

65) IT’S TIME REDDY MOVED TO GROWTH FROM STABILITY

US Federal Reserve’s 75 basis points policy rate cut a week ahead of the scheduled meeting of its policy making body, the Federal Open Markets Committee (FOMC), is history now. The global financial markets are awaiting the outcome of the FOMC meeting next week. It’s fairly certain that there will be another round of rate cut even as analysts are debating on the depth of the cut. The pressure is on the Reserve Bank of India governor Yaga Venugopal Reddy to ease his policy stance and cut the interest rate when he reviews India’s monetary policy on 29 January.

Reddy began raising interest rates in October 2004 and intensified his monetary tightening measures in 2006 to fight rising inflation, higher capital inflows and fast growing bank credit. Since January 2006, RBI has raised the repo rate, or the rate at which it injects liquidity in the financial system, by 150 basis points to 7.75%. During this period, the reverse repo rate, or the rate at which RBI sucks out liquidity from the system, has been raised by 75 basis points to 6%. It has also raised the cash reserve ratio, or CRR (which defines the amount of money commercial banks have to keep with the Indian central bank), by 250 basis points to 7.5% since December 2006.

Will Reddy reverse the trend now? Although his stated monetary stance has all along been “price stability” and “adequate credit flow to the productive sectors,” in the past few years, as the economy boomed, his bias was distinctly in favour of stability as he believes stability over a period of time ensures growth.

Let’s look at the factors that could prompt him to continue with this stance.

First and foremost, India is still a relatively closed economy and exports do not account for more than 20% of the nation’s gross domestic products. Besides, the Indian banking system has virtually no exposure to the US subprime market. So, the threat of recession to the world’s largest economy has very little to do with India, at least theoretically.

Second, although wholesale priced-based inflation is at 3.83%, much lower than the 6.7% seen in January 2007 and well below RBI’s comfort level of 5%, risks still persist. Higher food prices and surging global crude oil prices continue to threaten the inflation outlook. In the past one year, the price of India’s imported basket of domestic crude oil has risen by one-third, but this has not been passed through to the domestic market. If the government decides to go for a 10% hike in petrol and diesel prices, the inflation rate will go up by around 40-50 basis points.

Third, excessive monetary expansion also adds to the inflationary pressure. Money supply, or M3, has been growing more than 22.5% against RBI’s targeted growth of 17-17.5%. This is a result of the Indian central bank buying dollar from the foreign exchange market. RBI has been buying dollars to rein in the run-away appreciation of the rupee that hurts exporters as their income in rupee term comes down. For every dollar it buys, an equivalent amount of rupee flows into the system, and adds to the monetary expansion.

Finally, there is no serious sign of slowdown in Indian economy as yet. The bank credit growth has come down to around 22% after a 30% growth in a row for past three years, but this is an RBI-engineered slowdown. So, on the domestic front, there is no real concern as yet that could prompt Reddy to cut interest rates.

But a smart central banker does not react to a development. He anticipates events and takes action proactively. The single most influencing factor for easing the monetary policy in India through a rate cut is the widening interest rate differential between the US and Indian. The difference between the US and Indian policy rate has risen from 250 basis points in September to 425 basis points now, and it will widen further after the next round of Fed rate cut. This will increase capital flow and put pressure on the local currency that has been appreciating against the greenback continuously.

The choice before Reddy is to cut the rate now and discourage capital flow, or hold on to the rate and continue to buy dollars from the market and add to the monetary expansion that can later be drained either through a hike in banks’ CRR or floatation of bonds under the monetary stabilization scheme (MSS).

He should not worry much about the level of inflation as the government is unlikely to aggressively hike the fuel prices in the run-up to the general election. The industrial production data indicate a moderation of economic activities and it is now widely accepted that the Indian economy will not be able to maintain its more than 9% growth, seen in the past two years in a row. RBI has tamed the bank credit growth, but if it dips below 20% by the year end, alarm bells will be pressed. So, it is high time Reddy shifted his bias to growth from stability.

What should he do? Unlike the US Fed that has only one policy rate, the Indian central bank has a rate corridor of 6% to 7.75%. Reddy should cut the upper end by 25 basis points and shrink the corridor. He also needs to ensure adequate liquidity in the system to make 6% the policy rate. He does not need to cut CRR for this. If RBI refrains from regular floatation of MSS bonds, there will be ample liquidity in the system and this will bring down overnight rates to the lower end of the corridor, making it the effective policy rate. It can be followed up by another 25 basis points cut in April at the annual monetary policy. The challenge before Reddy is to be seen as doing something to “decouple” India from the US economy.

Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as the Mubai Bureau Chief of Mint. Please email comments to bankerstrust@livemint.com

64) Ideavirus and market cycles

Fear is more powerful than greed. So, the ideavirus from the pessimists spread faster than the ones from the optimists.

The stock market crashes in India almost every year. The pattern is the same. We hastily bid up asset prices to a point where valuations become stretched. Pessimists’ then enter and hammer prices down. How does this cycle occur? We turn to a concept called ‘ideavirus’ for an answer. What is it?

Seth Godin popularised the word and also wrote a book about it. An ideavirus is an idea that is contagious as a virus. Assume that your favourite sportsperson bleaches her hair orange. You will most likely bleach your hair too, as will her other fans. And soon, orange will become a fashionable hair colour.

Investing is also about ideas. You buy a stock because your broker tells you to. Your friend apes your action. And before long, your entire neighbourhood is loaded on the same stock!

But not all stocks go up. The reason is to do with the people who initially spread the ideavirus. Seth Godin calls them sneezers. Sneezers can be promiscuous sneezers or powerful sneezers.
Any stock broker could be a promiscuous sneezer. He spreads an ideavirus because it helps increase his income. A promiscuous sneezer can, therefore, be bought for a price.

A powerful sneezer cannot be bought. An ideavirus will spread fast if, say, Warren Buffett were to declare that Infosys is a good stock at the current price.

Asset prices typically go up due to promiscuous sneezers. Even if we know that the sneezer is motivated to spread the ideavirus, we buy the idea because we do not want to be left behind if the stock climbs up.

Then, economics takes over. As ideavirus spreads, demand picks up as does the stock price. That is what happened with Essar Oil and all other stocks.

But why did the market turn so viciously? Fear is more powerful than greed. So, the ideavirus from the pessimists spread faster than the ones from the optimists. That lopped off all our portfolio gains and some capital in the two days as most prices crashed 50 per cent.

B. Venkatesh

(The author is a Chennai-based investment strategist.)

63) What’s driving bullish trends in asset prices

Macroeconomic factors, broader than earnings or dividend growth, are now driving stock valuations. These factors seem to be pushing the benchmark valuation ratios to progressively higher levels, so that historical averages increasingly seem less important.

Over the past five years, there has been a sharp rise in the valuations of a wide range of financial and physical assets. As the accompanying chart shows, stocks have multiplied seven times between 2003 and 2007. Gold has doubled, though it obviously does not compare with the stupendous rise in stocks (Chart 1). Real estate — both commercial and residential — valuations have not been shown here as organised price collection and dissemination with respect to thi s asset class is yet to take ground in the Indian markets. But despite the limited data, it is safe to say that prices, on an all-India basis, in this asset segment too have more than doubled in the past five years.

The breadth of the movement, encompassing almost all asset classes (Indian bonds and the currency have not been included here though the Indian currency, particularly, has registered smart gains in the past five years), seems to suggest common drivers. If so and if those common factors were still in operation, what does this presage for asset valuations from here on?

Here, we identify some possible explanations for the widespread nature of gains in Indian asset markets from a macroeconomic perspective. This explanation is attempted with respect to the equity markets though it could well apply to real estate/precious metals also. This does not rule out periodical market reversals of the type we have had very recently and also in the past 3-4 years. These are event driven in nature and do not weaken the larger macroeconomic drivers.

Such a macroeconomic approach could possibly throw light on why the conventional valuation ratios — the P/E and the dividend yield — are now well above (below for dividend yield) even their averages of the past year or two, leave alone medium- and longer-term averages. Segmental analysis of asset price movements without going into the macroeconomics which is structurally impacting the valuation ratios may have some limitations in explaining this broad-based move in Indian asset markets.

For instance, a study of the price-earnings ratio or the dividend yield (vis-À-vis their medium-term historical averages) may suggest that Indian equities are currently dangerously overvalued. Such a study could further say that a reversion to more “normal” valuation levels (the “mean reversion”) can well be expected any time.

The Nifty’s PE, for instance, has been between 12 and 18 for close to 60 per cent of the time in the past nine years — 1999 to 2007. And it was in the 18 to 25 range for another 35 per cent of the time. But Indian equities have risen so much, particularly in the past half year, that valuation ratios currently are above even the average of the past year or two, leave alone longer term averages. ( Chart 2 shows the historical movement in the P/E and dividend yield on the Nifty index).

Analysts have pointed out to the high earnings growth which is required to justify such rich relative valuations. Equally, disappointment on the earnings front is seen capable of producing deep price corrections. One of the critical variables in the conventional equity valuation framework is the level of the equity risk premium. It is possible that the macroeconomic factors have lowered, at least temporarily, the compensation for bearing equity risk.

Macroeconomic Factors:

Chiefly, the macroeconomic factors which are possibly driving asset prices could be:

The high level of broad money growth in India. Broad money growth in the overall financial system has been well above the level of nominal GDP growth (or equivalently, the nominal expenditure growth in the economy). While nominal GDP has grown 12 per cent per annum on average in the past five years, average broad money growth has been much higher at 16 per cent. (Chart 3)

(Known as M3, broad money comprises coins/notes in circulation and most importantly, the deposits with the banking system.)

This level of growth in broad money supply if met by increased demand for money/near money balances may neither cause inflation in the prices of goods/services NOR spill over into demand for and consequently higher prices on other assets.

The demand for money basically comes from a transactions motive and also for being held in a portfolio of assets. Changes in the relative attractiveness of money when compared with other assets (the opportunity cost) could alter the share of money in overall asset portfolios of all economic agents. To the extent that the private sector holds more monetary assets than it prefers, there would be a shift of the excess money balances into other assets such as equity.

In a financially liberalising economy and also in an environment of macroeconomic adjustment (such as the case in India), money demand from a transactions motive will be high in the initial period of liberalisation. This is because the number and value of transactions go up as the economy opens up.

The key to maintaining growth in transactions money demand is to deepen financial inclusion, broaden credit creation and financial intermediation. In the absence of the same, the excess money balances will inevitably spill over into demand for other assets — be it equity, gold or real estate. Analogously and more broadly, if there is a paucity of good quality assets in which the excess money flows can be invested, it is likely there will be excesses in the valuation of existing assets. This broad pattern seems to fit quite well in the Indian case so far in this decade.

Broad money has grown sharply in the last 7-8 years. This has chiefly been on account of a larger macroeconomic policy preference for building up foreign exchange (FX) reserves. Indian FX reserves have grown from $40 billion in March 2001 to $270 billion in December 2007. To be sure, there have been valiant attempts to mitigate the effect on broad money growth of this massive increase in FX reserves. But the banking system has still been able to produce a level of broad money which is consistently running ahead of the economy’s capacity to absorb it without fuelling price pressures — both in the goods/services markets and in asset markets.

There has possibly been a portfolio shift of excess money balances on account of the lower level of interest rates on bank deposits till the middle of this decade vis-À-vis returns on other assets — partly corroborated by the near quadrupling of mutual funds’ AUM in the past 4-5 years. A broad range of Reserve Bank of India data shows that growth in transactions money demand may be weakening after expanding robustly earlier in this decade. This is also corroborated by the RBI’s own data on the level of financial exclusion and the narrowness in credit creation in the financial system.

Concurrently, the broader financial architecture has not been able to supply the required level of good quality assets which can absorb the increasing money supply. A bond market, for instance, is conspicuous by its absence in an economy of India’s size and potential.

Sustainability of current valuations:

It is possible that Indian equity markets have moved into a high valuations environment for some time to come. The push for that seems to come from the present configuration of macroeconomic policy and the (high) likelihood of the current policies being persisted with. (Proof of that comes from the fact that Indian FX reserves increased by as much as $9.6 billion in the period ended January 18 in this calendar year. The stock markets have corrected severely in the subsequent two weeks. Just visualise where all the money created by that massive increase in FX reserves is going to get deployed in the coming weeks/months.)

Factors endogenous to the equity capital markets — their organisation, product suite, trading and settlement practices, the steady improvements in these as also the structural improvements in corporate financial performance — may only reinforce the above trends.

But, as is often pointed out in economics, everything depends on everything else and other things remaining the same. These other things — such as global macroeconomic, financial market conditions and how they impact the expected compensation for bearing emerging market risk — are currently favouring Indian markets. And they may well continue to do so in the ensuing period. However, it is difficult to say how far into the future is that ensuing period.

Note: This article was written before the recent severe fall in the stock markets. The author, nevertheless, believes that the arguments/line of reasoning advanced in the article hold good).

T. B. Kapali

(The author is Vice-President (Economic Research), Shriram Group Companies, Chennai. These are his personal views.)

62) Breaking the fall with circuit filters

One reason for the sharp decline in asset prices last week was the absence of circuit breakers on securities in the derivatives segment. There is now a debate as to whether the stock exchanges should impose circuit breakers on these securities as well. This article argues that such a device may be against the free-market forces but helps in moderating margin calls during crashes.

The market crash on January 21, 2008 and the following day saw many investors lose most of what they had earned in the last four years.

Those who had exposure to derivatives and to stocks that were part of the derivatives segment were the worst affected, as such securities do not have circuit breakers.

This has led many to wonder whether the stock exchanges should have circuit breakers on all securities. If there were a circuit breaker on, say, Reliance Natural Resources, the stock would not have fallen from Rs 203 to Rs 145 on a single day.

Circuit breakers work against the free-market forces- traders cannot freely price their behaviour into the asset. But not having one creates problems too.

We believe that circuit breakers moderate distress sale due to margin calls. And that, in turn, moderates the severity of a crash. Circuit breakers on all securities could play a vital role in the market microstructure. What free market?

A circuit-breaker is a device that halts trading in a stock if the price changes by a pre-determined percentage on a given day. The stock exchanges currently have 2, 5, 10 and 20 per cent circuit breakers on stocks that are not part of the derivatives segment.

Votaries of free-markets think that circuit breakers only cause more panic. Free-market is good if we are disciplined.

But psychologists have showed that we are not wired for discipline. The fact that a market crash occurs almost every year is standing testimony to our lack of discipline.

A tempered external interference is required to smoothen the functioning of any system. This is true of traffic systems as it is of emergency exits.

In a study conducted after a truck-bomb attack in 1993 on the World Trader Center, researchers found that a post installed near the emergency exit helps the evacuees. Why? The post tempers a collision of people at the exit and prevents a pile-up.

The case is no different with the financial markets. We overreact to information. If Infosys reports an unexpected increase in earnings, we enthusiastically bid up the asset price only to realize soon thereafter that we were hasty in doing so.

Likewise, on January 21, 2008 our overreaction pushed most asset prices down 25-40 per cent.

Having circuit breakers on securities in the derivatives segment would have given us time to ruminate and temper our overreaction. It acts like a post at the emergency exit that forces people to gather their buy-sells in an orderly manner.

The portfolios that had minimum losses last week were ironically the ones that were loaded on stocks with 5 and 10 per cent circuits! And most of these stocks are fundamentally weaker than the large caps and mid-caps that took a sound beating. NSE and Derivatives

The free-market supporters believe that it is not about circuit breakers. Rather, it is all about the stocks that constitute the derivatives segment.

They argue that stocks such as Ispat Industries and Oswal Agro should not be part of the derivatives segment at all. And even if they were to be included, NSE should shed the rule of a contract size based on value.

Instead, having 100 as a uniform contract size would help. This, by itself, could moderate the fall.

As for the other stocks, the free-market supporters argue it is best to let the asset prices witness a free-fall. That way, the downside correction may be over in a short period.

But circuit breakers play a pivotal role that the free-market supporters fail to see. And that is to do with margin calls.

When the near-month futures on Reliance Natural Resources declined from Rs 207 on Friday to Rs 158 on Monday, traders had to pay a mark-to-market margin of Rs 1,40,000 on each futures contract. Such margin has to be always paid in cash.

The margin requirement would have certainly been lower if the underlying and the futures contract had a 10 per cent circuit breaker.

It is important to impose circuit breaker on futures as well as the underlying. Imposing on the underlying and not the futures contract will lead to disconnect in the prices.

Yes, the traders in a fit of panic may push the price down the next day as well. But margin calls may not be exacerbated. After all, the trader will have one more day to arrange for funds. And that is important when a market crashes.

Tempering margin-call requirement is an important factor in market crashes.

Maybe this is good reason for the stock exchanges to impose circuit breakers on all securities- till one finds a better device to moderate human behaviour and the resulting market crash.

B. Venkatesh

(The author is a Chennai-based investment strategist. He can be reached at enhancek@gmail.com)

61) Fund ideas for the medium term

A sweeping market meltdown of the kind that we witnessed last week does not come about too often. But when it does, and you are inclined to invest in stocks, the choices can be befuddling. The recent market rout cut such a wide swathe across stocks and sectors that even investors who had the resources to make fresh investments would have found it difficult to decide what to buy.

What is more, the intense intra-day volatility witnessed in individual stocks would have also made it well nigh impossible for investors to catch fancied stocks at low prices.

Taking the mutual fund route to equity investments may be the ideal way to resolve this dilemma. Equity funds allow you to buy a basket of stocks without day-to-day monitoring. Diversified equity funds with a good track record across market cycles such as Birla Sun Life Equity Fund, DSP ML Opportunities Fund, Sundaram Select Focus, Magnum Contra and HSBC Equity Fund, should of course remain on the “buy” list of investors at times such as this. But in addition, here we present a few theme and index funds that appear attractive for investors with a three-year perspective. Investors may consider adding one or more of these funds:

Junior BeES Exchange Traded Fund: The Junior Nifty index offers investors a good exposure to the emerging large caps of India Inc without the liquidity risks inherent in the mid-and small-cap stocks. Emerging large cap stocks are likely to be high on the radar of institutional investors- both foreign and domestic- looking for less expensive options outside the Nifty and Sensex baskets.

The recent corrective phase has trimmed the valuations for the Junior Nifty index from about 31 times trailing earnings in the second week of January, to 24 times now. The top sector exposures in this index at present are petroleum products, banking/financial services, telecom services and capital goods. Investors can take exposure to the basket of Junior Nifty stocks, through the passive exchange traded fund-Junior BeES, in the secondary market.

Sundaram Capex Opportunities: Despite their premium valuations, stocks of capital goods companies appear likely to remain out-performers, given their domestic focus, highly visible earnings prospects and a likely acceleration in government spending this year also points to strong earnings.

Sundaram Capex Opportunities Fund is a thematic fund that is sharply focused on companies that supply products/services to the basic industries that feed infrastructure growth. The fund has a large-cap tilt and buys stocks with a two-year view; but takes concentrated exposures to its top stocks. This strategy has helped lend the fund a leading slot among the infrastructure theme funds.

Reliance Banking Fund: Strong earnings growth, a more benign interest rate scenario that may lead to higher credit offtake and pockets of attractive valuation, suggest that stocks from the banking and financial services sector could outperform broad markets over the next couple of years. A banking theme fund will help investors acquire a diversified portfolio of private sector banks, PSU banks and companies in the consumer credit and broking businesses; holding any one of these businesses may be more risky.

Reliance Banking Fund has managed a compounded annual growth of 37 per cent since inception and 49 per cent in the past year. A significant 21 per cent cash holding in end-December may help the fund capitalize on recent declines to add to its portfolio.

In addition to the above equity-oriented funds, here is another thematic fund which may make a good diversifier to your portfolio:

DSPML World Gold Fund: Higher uncertainties on the global economy due to the US sub prime crisis and the prospect of a US recession which may weaken the US dollar, suggest that year ahead may be a good one for gold as an investment option. The DSPML World Gold Fund is a unique play on gold, which invests in gold mining and precious metal companies across the world.

This fund redirects investments into the World Gold Fund managed by the global natural resources team of Merrill Lynch. Given that the fund invests in stocks of precious metal companies and not directly in precious metals, returns may be higher during periods of high gold prices.

The fund had a 80 per cent exposure to gold-related sectors and a 8.9 per cent exposure to platinum-related sectors in December. Investors should consider this fund, not because it may offer higher return potential than equity funds, but because it may provide good returns at times when equities fail to perform. Some alerts
In the end, a couple of caveats to qualify the above recommendations:

As each of the above funds is focused on a specific theme, they do carry a higher risk profile than a plain vanilla diversified equity fund. Erosion in the NAV, in the event of a reversal in the focus sector or theme, can be sharp. Thus, these funds are best suited to investors who already have a core portfolio built around diversified equity funds or those who have a portfolio consisting mainly of direct stock market investments.

Theme funds can strongly outperform the markets over short time frames and may require investors to time their entry as well as exits well. While lumpsum investments can be made, these can be phased out to take advantage of volatile phases in the market. Investing in the dividend options of the above funds, wherever available, may help investors cash in on periods of exceptional returns, whenever they arise.

Aarati Krishnan

60) Leverage gives you extra power

Leveraging is all about putting the right force at the right position through a lever.

Who says there are no free lunches? You just need the skill of pulling the right lever at the right time. Take the case of our friend Johnny. Whenever he invites a new friend for lunch, he ensures that one of his old friends also comes along. The new friend enjoys the free lunch and thanks Johnny whereas the old friend pays the bill. A day will come when this lunch table will complete a full circle and this new friend will be paying for the lunch of some other new friend of Johnny. But Johnny, who brings the old and new friends together, will always enjoy a free lunch. Johnny is leveraging a free lunch out of his networking skills to his advantage. But what Johnny is doing is pretty small compared with what others are doing with leveraged money in the financial markets.

Johnny: Leverage? I have read this term so many times in so many articles in Mint but I really do not know what it means.

Jinny: Well, you might have heard about using a lever to lift weight by employing minimum force.
How does a lever work? If you have to budge a heavy stone, you simply use a long stick as a lever through a supporting point. If your lever is positioned correctly, you can budge even a heavy stone by using minimum force. So leveraging is all about putting the right force at the right position through a lever. In business and finance also, leverage seeks to achieve the same objective. It enables you to enhance your financial force by using the lever of borrowed money. In other words, the term leverage signifies the extent to which you are able to use borrowed money for your business. You have only Rs100 in your pocket but you are able to borrow Rs1,000 more from others. How are you able to do that?

Well, you show your Rs100 to Peter and ask him to lend you Rs100 more. Now you have Rs200 in your pocket, which you show to Paul to borrow Rs200 more. In this manner, you just keep on borrowing. Anyone who is able to borrow many times more than his own money is called highly leveraged.

Johnny: But I am not able to understand whether leverage is good, bad or ugly for the financial markets.

Jinny: Leverage gives you extra power. If you had only Rs100 in your pocket, without leverage, you would have ended using Rs100 only. Now you have extra cash, which you can use to increase your profit. But too much of anything is bad. Applying too much force on a stick to lift a heavy stone can sometimes break the stick. Similarly, too much of financial leverage can also put a company on the door of bankruptcy.

If your business is not able to generate enough profit, how are you going to pay back your lenders? So, leverage can work in both ways. It can increase your gains many times but it can also cause a heavy loss. Maintaining a proper balance between what you borrow and what you own is always necessary.

Johnny: That’s true. But tell me, how does leverage work in the case of derivative instruments?

Jinny: You can use derivative instruments for getting leverage in the financial markets. Let us try to understand this through an example. Suppose you have Rs1,000, which you want to invest for a month in the stock market. Suppose you want to purchase the stocks of a company, which is presently trading at a price of Rs10 per share in the spot market.

If you purchase the shares directly from the spot market, you can purchase only 100 shares. But take a look at another strategy. Instead of purchasing the shares from the spot market, you purchase one-month futures contracts of the same shares at the future price of, say, Rs12 per share.

For entering into a futures contract, you are not required to pay the whole future price of the shares. You only pay the initial margin money and marked-to-market margin on a day-to-day basis. Initial margin is what you pay upfront and marked-to-market margin is what you pay on the day-to-day value of your derivative contract.

If your broker is taking 10% as initial margin money, your Rs1,000 will fetch you shares worth Rs10,000. Even at a future price of, say, Rs12 per share, which is higher than the spot price, you would end up controlling more than 800 shares by following this strategy.

By using derivatives, you can earn a profit or suffer a loss, many times more than what you could have earned or lost by trading with the same amount of money in the spot market. This is how leverage through derivatives works.

Johnny: Thanks, Jinny, for telling me all this. I just remembered that I have invited some of my friends for lunch today. So, I will leave now. Bye.

What:The use of borrowed money for enhancing return on investment in business and finance is known as leverage. A company with more debt than equity is called highly leveraged.

Why: Leverage increases the potential for heavy profit but it also increases the potential for heavy loss.

Why not: Too much leverage can cause financial instability or even bankruptcy if the business is not able to generate enough profit.

Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to both of them at realsimple@livemint.com

59) Another step towards tracking the ‘insider’

SEBI’s latest proposal to deal with the problem of insider-trading is fair and refreshingly simple.

The Japanese, with their fierce sense of commitment and loyalty to the organisation they are associated with, were ironically blasé about insider trading as typified by the general response to the law brought in 1988 in Japan to tackle the menace — what is wrong in being smart?

Equally ironical is the assiduity with which insiders are pursued in the US. A journalist was hauled over the coals there for making a fast buck out of the information she garnered during the course of analysis of a company.

Thin dividing line

While the line between crookedness and smartness may be thin, insider-trading cannot be allowed to go through as it would often be at the expense of those who did not have the price-sensitive information the insiders had.

The Securities and Exchange Board of India (SEBI) in its consultative paper on the issue brought out on New Year’s day has proposed to deal with the problem of insider-trading in a refreshingly simple manner.

The designated insiders, which would include all directors and officers of the company, and those who hold more than 10 per cent of the equity of a company will have to disgorge the profits to the company arising out of sale of shares they have made within six months of acquiring them.

No mens rea needs to be established. The fact that they were insiders and made profits in a short swing operation gives rise to the obligation to disgorge, period.

Fair enough, given the fact that those with long-term outlook are expected to hold on to the shares for a longer term. That they have resorted to short-termism, as it were, is enough to pin them down.

It is not clear though how a 10 per cent shareholder ipso facto becomes an insider unless he gets a seat on the board of directors.

On this touchstone, many FIIs operating in India could be insiders and their activities hamstrung should the regulations go through as they are.

Unwittingly perhaps the regulations are going to force FIIs to have a longer term perspective on their investments in India and should this happen the stock market may become a quieter place.

A few glitches

While the proposed new dispensation seems to be fair, there are a few minutiae that need to be addressed. The consultative paper proposes to follow the Last in First out (LIFO) principle for finding out whether a share was sold within six months of its acquisition. Let us say 10,000 shares of a company were acquired by the designated insider on January 1 and another 10,000 shares of the same company were acquired by him on May 4 of the same year. On June 29 and July 2 respectively of the same year, he sells these two lots and profits from both.

Now, according to the proposed dispensation, the profit from the first sale would have to be disgorged, hit as it is by the LIFO principle and the profit from the second sale will not have to be disgorged as it is saved by the LIFO principle — separation of buy and sell by more than six months. Had FIFO been the norm, both would have been caught by the new SEBI pincer on the anvil.

It is noteworthy that SEBI sets store by the LIFO principle whereas its counterparts in the Ministry of Finance, while drafting Section 45(2A) of the Income-tax Act, have set store by the FIFO principle for calculating capital gains on shares held in the depository mode.

A case can be made that relatives of auditors (auditor himself can hold shares in his client company only at the risk of attracting disqualification under Section 226 of the Companies Act), officials of SEBI, banks and financial institutions are also brought within the purview of the definition of ‘designated insiders’ irrespective of the quantum of shares held by them as they are also privy to price-sensitive information.

There is a view that the designated insiders would bide their time — let six months pass — before booking their profits a la investors who wait for a year to pass before selling so as to clothe their profits with the long-term capital gains tag in order to escape tax.

But this misses the point — while other investors can afford to wait for a year, an insider brooks no delay. Quick disposal is of essence to him as making a fast buck is what insider trading is all about.

Benamis roped in

The regulator however, may have a challenging job on hand. It has to keep an eagle eye on the designated insiders because there would always be temptation to make a fast buck based on inside information through the services of benamis.

To the credit of the draft regulations, it must be said that benamis are also being roped in — both independent operations and operations in concert with others on the part of the insiders would come under the regulations’ purview.

But then benami has always been the bane of this country and successive governments have shied away from taking a call on implementing the law on the issue gathering dust for about two decades now perhaps for the fear of stirring the hornet’s nest or out of the depressing realisation that the governmental machinery is not strong enough to establish benami ownership.

It remains to be seen how SEBI implements this law. The institution of benami could well frustrate it.

S. Murlidharan

(The author is a Delhi-based chartered accountant.)

58) The fear factor in allocation switches

Active funds have generated alpha returns in the current uptrend while their passive counterparts, the index funds, have trailed the benchmarks. This had led many to conclude that active funds would give maximum gains in the current market structure. This article suggests that investors would do well to switch from active funds to index funds when their fear-factor is high and move back to active funds as the fear-factor fades away.

The issue of Business Line dated December 30, 2007, carried an analysis of the performance of index funds for 2007. The analysis concluded that several such funds trailed the benchmark index. Active funds, on the other hand, have largely beaten their benchmarks.

This divergent trend in the mutual fund universe has led many investors to conclude that their exposure should only be in active funds and that index funds have lost relevance in the current market structure.

This article explores this perception. We believe that active funds will continue to outperform their benchmarks as long as the market is trending up. These funds will likewise under perform when the market turns down. Since investors cannot time the market turns, an optimal strategy would be to shift from active funds to index funds when the personal fear-factor is high and switch back to active funds when the fear-factor fades away.

Active funds, Alpha returns

Active funds generate alpha. Alpha is the excess return generated because of the manager’s skill. Suppose an active fund with a portfolio beta of 1.5 returned 100 per cent last year against a market return of 50 per cent. The fund’s beta-adjusted return will be 75 per cent (50 times 1.5). The difference of 25 percentage points is due to manager selection and is called the portfolio alpha.

Alpha generation has been possible because active managers loaded large-cap stocks such as BHEL and mid-caps such as Unitech well before the uptrend began. These fund managers continually take profits and move into other stocks that are potential alpha generators.

The problem is that portfolio managers cannot consistently beat the market with the same alpha-generators. After sometime, alpha returns will be replicated by other investors and will, therefore, become beta-drivers or market returns.

We, however, do not believe that the total alpha generators in the market will decline as more professional managers exploit mispricing in asset prices. Funds will continue to generate alpha, as portfolio managers plumb new models to uncover hidden values in the market. But alpha generation has its risks.

Active Risks

The primary risk in active management is the underperformance risk. What if the portfolio manager bought Aban Offshore at Rs 1,000 and the stock did not move to Rs 4,500 but instead fell to Rs 500?

The active risk is very high for two reasons. One, funds have large exposure to each stock. If the portfolio manager sells the shares because her security selection was wrong, the fund will suffer high impact cost. Second, when the market turns down, failed alpha-generators typically decline the most.

The active risk in a market downturn is higher than that in an uptrend. A portfolio of 20 stocks will carry at least 4-5 large alpha-generators. The portfolio manager will not, therefore, bother about selling the underperforming stocks as long as the other non-alpha-generating stocks provide market return.

In a downturn, however, the manager will have to necessarily sell such stocks and rebalance the portfolio to contain overall risk.

Often, the failed alpha-generators the manager had in the portfolio will decline the most. And that translates into large losses, forcing active funds to lose more than the market index. So, how should an investor tilt her exposure to mutual funds?

Fear-factor

We believe that the discerning investors should move between active funds and index funds when the market turns.

An investor need not use any analytical tools to pick the market turns. We believe that intuition works well in the market, especially when it has to do with fear.

The fear-factor is a function of an investor’s psyche, media exposure and intelligence gathered from market sources. The fear-factor is high when the investor reads and hears about a market decline and strongly believes that such a turn is highly likely.

We suggest that an investor shift at least 30 per cent of the total portfolio to index funds when her fear-factor is high. The balance 30 per cent can remain in the active funds and 40 per cent should be in money market funds.
When the fear-factor fades away, the investor should move back from index funds to active funds.

This is not a tactical asset allocation process. That is, the investor is not encouraged to time the market turns. Neither should the investor engage in such rebalancing process often.

The move from active funds to index funds should happen only once and that too when the fear-factor is high. The move back to active funds should happen when the fear-factor fades away.

We believe that the fear-factor would coincide with what Elliot-wave practitioners call as the fourth-wave structure. The objective is to participate in the uptrend through active funds and to contain price risk in a downturn.

B. Venkatesh

(The author is a Chennai-based investment strategist. He can be reached at enhancek@gmail.com)

57) Stock valuations are not about earnings alone

Listing of subsidiaries, re-rating of peers within a sector and news of private equity deals are among the factors that can transform the valuation picture.

Healthy growth in corporate earnings, rising institutional interest and ample liquidity have been the main drivers of high stock prices over the past three years. Conventional parameters apart, the recent re-rating of stocks has also been driven by other factors. Companies are valued not just for their core businesses but also for other strengths that have the potential to add value to core operations. Here are a few such triggers investors need to take note of:

Listing of subsidiaries

With the primary market in spate, companies seeking to hive off a new business for subsequent listing stand to receive an attractive valuation for the new business that isn’t captured in the company’s books. The listing of a subsidiary by an existing company has more often than not delivered value to the holding company. Consider Reliance Energy.

Since the filing of the draft prospectus of Reliance Power (early October-07), Reliance Energy has returned about 76 per cent, while the Sensex appreciated by only 10 per cent. Pantaloon Retail, following the announcement of the listing of Future Capital Holding (late September-07), its 78 per cent subsidiary, spurted 40 per cent between the date of announcement and that of the IPO, outpacing the 20-per cent rise in the Sensex.

The price surge in HEG and Rajasthan Spinning and Weaving Mills (RSWM) can be traced to similar factors. Given their rather indifferent valuations, news of the potential listing of Bhilwara Energy, their commonly-held subsidiary, drove their stock prices to new heights.

HEG more than doubled and RSWM appreciated more than 150 per cent in just two months while the Sensex managed a piffling 6 percent rise only!

Going by these trends, investors looking for potential upsides should watch for proposed listings of subsidiaries by companies such as ICICI Bank (planned listing of ICICI Securities and ICICI Ventures), M&M (Club Mahindra) and L&T (L&T Infotech).

Tracking the draft prospectuses of these arms on the SEBI site and looking into the potential valuations of these new companies may help investors time their investments in these stocks. One caveat here is that valuations would hinge on the sector leanings of the subsidiaries concerned.

Peer re-rating

Had you invested in Tata Power three months ago, you would now be sitting on profits of over 70 per cent on the investment, thanks to the high-profile Reliance Power IPO. In the same three-month window, other power stocks such as Torrent Power, JP Hydro, NTPC and CESC have turned in double-digit returns, a rare phenomenon in the sedate power sector. This bout of re-rating was prompted by the Reliance ADAG group’s decision to list Reliance Power.

The spate of new listings in the brokerage/financial space in recent times — Motilal Oswal Financial Services, Religare Enterprises and Edelweiss Capital has had a trickle-down effect on listed brokerage firms, such as India Infoline and Geojit Securities, IL&FS Investment Managers, and so on. The price investors were willing to pay for Motilal’s offer also pegged up the valuations for holding companies with unlisted broking businesses — such as Kotak Mahindra Bank and Indiabulls.

The mega public offer of DLF also had a similar impact on its realty peers. Given that most IPOs today enjoy strong investor appetite, a new listing usually contributes to a fresh discovery of the prices investors are willing to pay for the growth prospects of the business.

In this context, the price action in peer group companies of Emaar MGF (DLF), Oil India (ONGC), Wockhardt Hospitals (Apollo Hospitals and Fortis Healthcare) and Titagarh Wagons (Texmaco), among the many in line for initial offers, bear close watching in the weeks ahead.

Private equity deals

The private equity party in India has just begun; nonetheless, PE deals have altered the price discovery mechanism of our markets. For instance, Eton Park Capital’s acquisition of a 5 per cent stake in Reliance Capital for Rs 500 crore had valued the latter at about 13 per cent of its assets under management. This valuation was quite liberal when compared to the values earlier accorded to Reliance Capital’s asset business and thus drove a re-rating of comparable AMCs, such as Birla Sun Life.

Birla’s AMC business is housed with Aditya Birla Nuvo, the flagship company of this group. The Aditya Birla Nuvo stock gained 30 per cent from the time of this deal.

Similar benchmarking was also used to drive an expansion in price-earnings numbers of several listed broking companies, which attracted private equity deals in good number over the past year or so.

Valuation ‘gaps’ between two firms in a similar business have been swiftly bridged. This underlines the fact that investors are increasingly willing to bet on businesses and stocks if they are available at cheaper valuations in a bull market, rather than try and justify standalone absolute valuations for a business.

Nonetheless, it might not be such a great idea to invest blindly in companies that have attracted PE money. While most such companies have generated profits for shareholders, investors may be better off tracking the company fundamentals before taking the plunge.

For instance, while Nagarjuna Constructions returned about 85 per cent after the Blackstone deal, Gokaldas Exports, despite a similar private equity deal, has delivered only about 7 per cent.

Investment books

Prolonged bull markets, such as the current one, tend to soak up the supply of stock candidates that are available at good “value”. This may explain the trend among market participants to unearth hidden sources of “value” in a company’s asset base or balance-sheet that could add a few rupees to the company’s intrinsic worth.

The market value of investment books of companies (the value of securities/stakes held by the company as a part of its trade or non-trade investments) have been drivers of re-rating for stocks such as Tata Investment Corporation, Ramco Industries, Rallis India, IDFC, and many others. Consider Ramco Industries. The stock price shot up by a whopping 33 per cent in the last one month on discovery of a valuation mismatch; its investment book value per share was higher than the market price.

Arguments on similar lines may partly explain the surge in stock prices of companies such as Tata Investment Corporation, LMW, Dewan Housing and IDFC, to name a few. For instance, in Tata Investment Corporation, the value of its investment book would stand at about Rs 841 per share at current market prices; LMW’s investment book would be valued at about Rs.64 per share.

However, the caveat here is that though the market value of the investment book may be much higher than the book value, it must be capable of value unlocking through a sale of those shares at market price. Companies that do not actively manage their equity portfolios and cross-holdings between group companies may not lend themselves to such unlocking. Moreover, the market value of the investment book too is directly related to the state of the stock market and any meltdown could lead to a swift mark-down in values.

Beware the black swan

More often than not, while such triggers have made stocks outperform the broad market till now, they may not continue to do so. Investors should primarily base their investment decisions on a company’s core business fundamentals.

The Bajaj Auto demerger is a case in point. Contrary to the general market sentiment that demergers are good for shareholders, the stock crashed by about 13 per cent after the terms of the demerger were announced; the stock continues to languish despite a bull market. Investors expecting value discovery for Bajaj’s insurance business were caught off-guard on disclosure of a call option at a nominal price with its insurance partner, Allianz.
This came as an unpleasant surprise to market participants who were pegging up Bajaj’s insurance business at about Rs 600-1000 per share. Such damp-squib occurrences are rare but they prove that investors may be better off going by stock fundamentals for long-term investments.

56) Have the commodity futures markets delivered?

The futures markets provide signals of the steep bends ahead, but are not responsible for them.

Four years into the operation of commodity markets in India, a pertinent question to ask, is whether or not they have delivered adequately. More so, because while there was considerable fanfare with which these markets were resurrected after much debate, there is a modicum of scepticism underlying their operations today. Some critics have even questioned their existence. The issue can be addressed by juxtaposing it with the objectives of reintroducing commodity futures in 2003. The market was to lead to efficient price discovery, involve more hedgers and bring home the benefits to farmers. How far have the markets redeemed themselves?

Price influence

The year started off well for the market with business volumes increasing at a rapid rate. Subsequently, there was a ban on trading in wheat, rice, tur and urad ostensibly on account of their contribution to inflation. Interest in trading in agri products naturally ebbed as players were apprehensive of trading in this segment. Consequently, trading in agri commodities came down and the share of these products in total volumes traded fell to less than 20 per cent.

Today, interest is generally in metals and energy, which are safer avenues from the trading perspective as the perceived possible influence on prices is negligible, as price discovery is a global phenomenon. Hence, they make good trading and investment options.

Agri futures

Subsequent to the ban, the prices of wheat, rice and tur rose quite sharply in the market as supplies were lower. In fact, rice saw a sharp increase in price though it was not traded on the exchanges. While urad prices came down, this was indicated by the futures prices at the time of the ban. It is now quite accepted that futures trading was not responsible for inflation; and the market is awaiting the final word from the Abhijit Sen Committee.

Let us objectively evaluate how the markets have performed. First, price discovery has been quite efficient, especially for the agri products. Price signals that have been sent in case of wheat, pulses, spices and oilseeds have been fairly accurate. In the case of wheat, in both 2006 and 2007, accurate signals were sent, which were actually used by the government to raise the minimum support price (MSP) for the purpose of procurement.

Second, there is evidence that price volatility has come down in all the liquid contracts, which is but natural when large volumes are traded, where the noise levels are reduced.

Prices have also tended to converge in case of most contracts — which is the ultimate test of price efficiency in this market. Third, there are companies that are hedging on the exchanges as depicted by the ratio of hedger’s positions to open interest, especially in some agri products.

Awareness

Fourth, the picture from the farmer’s side is mixed. Direct participation is negligible because of the barriers in terms of direct access, processes and contract size etc. But, the business of futures trading involves extensive price dissemination campaigns, which are out in full flow. Newspapers, TV channels, radio, usage of electronic ticker boards etc, have been used by the exchanges to popularise these prices among participants.

The regulator — the Forwards Market Commission (FMC) — has initiated extensive awareness campaigns with the exchanges to have programmes for the farmers where the intricacies of trading are discussed.

There are studies which show that farmers are using the prices to enhance their bargaining power. Last, by enabling deliveries, which could go beyond 50,000 tonnes every month, there is a parallel system in place for physical handling of the goods, which is significant as there are certain standards being set for the quality, handling and grading processes, which is currently underdeveloped and would take another five years to become all-pervasive. Therefore, the markets have satisfactorily redeemed the charter that was laid before them four years ago.

It must, however, be reiterated that futures trading is not a panacea for the ills of agriculture. Futures markets provide a platform for farmers to sell and/or hedge their price risk by enabling physical delivery. They are good indicators of expected cropping supplies and are, hence, useful for policy formulation.

Further, the price discovery process must be evaluated form the point of view of whether or not they reflect the fundamentals and not so much from the point of view of whether the farmers are getting a higher price.

Caution required

This must not be missed because when we take sides we may arrive at erroneous conclusions when the result is not to our liking.

To draw an analogy from the traffic on the street, the futures markets provide signals of the steep bends ahead, but are not responsible for them. It is left to the motorist to take care. This is the spirit with which these markets must be evaluated.

Madan Sabnavis

(The author is Chief Economist, NCDEX Ltd. The views expressed are personal.)