106) Tapping the reserves

India has thought it appropriate to use its own reserves for real economy needs. But welcome as the IIFCL in London is, too little has been done too tardily.
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After more than a year, the plan to use a part of the country’s foreign exchange reserves finally got off the ground with India Infrastructure Finance Company Ltd (IIFCL) announcing a London subsidiary that will get the first line of credit from the Reserve Bank of India. The subsidiary will help Indian companies investing in infrastructure to fund import of capital equipment for their domestic projects. When the subsidiary commences operations next month, it will do more than commit public investment for infrastructure; it would have pioneered the first initiative of this government in the innovative use of surplus foreign exchange assets.

Against the backdrop of the country’s massive financing needs, the RBI’s credit of $250 million may be tiny. It is the first tranche of the proposed $5-billion that the IIFCL will raise through the RBI for its subsidiaries abroad. That amount was announced by the Finance Minister in last year’s budget as the sum that the central bank would lend from the reserves for infrastructure. The policy that led to this development, however, has had a protracted history with the central bank’s traditional approach to foreign exchange assets as safeguards against external shocks. But Singapore, China and Korea have shown how reserves can be deployed more profitably after accounting for rainy days. While these countries have used their massive surpluses to foray into Wall Street, India has thought it appropriate to use its own reserves for real economy needs. But welcome as the IIFCL in London is, too little has been done too tardily.

India’s reserves have crossed $300 billion and the mandated amount of $5 billion is far too paltry. The Deepak Parekh Committee on Infrastructure Financing had suggested double that figure and an additional 10 per cent on accretion to reserves. The 11th plan estimates $490 billion for the requisite push for this sector. Reserves are more than adequate for external shocks; surely, it can commit more for such an important sector. Its current returns on government bonds or deposits in other central banks do not cover the cost of sterilisation of the reserves pile-up as the Parekh Committee noted last year.

The stresses that the fisc will bear on account of various subsidies and the farm waiver may be justified; similarly, the burden of its guarantee on the RBI credit to fund roads, power and irrigation will entail small costs for immeasurably large long-term social and economic benefits.

105) An alternative oil pricing strategy

Given the need to set prices in a transparent and simple manner, an alternative way could be to fix a base price and then extrapolate it by the monthly/quarterly crude price (of the Indian basket).

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Effective February 14-15, the long ‘awaited’ increase in the prices of petrol and diesel was brought about — roughly a 4 per cent hike in the case of petrol. There was unanimity among political parties in opposing the hike.
The hike, however, is modest in relation to what the oil companies needed to break even. In the case of Indian Oil, for instance, it was reported in early January that a hike of Rs 8-9 per litre would only partly offset the gap between “the controlled retail prices and the high international prices of crude petroleum.” Price gap

Given that crude oil accounts for some 90 per cent of the cost of production of refined petroleum produtcs, it is to be expected that crude and retail product prices move in tandem. However, the Indian retail prices are not fully reflective of the changes in crude prices, as the data in Table 1 demonstrate.

If we go by the 2002 and 2008 prices changes, the application of the price relative for crude (106.27/23.22) would imply a present Indian retail price of 4.58 times the price in 2002, or a little less than Rs 140, which is way above the current Rs 50.51.

Despite the Government announcement to dismantle the Administered Price Mechanism (APM) effective April 2002, subsidies on Public Distribution System (PDS) kerosene and domestic LPG continue.

The products are assumed to be largely consumed by the “economically weaker sections of society”, though in reality leakages abound. The subsidies were to be phased out in 3-5 years.

In the meantime, the Oil Marketing Companies (OMCs) were to adjust retail selling prices gradually in line with international prices. But politics seems to have prevailed over economics. The prices of PDS kerosene and domestic LPG were not adjusted commensurately, resulting in losses on account of these two products.

The Government decision of 2003 was that the OMCs would make good about a third of the losses on the two products from the surpluses generated on petrol and diesel, while the balance losses would be shared equally by the upstream companies (ONGC/OIL/GAIL) and the OMCs.

Oil dependency

If the country had sufficient crude oil resources, the Government could have fixed a publicly acceptable price for petroleum products. However, the ground reality is different and the data in Table 2 show clearly our oil dependency. Domestic production has been stagnating more or less and imports have been growing fast. On top of this, there is also the huge increase in import prices of crude oil to contend with.

Hiking petrol prices (and related price changes in other petroleum products such as diesel, kerosene and LPG) is no doubt a sensitive matter. It, for one, makes commuting costlier for the public. How then does one go about pricing petroleum products?

This is an important question and the Government has tried to address the issue in its usual way: By appointing a committee to look into the matter.

Committee on Pricing

The Committee on Pricing and Taxation of Petroleum Products under the Chairmanship of Dr C. Rangarajan, submitted its report to the Government in February 2006.

The following principles were adopted by the Committee:

Pricing and taxation of petroleum products should be rationalised to transmit the right price signals so as to minimise, if not eliminate, distortions and inefficiencies that result in misallocation of resources;

Prices of petroleum products should, as far as possible, be aligned with international prices;

Across-the -board subsidies result in inefficiencies and place an undue burden on an already strained fiscal situation;

Subsidies should be minimal, targeted and restrained by a monetary ceiling;

To the extent the Government decides to extend subsidies, the burden should be borne entirely and transparently in the Budget;

Oil marketing companies should be freed from the burden of subsidy;

Customs tariff on crude and products should be rationalised so as to moderate the effective rate of protection to a level that will offset the disadvantages suffered by the domestic producers without, at the same time, allowing them any undue cushion; and

Excise tariffs should be restructured to protect the consumers from excessive volatility in prices.

The set of recommendations relating to pricing of petrol and diesel are:

Shift to a trade parity pricing formula for determining refinery gate as well as retail prices;

Government to keep an arm’s length distance from price determination and allow flexibility to oil companies to fix the retail price under the proposed formula; and

Reduce the effective protection by lowering the Customs duty on petrol and diesel to 7.5 per cent.

As for petrol and diesel prices, the recommendation was to apply a weighted average of the import parity and export parity prices in the ratio 80:20.

A Possible Alternative

Given the need to set prices in a transparent and simple manner, the alternative should be easy to understand, devise and implement. One way is to fix a base price and then extrapolate it by the monthly/quarterly crude price (of the Indian basket).

Table 3 — based on the data in the Rangarajan Committee report — presents the cost structure of petrol in Mumbai and its constituents in December 2005. Costs, including delivery and dealer commission, represent about 45 per cent of the retail price with the balance 55 per cent being Central and State taxes.

In an alternative disposition, the cost, including delivery cost, could be fixed in the base period appropriately, dealer commission pegged at 2 per cent of the cost, and Central and State taxes at 25 per cent each.

Thus, to the cost in Table 3 (Rs 22 per litre), a factor of 2.5 (ratio of the crude price in March 2008 to that in 2005) is applied to obtain the acceptable cost for March 2008: Rs 55. Dealer commission and government taxes will be Rs 1.1 and Rs 27.5 respectively. The retail price will be Rs 83.6. The bitter pill is hard to swallow.

The way out is to plan for a smooth transition by stating clearly that the price will escalate on a quarterly basis. Announce the changes well in advance and let the rest follow.

If the resultant price increases were to dissuade a few private car purchases, so be it.

Bhanoji Rao

(The author, formerly with the National University of Singapore and the World Bank, is Visiting Faculty, Sri Sathya Sai University, Prasanthi Nilayam. He can be reached at bhanoji@gmail.com)

104) Understanding exchangeable bonds

The Finance Minister, Mr P. Chidambaram, introduced the term Exchangeable Bonds (EBs) to the Indian financial market’s vocabulary in his Budget Speech of 2007. However, EBs did not find any specific mention in his latest Budget Speech.

While the much-awaited guidelines with respect to Foreign Currency Exchangeable Bonds (FCEBs) were issued by the Finance Ministry recently, the country still awaits detailed guidelines on domestic EBs which facilitate domestic fund raising activity.

It is relevant to note that internationally EBs are not a new concept at all. They are recognised as well-acclaimed instruments of raising debt in the world markets.

What are exchangeable bonds?

An EB gives the holder the option to exchange the bond for the stock of a company other than the issuer (usually a subsidiary) at some future date and under prescribed conditions. So one can say that it is a quasi-debt instrument that carries a burden of periodic interest payment and is callable at preset prices, that is, bond holders have a call option on the bonds before maturity.

The issuer could be a holding company, an operating company or a special purpose vehicle (SPV) depending on the market and more specifically upon the business advantages for the issuer.

If there is a business case for selecting an SPV as the issuer company, typically a full guarantee is required to be given by the company of substance or a third party in favour of the SPV.

Most of us are aware of another category of bonds (convertible bonds) that grant the bondholder similar rights, except for a specific difference that a convertible bond converts into equities of the same company, that is, the issuer (referred to as holding company) and not for the shares of the group companies as in the case of EBs.
Thus EBs act as a very effective disposal mechanism for the holding companies of the shares held in their subsidiaries (referred to as operating companies).

What’s THERE for stakeholders?

EBs serve as an effective tool for the holding companies to monetise their shareholding in the operating companies in case of fund requirement without immediate divestment of their stakes.

The issuer company may take advantage of high expectations and business valuation of its operating subsidiaries to issue such bonds on favourable terms. This proves to be an effective tool for disposing of the shares by a holding company in its subsidiaries; thereby unwinding interlocked corporate holding.

Unlike the convertible bonds, which on conversion into equity of the holding company result in dilution of issuer’s shareholder’s equity stakes, EBs prevent the occurrence of dilution of stakes. At the same time, EBs enable the holding company to exercise its voting rights in the subsidiaries until the conversion happens.

EBs give an opportunity to the bondholders to benefit from any increase in the value of equity linked to the bonds issued. Periodic interest payments keep the bondholders interested!

EBs facilitate portfolio diversification for the bondholders who otherwise would not have considered investing in the subsidiaries of the holding company.

In developed markets, EBs themselves can be traded even when not converted into equity. Thus a market exists even while the instrument is a bond.

Some of the instances of Global EB transactions are given in the Table. The sample of examples clearly evidences the potential benefits which could accrue to the interested parties. One can clearly gauge how critical it is that the terms and conditions of EBs are well thought through both from the issuer and the bondholder’s perspective and built into the agreement upfront. Agreements can be appropriately structured to incorporate varied considerations of the parties concerned.

Listing of EBs on the stock exchanges is a common feature of global EB transactions which are quite highly appreciated, especially in the EuroMarket. Indian vs global picture

With the ever increasing exposure of the Indian industry to the world markets and the increasing globalisation of the financial instruments, introduction of one more global financial instrument, namely “EBs”, in the Indian markets is inevitable. In light of the performance of this breed of debt-equity instrument at the global stage and the resulting benefits, EBs appear to be a win-win story for its stakeholders in this growth scenario.

The recent FCEB guidelines have a specific mention of the income-tax implications arising on issue and transfer/conversion of FCEBs in addition to the foreign exchange regulations as may be applicable. Though prima facie the guidelines envisage certain tax exemptions in India upon exchange and transfer of FCEBs on one hand, on other hand there are a number of in-built regulatory approvals to be obtained.

We hope that the Indian regulatory authorities take some cue from the successful EB transactions abroad and draft the regulations accordingly with necessary inputs from the Indian corporate houses. It is only then that EBs would be as successful a story in India as it is overseas.

With the constantly increasing need of the Indian companies to raise funds, more importantly from foreign sources, it has now become a critical that detailed and clear-cut guidelines on EBs (not just FCEBs!) are issued by the Finance Ministry and their implications under various other applicable laws, such as the Companies Act, the Income-Tax Act and SEBI laws, are brought onto the table. Until then it’s a wait and watch game for the Indian corporates and one hopes the game ends soon!

Monika Wadhwa

Sanjiv Aggarwal

(The authors are Manger (Global Tax Advisory Services) and Principal (Transaction Advisory Services), respectively, Ernst & Young.)

103) Is a buy-and-hold strategy optimal?

A straightforward buy-and-hold strategy could be a costly proposition under today’s market conditions. Investors should consider a comprehensive investment plan constructed within a core-satellite portfolio framework and based on planned re-balancing across assets.
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Stock price movements in the last two months have left many wondering whether a buy-and-hold strategy is the most optimal form of investing.

This column, in the edition dated February 28, discussed a core-satellite approach to portfolio construction. We address the buy-and-hold strategy here within this core-satellite approach.

The core-satellite portfolio is constructed based on an investment plan. Such a plan contains five elements- an investment objective, entry price, money management rules such as stops to minimise downside risk, price objective and an investment horizon.

The core portfolio, with exposure to low-cost index funds, should be held till the investment horizon. Any rebalancing is based on the loss tolerance level for the investor.

The satellite portfolio should be actively managed based on a well-crafted tactical asset allocation policy.

On the other hand, a straight forward buy-and-hold approach, which is not tailored to an investment plan, may not work as well. Here are three reasons why:

Suppose the price objective (based on intrinsic value) of a stock is Rs 200.

The high level of noise (speculative) trading in the market means that the stock could trade anywhere between Rs 50 and Rs 500!

Price objective and exits
Buying it at Rs 100 and holding it for a price objective of Rs 200 may then be a costly proposition.

What if the asset first moves to Rs 50 and stays there for 6 months? Or what if the asset moves to Rs 175 and then declines to Rs 50 in one month?

The reason asset prices wander far-away from the estimated intrinsic value is because noise-trading leads to high volatility. Now, volatility varies based on time. Today’s volatility is dependent on yesterday’s volatility, which may be dependent on the day before.

And volatility tends to be bunched up across trading sessions. A period of low volatility suddenly changes to a period of high volatility and vice-versa.

A straightforward buy-and-hold strategy in a highly volatile phase may underperform a strategy that leans on planned rebalancing between assets.

Opportunity cost
If the investor in the above example where to doggedly hold the asset at Rs 50 for 6 months, she will lose the opportunity to generate optimal returns from other investment avenues that are available today, thanks to innovative financial engineering.

Here is where fusion investing helps. Fusion investing optimally combines asset valuation models with technical analysis to reduce opportunity cost and enhance portfolio returns.

A buy-and-hold investor would simply take exposure in a stock because the current market price is lower than the estimated intrinsic value. An investor within core-satellite framework would not.

In the example mentioned earlier, the investor may buy the stock only at Rs 125 and not at Rs 100.

The additional Rs 25 per share is the price that the investor pays for trend confirmation, which lowers opportunity cost.

And remember, the money not invested in the stock is deployed in some other income-generating assets.

Buying a stock for dividend was the order of the day 10-15 years back. Then, assets traded not far away from their face-value.

Dividend Yield
So, dividend of 50 per cent on the face-value would translate into a yield of more than 7 per cent. Any profit from capital appreciation was a windfall-gain. Not any more. Asset prices trade several times their face value.

Even a 100 per cent dividend would translate into a yield of less than one per cent. So, buy-and-hold strategy set-up for dividend yield is sub-optimal.

All investors have to look primarily at capital appreciation to enhance portfolio returns.

And that requires an investment plan. The core portfolio has a rebalancing plan, even if it has an investment horizon of 10 years! A buy-and-hold strategy does not have a defined investment horizon.

Neither does it have effective stops to minimize downside risk. Banking on a belief that equity will generate positive returns in the long run is a costly proposition.

Conclusion
There is a belief among several investors that a buy-and-hold strategy is optimal for exposure through mutual funds.

That may not always be true. Even mutual fund investments suffer from the three reasons stated above. So, mutual fund investors need to have a rebalancing plan even if their investment horizon is long-term.

Otherwise, their capital will suffer large drawdown, as investors have now realised after the market crash in January.

It is, hence, optimal for investors to draw a comprehensive investment plan based on the core-satellite approach.
A naïve buy-and-hold strategy would only be the choice for investors who neither want to seek financial advice nor craft an investment plan on their own.

B. Venkatesh

(The author is an investment strategist. He can be reached at enhancek@gmail.com)

102) Debt and liabilities of Govt.

Treasury bills are instruments that finance the short-term requirements of the Government. They are highly liquid having an active secondary market and are issued at a discount to face value.
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Any guesses on how much the Government of India owes various parties? Rs 50,000 crore? Oh, that is huge to you and me, but trivial for the government. Rs 10,00,000 crore?

No, it is almost triple that at around Rs 29,00,000 crore as per the revised estimates for 2007-08. Budget 2008-09 expects this indebtedness to grow by 5.5 per cent to reach Rs 30,60,000 crore by March 2009!

What does this huge figure comprise? If it were a company, sure we would know that it may either be debentures, bonds or, simply, bank borrowings. Is it the same with the government too?

Government debt
The government presents its debts under two broad heads — internal and external. Internal borrowings constitute bulk of the debt, forming almost 95 per cent of the total debt.

Internal debt includes loans raised by the government in the open market, special securities issued to the RBI, rupee securities (non-interest bearing) issued to international institutions such as the IMF and the World Bank and, most importantly, treasury bills issued to State governments, commercial banks and other parties.

Liquid instruments

These treasury bills are instruments that finance the short-term requirements of the Government. They are highly liquid instruments having an active secondary market and are issued at a discount to face value.

The bills may be 14-day bills or 91-day, 182-day or 365-day bills. Since they are issued at a discount, the return for the investor is the difference between the maturity price and the issue price.

Revised estimates for 2007-08 suggest that the liability for 14-day bills is Rs 39,475 crore, 91-day bills is almost Rs 58,000 crore and for 182 and 364-day bills is approximately Rs 8,000 crore and Rs 33,500 crore respectively.

Market Stabilisation Scheme
The money sucked in by the Market Stabilisation Scheme (MSS) is also shown in the government’s statement of liabilities. Introduced in April 2004, the scheme envisages the issue of treasury bills and/or dated securities to absorb excess liquidity arising out of the excessive foreign exchange inflows. In 2007-08, the government capped the value of outstanding liabilities under MSS at any given time (face value of dated securities and discounted value of treasury bills) at Rs 2,50,000 crore. This ceiling applies for the ensuing year too.

The liabilities under MSS are required to be shown separately in the government’s statement of liabilities. For the year-ended March 2008, the liability under MSS is expected to be Rs 2,17,805 crore. By March 2009, the government expects to absorb another Rs 30,000 crore, taking the total liability under MSS to Rs 2,47,000 crore.

The debt of the government also includes others like the outstandings against small-savings schemes, provident funds, deposits under special deposit schemes and reserve funds of departmental undertakings.

These debts are shown under a separate head titled ‘other liabilities’. Revised estimates for other liabilities up to 2007-08 stand at Rs 9,40,240 crore.

Parvatha Vardhini C.

101) Derivatives: Not the rotten apple after all!

Most of the empirical evidence suggests that derivative markets do not increase volatility in cash markets (where contracts are settled immediately), but do tend to make them more liquid, and more information efficient.

March 1996. Barings goes bottoms up due to “rogue trading”. 2001: Leading bank in Australia declares large trading losses. Megellashaft, Orange County and LTCM are not the names of some exotic holiday resorts but entities that have come to woes on use of derivatives. 2008: major European bank acknowledges huge losses from complex trading instruments. A leading commercial bank in India had to declare additional provisioning on credit derivatives. One of India’s largest engineering companies faces large notional losses due to trading on the London Metal Exchange. So what are “derivatives”?

For centuries, people have taken bets on uncertainties or possible happenings. A ship loaded with goodies from the Far East; would it return safely across the 7 seas? How does one cover the uncertainty here? Here was born the rudiments of insurance (marine insurance). Such instances of commercial activities multiplied over the years and human ingenuity started to discover uncertainties or elements of risk in “mundane” events like rainfall, prices of commodities, foreign exchange and other tradable goods and services.

The risks could technically be transferred or shifted to someone or some other asset. More importantly, apart from Credit Risk (risk of default of payment), Market Risk (reflecting uncertainties in the market due to a host of factors) became a key risk indicator and risk mitigating instruments were demanded to address market risks. Thus, risk products like options, swaps, swaptions etc were developed based on a certain asset class or set of cash flows.

Market types
Any activity related to the market should bring in efficiency and productivity. The Arrow-Debreu theorem has some basic lessons on markets: There are 3 discernible types of markets (Derivative Markets in India..Tata McGraw Hill series): Normal markets – for goods and services; Market for time – Credit (loan) markets and debt markets; and Market for risk products – derivatives etc.

The Arrow-Debreu theorem assumes that: Markets must exist. There must be a mechanism for trading goods and services for a price and these apply to markets for credit and risk also.

Markets must be competitive for the price to reflect the true value of the goods.

In sum, “under certain conditions of competition and existence of markets, you will get an efficient system and an efficient economy…”

The popular assertion that derivatives on equities, fixed income, currency and commodities tend to destabilise the underlying assets markets has persisted for decades. This has often been reinforced by large corporates and banks losing huge sums of money on “wrong bets”.

Derivatives can be classified, based on different types of assets (notional amount) such as commodities, equities (stocks), bonds, interest rates, exchange rates, indices (such as a stock market index, consumer price index or even an index of weather conditions, or other derivatives) and credit. The performance of the underlying asset determines both the amount and the timing of the payoffs (loss of profit).

Classification
The alternate school of thought classifies derivatives based on which market it is being traded. Broadly speaking, they can be categorised as Over the Counter (OTC) or Exchange Traded Derivatives (ETD). In the OTC market, orders are privately negotiated between the potential buyers and sellers without the intercession of an intermediary. Plain vanilla Swaps, Interest Rate Swaps (IRS), Forward Rate Agreements (FRA), Exotic Options, Range Accruals and structured products (financial derivatives) are traded on OTC markets. According to statistics published by the Bank for International Settlement statistics, the total outstanding notional amount stands at a whopping $516 trillion.

ETDs: The risk of credit default is virtually eliminated when derivatives are traded through an exchange. The exchange provides the platform for buyers and sellers to meet anonymously and trade, ensuring greater transparency and emancipation of prices of the underlying asset.

Like other derivatives (OTC), these publicly traded derivatives provide investors access to risk / reward and volatility (price/value fluctuations) characteristics that, while related to an underlying asset, nonetheless are distinctive.

Tracing its history
The advent of modern day derivatives contracts is attributed to the need for farmers to protect themselves from any decline in the price of their crops due to delayed monsoon, or overproduction. The first ‘futures’ contracts can be traced to the Yodoya rice market in Osaka, Japan around 1650. These were incidentally standardised contracts, which made them much like today’s futures. The Chicago Board of Trade (CBOT), the largest derivative exchange in the world, was established in 1848, where forward contracts on various commodities were standardised around 1865. From then on, futures contracts have remained more or less in the same form, as we know them today.

Derivatives have had a long presence in India. The commodity derivatives market has been functioning in India since the nineteenth century with organised trading in cotton through the establishment of Cotton Trade Association in 1875. Since then, contracts on various other commodities have been introduced as well.

In India, exchange traded financial derivatives (where the underlying asset could be the stock price or stock market index) were introduced in the new millennium at the two major stock exchanges, NSE and BSE. There are various contracts currently traded on these exchanges. Subsequently, three national level exchanges were introduced in 2003, to provide platforms for commodities derivatives trading. The derivatives market in India has grown exponentially, especially at NSE.

It should be understood that derivatives themselves are not to be considered investments since they are not considered as an asset class. They simply derive their values from assets such as fixed income securities, equities, currencies, commodities etc. and are used to either hedge those assets or improve the returns on those assets.

Most of the empirical evidence suggests that derivative markets do not increase volatility in cash markets (where contracts are settled immediately), but do tend to make them more liquid, and more information efficient.

Since derivative markets allow producers to hedge price risk, the existence of futures may affect a producer’s decision of what to produce, how much to produce, and what production techniques to use. In addition, the futures price may contain information about anticipated demand that can feed a production decision.

Robin RoyChiragra ChakrabartyAnkan Mondal
(The authors are employed with PricewaterhouseCoopers.)

100) IPOs: FIIs too can take a short-term view

Large investors too are driven by profit motives and their mere presence in an IPO may not be a vote of confidence in the company or its long-term prospects.

If you have tracked book-built initial public offers on the stock exchange Web sites, you would have noticed that retail investors typically rush in at the last hour.

This is because most lay investors are looking out for the subscription numbers for the QIB (Qualified Institutional Bidders) portion of the IPO, especially of FIIs, before they decide to take the leap.

Retail investors often rely on the extent of over-subscription in the QIB portion when deciding to invest or refrain from IPOs. This is built on the premise that FIIs have a much better understanding of new businesses or untested business models when it comes to evaluating IPOs.

Now for the detour. What if the big guys you were tracking were in the issue for the short term? What if they flipped on listing day itself, after securing the much-sought-after allotment?

Business Line looked up large transactions (bulk and block deals) that occurred on both the BSE and the NSE platforms for the 35 IPOs listed from mid-October. The evidence of institutional investors making a short-term profit on the day of listing (known commonly as ‘flipping’) was strong.

Of the 62 transactions (both buy and sell) that occurred on the listing days, 34 were “sell” trades. Of these, institutional investors exited the stock with substantial profits on 25 occasions.

The numbers may be small but the trend reveals that FIIs too have not been averse to taking a short-term view with their IPO investments.

Cashing in
Mauritius-based investment firms or arms of well-known investment banks feature prominently on the list of investors that made a killing on listing.

Right from BSMA (affiliate of Bear Stearns), Mavi Investment Fund (sub-account of Switzerland-based M.M. Warburg Bank) to less known entities such as Prime India Investment Fund, ITF Mauritius, Amas India Investments; all have been regular investors in IPOs, who have taken profits on listing.

Could it be the overall market mood that caused FIIs to rush in on the day of listing and cash in on their profits? Maybe not. True, the Sensex lost around 22 per cent in value since the first week of January, with many volatile ups and downs in between. However, even through this period, FIIs did keep up steady buying in shares of companies such as Maytas Infrastructure, Edelweiss Capital, Consolidated Construction Consortium (CCCL) and BGR Energy Systems, on Day One.

When it comes to a fancy for newly listed stocks, FIIs do not seem to be very different from the small investor.
Just as a small investor would try to buy shares in the secondary market for a company in whose IPO he/she did not get allotment, foreign investors too seem to follow this practice. This may partly explain the bulk deals in Maytas, Edelweiss, CCCL and BGR, whose issues were oversubscribed over 50 times during their IPOs!

What about other constituents of the QIB group who are allocated around 50-60 per cent of a company’s net issue? Apart from FIIs, mutual funds and financial institutions, insurance companies also are included in this list.
An analysis of the reported transactions shows that domestic mutual funds have not engaged in ‘flipping’, as much as the foreign investors. They feature prominently in the buyers list on the day of listing, with funds such as JM Financial, Franklin Templeton MF, ICICI Prudential and HDFC MF actively engaged in buying shares.

India’s largest bank, the State Bank of India, also seems to be a participant in the IPO segment, making quick gains with investments in IPOs of Barak Valley Cements and Renaissance Jewellery.

But could it happen that daily market movements too influence these deep-pocketed investors? They do not, as an analysis for the October-February period shows. ‘Sell’ transactions in IPO stocks were roughly the same in number whether the Sensex finished lower or higher on listing day.

While most transactions by institutions on listing day appeared to be motivated by the chance to make quick gains, a few also helped limit the downside. DB International, India Diversified Mauritius, Ultra India Mauritius, Deutsche International and Elara India Opportunities were some institutional sellers on day one, in stocks such as Empee Distilleries, KNR Constructions and Bang Overseas.

Their move to exit was well-timed, as each of these IPOs lost as much as 20 per cent on listing day. Cords Cable Industries was among the exceptions, which managed to close at a 3 per cent premium after listing at a discount.

What’s in it for you
Many small investors take cues from strong QIB subscription numbers to subscribe to and project listing gains on IPOs.

Strong institutional interest during an IPO is taken as a sign that the stock may attract buying post-listing. However, if above trends are any evidence, it is possible that institutional investors too (at least a few of them) are in the game for the short term.

Remember the hype surrounding Reliance Power IPO? Overall, the IPO was oversubscribed 62 times, while the QIB portion was over-subscribed a massive 83 times. But the stock still closed Day One well below its offer price.

Although there is no record of bulk/block deals related to the Reliance Power stock on listing day, one must remember that quite a bit of institutional selling may escape the “bulk deals” net, if transactions are broken into smaller trades, thus escaping notice.

Apart from ‘flipping’ being a risky game (refer ‘Flipping your stock is a risky game’, Business Line, September 30, 2007), these trends are reason to take IPO subscription numbers with a pinch of salt.

Large investors too are driven by profit motives and their mere presence in an IPO may not be a vote of confidence in the company or its long-term prospects.

Kumar Shankar Roy

99) Harvesting alphas on upside and downside

This article looks at harvesting alphas on either side of the market. Called active extension, this strategy helps investors and portfolio managers optimally exploit their positive and negative views on assets. The article also presents a strategy called modified fence for retail investors.

The secular uptrend in the market has been arrested for over a month now. Portfolios of most institutional and non-institutional investors have suffered large losses since this January. Yet, the sharp decline in asset prices on January 21 and the wobbly market since then has been good news for some investors — those who were short Nifty futures or long on Nifty puts. This is a testimony for investors who do not believe that returns can be harvested on the downside as well.

This week, we focus on a strategy that can generate alpha on either side of the market. We call it modified active extension and style it on the lines of the popular active extension strategy, also called beta-one fund.

Long-only strategy
Professional money management is typically a long-only strategy. Take a mid-cap fund. The portfolio manager is benchmarked to the CNX Mid-cap index. Suppose the portfolio manager has a positive view on Balrampur Chini but carries a negative view on Bajaj Hindusthan.

The portfolio manager has two choices as far as Bajaj Hindusthan is concerned. She could underweight the stock in the portfolio. Suppose the stock carries 0.70 per cent in the index, she may choose to have only 0.10 per cent weight in her portfolio. The second choice would be to have no exposure in the stock. Typically, this would depend on how much weight the stock has in the index and what tracking error the portfolio manager is allowed.

In either case, the manager is not optimally using her view on the assets. Ideally, she should have gone long on Balrampur Chini and short on Bajaj Hindusthan. She could not construct such a portfolio because of the long-only constraint.

Active extensions
In active extension strategy, the portfolio manager can set-up a position to take advantage of her view on both the stocks. The portfolio can now generate alpha returns on either side of the market. The most preferred strategy is 130/30. The portfolio manager will invest 100 per cent of the assets in mid caps just as a long-only manager does. She will go short on mid-cap stocks on which she has a negative view to the extent of 30 per cent of the assets.

She will borrow stock from the broker to deliver against the short positions. Then, she will borrow cash or use the proceeds from the short-sale to buy 30 per cent more of mid-cap stocks on which she is positive.
The portfolio will, thus, have 130 per cent exposure in longs and 30 per cent exposure in shorts and sometimes 30 per cent borrowings. The net long in the stock market is only 100 per cent.

The 130/30 strategy will be subject to all other constraints such as beta exposure, sector caps and individual exposure caps, just like a long-only fund. Note that the active extension strategy can be 120/20 or even 140/40, as long as the net long is 100 per cent.

Professional money managers who run separately-managed accounts in brokerage firms and investment banks and as well as discerning investors can apply this strategy to generate alpha returns.

Modified Extensions and fence
Active extension strategies are not possible till our market has well-established stock-borrowing mechanism. Money managers and HNIs can instead use futures to take short positions.

The long exposure in the stocks can be used as collateral for the short futures position. Of course, the entire portfolio cannot be invested in longs, as the money manager will need cash to meet the mark-to-market margin on short futures. The cash drag on the portfolio will be, however, compensated by the alpha returns generated on the short futures.

Retail investors cannot benefit from this strategy, as the asset size required to optimally implement the strategy is likely to be large. The best that retail investors can do is to implement what we call as “modified fence”.

A fence is a strategy where a trader holds the underlying and buys lower-strike puts and sells higher-strike calls on it. In a modified fence, the puts and calls will not be on the same underlying.

Suppose a retail investor holds 75 shares of Reliance Industries. She will write 2,400 calls on Reliance and collect Rs 4,950 as premium.

The shares can be offered as collateral for the short calls. The premium collected can be used to buy 930 puts on ICICI Bank on which she has a negative view. The total outlay will be Rs 5,775. This strategy helps the retail investor take positions on both sides of the market.

It is important for investors to set up long and short exposures to optimally exploit their view on assets and consistently outperform the market. We believe that modified active extension would be a good strategy to harvest alphas.

B. Venkatesh

(The author is an investment strategist. He can be reached at enhancek@gmail.com)

98) Choose from diversified and theme funds

If you thought choosing appropriate mutual funds for investment was an easy task, think again. Diversified funds, sector funds, theme funds, tax saving funds… the list just keeps growing.

What is the investment logic of diversified, sector and theme funds and how can such funds fit into portfolios of young investors like you? Read on to find out.

Diversified Funds
As the name suggests, these funds invest in a wide basket of stocks, picked from several industries. Diversified funds are particularly suitable when the market rally is across the board. That is, when many sectors and stocks are expected to do well.

This diversified approach creates many advantages. First, it reduces the risk from concentrated holdings in select stocks or sectors. Performance is not dependent on the returns of a small set of stocks or a particular sector. If some sectors/stocks are not doing well in the portfolio, the other ones may be expected to outperform and deliver better returns and, therefore, compensate investors.

On the other hand, if sentiment in the market is bearish, many sectors could simultaneously go crashing down! Usually, however, some sectors are more adversely hit than others. For instance, the prospect of a US recession creates jitters in the Indian markets. But stocks of export-oriented companies take a greater hit than domestic-focused companies. The extent of decline suffered by a diversified fund, which invests across sectors, is likely to be less or, in other words, the blow may be softened.

Second, diversified funds can invest across market capitalisation — small, mid and large — and take advantage of any rally in these stocks. Of course, there are exclusive large, small and mid-cap funds as well. However, a fund that has the flexibility to invest in stocks of varied market capitalisation may be in a better position to capitalise on prevailing trends in the market and could deliver superior returns over the long term.

Third, even as they stick to the principle of diversification, diversified funds can step up exposures to themes that are in market fancy at any given time and gain from the momentum in those sectors. Therefore, investing in diversified funds does not mean that you will miss out on prevailing ideas.

Fourth, a diversified fund reduces the importance of timing the market. This is because there is a long window of opportunity for different sectors to outperform and deliver superior returns. A diversified fund can also quickly switch its preference between sectors and themes and continue to outperform the market over a long period.

Because of these features, diversified funds are suitable for long-term investors.

Theme and sector funds
A theme fund invests in sectors surrounding a theme. For example, the technology theme may be taken to include IT services, telecom, media and entertainment sectors. But the central theme remains the same. Similarly, infrastructure can be taken to include sectors such as construction, capital goods, power and power equipment, and so on.

The advantage that these types of funds have is that when there is a sustained momentum in certain theme(s), the return upside can be substantial. In such phases of the market run, the returns from such themes are generally much better than the market. This has been the case with the infrastructure theme over the last three years.

But the disadvantage is that when the theme is out of favour, the slide in the fund’s NAV will be substantial and worse still, diversification to reduce risk is not possible as the fund has a specific mandate to invest in a theme only.

A sector fund, on the other hand, invests only in a single sector. For example, a banking fund will invest only in banking stocks or a power sector fund will invest in power transmission/distribution and power equipment stocks and so on. That is while a fund manager has the option to exit a stock in the sector, he cannot exit the sector itself!

Suffice it is to say that sector funds may be deemed much more volatile and risky than theme funds.

Appetite for risk
Diversified versus theme — In which type of fund should I put my money?

The phrase that guides all equity market relationships — ‘depends on your risk appetite’— is applicable here as well!

This means that your choices are dependent on your age, income levels, liquidity requirements and investment horizon. But if certain factors are kept in mind, a strategy can definitely be evolved.

A diversified fund with a good track record may be able to deliver steady returns across market upswings and reduce the negative impact during market downslides. So, these types of funds should form the core of your portfolio. That is, a good percentage of money should be parked here.

If the investment horizon is, say, five-ten years, then a strong portfolio comprising four to five diversified funds may be considered. A lump-sum investment is not a prerequisite. A SIP (systematic investment plan) may be considered by way of small monthly investments. This further minimises the impact of poor market timing and helps cost averaging during market downs.

A theme/sector fund investment may also be considered, but only if you are bullish on the sector(s) or theme(s). But considering the risks associated, these should form a smaller part of your portfolio.

Another aspect to be noted here is that in theme funds, the window of opportunity may be shorter. The market may fancy a theme for some time but it could suddenly go out of favour. This means two things. One, timing of the entry and exit is important. So you must be fairly knowledgeable about the sector or theme and be in a position to actively manage your investments in such theme funds. Second, investing a lump-sum may be a better option as it will maximise your return. Here again, invest in lump-sum only the surplus that you are unlikely to need for the medium term.

A mix of diversified and theme funds in line with your risk appetite will go a long way in increasing your returns. Figure out your goals and invest accordingly.

K.Venkatasubramanian

97) How to read an offer document

An offer document is only as good as the disclosures a company chooses to make.

Burnt your fingers in recent IPOs? While you cannot do much to change market sentiment, which is unpredictable, you can take greater care while investing in IPOs by reading the fine-print.

A big, fat offer document can be overwhelming. But you can quickly leaf through it and focus on some of the essential sections. The must-read sections are as follows:

Risk factors: This is the first section in the offer document. Reading through the entire section might be a little disconcerting and your first instinct might be to avoid the offer altogether. It is the duty of the company to disclose all conceivable risks to performance. However, try and focus on the ones that are specific to the company (client concentration, legal disputes, heavy indebtedness, exposure to risky revenue streams) rather than general risks that affect all companies in the industry or the country (disasters, terrorist attacks, slowdown in economy).

Objects of the issue: This section explains how the proceeds of the offer will be deployed. A detailed break-up of the expenses and an implementation schedule is usually provided. Reading this section will help you determine if your money will be invested in projects that will deliver higher returns than what the company is currently able to achieve. It will also tell you when these projects will begin to pay off. For instance, if newly expanded capacities are likely to come on stream two years from now, you would have to wait that long before your investment starts paying off.

Business overview: If you are familiar with the industry, you can quickly skip to the business overview of the company. This section should give you a detailed picture of the various segments and markets that the company operates in, its competitive strategy and some aspects of its operational performance such as capacity utilisation, terms of joint venture agreements, existing resources and facilities and competition. More information on the background of the company and its promoters can also be found in the history and management sections.

Financial Statements: The consolidated profit and loss account and balance-sheet are the main financial statements you need to look at and these should be read along with the management discussion and analysis. This should provide you a basic overview of the company’s revenue streams, profitability, debt and cash levels — basic information for those who do not understand financial mumbo-jumbo. Good offer documents would have a detailed break-up of segment sales and profitability and clearly explain factors that helped or hurt performance in each of the last three-five years.

A quick scan of these basic sections should suffice and help you raise the right questions when talking to your broker/financial adviser, rather than just take their word (remember, they could have vested interests) for it.

You can also take some investment cues from other sections of the offer document. For instance, the capital structure section could reveal the presence of blue-chip institutional investors, which could enhance your comfort level regarding the offer fundamentals.

The “basis of issue price” section should, theoretically, provide a justification for the valuation of an offer. This, however, is seldom the case.

Comparisons to “peers” could be misleading. It is important to relate the fundamentals of a company with players that are really comparable in terms of size and segments of operation. Similarly, it is better to restrict your valuation comparisons to immediate peers rather than refer to the “industry average”.

Finally, an offer document is only as good as the disclosures a company chooses to make. If a company discloses its practices in a clean and comprehensive manner, it speaks volumes of its management. When a company’s plans and strategy are well-articulated in the offer document, it tends to inspire greater confidence in the management’s execution capabilities. Reading an offer document for about an hour or two is time well spent, given that it provides access to qualitative inputs which are not readily available from the usual news sources.

You can download the final “red herring prospectus” from www.sebi.gov.in and from the company and lead manager Web sites.

Shanthi Venkataraman

96) Reining in the fiscal deficit

Can fiscal deficit be pegged at 2.5 per cent of GDP in 2008-09? With the likely slowdown in corporate and service tax collections and additional expense by way of the Sixth Pay Commission payment, it appears a challenging task.

Fiscal deficit management has been a source of great satisfaction for the Finance Ministry. The country is on the way to reducing the fiscal deficit as a per cent of Gross Domestic Product (GDP) to below 3 per cent, much ahead of 2008-09, the target set under the Fiscal Responsibility and Budget Management (FRBM) Act.

The aiding factors
What were the prime factors that aided in controlling the fiscal deficit in 2007-08? Will the Government be able to control it at 2.5 per cent of GDP as promised in the Budget? The revised estimate for the fiscal deficit for 2007-08 is Rs 1,43,653 crore or 3.1 per cent of the GDP. The Budget estimate for the fiscal deficit for 2008-09 is Rs 1,33,287 crore; that would be 2.5 per cent of the budgeted GDP. This rapid reduction from the high of 6.2 per cent of GDP recorded in 2001-02 is laudable.

If we consider the factors that contributed towards controlling this mismatch in government finances, the primary reason is the strong growth in corporate profitability leading to higher direct tax collections. Corporate taxes that comprise about 32 per cent of the total tax collections surged by 39 per cent in the period between April 2007 and February 15, 2008.

The other driver for the growth in direct tax collections was the stock market boom. As turnover on the bourses made new records between August and December last year, the Securities Transaction Tax (STT) yielded Rs 7,878 crores (Rs 4,267 crores) to the exchequer.

Indirect tax collections, however, continued to be lag. Tax evasion could be the prime reason behind this slowdown. Customs duties were impacted by the strengthening rupee that resulted in lowering the cost of imports.

The Government has complemented the buoyancy in revenues by controlling expenses. The revised estimates for 2007-08 reveal that the total non-Plan expenditure rose by 23 per cent while the Plan expenditure increased 20 per cent over the revised estimates for 2006-07.

The moot question is whether the fiscal deficit can be controlled at 2.5 per cent of GDP as promised in Budget 2008. Post-budget clarifications issued by various Finance Ministry officials suggest that they are ready for at least a 50 basis points hike in the revised estimate for 2008-09.

The key factor that can affect this figure is the recommendation made by the Sixth Pay Commission. Since the report is due only on March 31, 2008, the provision for this increase has not been included in the Budget document.

Then there are the subsidies given to oil marketing companies, fertiliser companies and the Food Corporation of India in the form of bonds that have the potential to further inflate the fiscal deficit figure (if included in the Budget document as recommended by the Finance Minster in his Budget speech this year).

Questionable assumptions
Even if this unaccounted expenditure is ignored, certain assumptions made in budgeting for the revenue for 2008-09 are questionable. The receipts budget reveals that the estimate of the corporate tax receipts for 2008-09 is higher by 21 per cent. The other segment where higher revenues are provisioned is service tax, which is slated to increase to Rs 64,460 (Rs 50,603). In other words, the budget is assuming that the buoyancy in the corporate tax collections would continue in 2008-09 too. But it is widely known that there has been a slowdown in corporate profitability in the second and third quarters of 2007-08. If this prolongs, the corporate tax collections could slow down too.

The STT collections are also likely to decline in 2008-09. The previous fiscal witnessed an unprecedented rally in prices that sucked in a wide gamut of investors from all walks of the society. But the crash in January has resulted in many of these investors withdrawing from the market resulting in the turnover on the Bombay Stock Exchange and the National Stock Exchange plunging by more than 30 per cent.

The same argument holds true for the increase expected from short-term capital gains tax. With trading interest on the bourses at an ebb due to the lethargic movement of stock prices, short-term churn in portfolios is also likely to lessen.

New levies
However, new levies in the form of commodities transaction tax (CTT) and service tax on exchanges and clearing houses could enhance the revenue from this sector to some extent.

There is a segment of opinion leaders who decry this zeal to rein in the fiscal deficit, as it is resulting in the Government tightening the purse-strings where infrastructure-spend is concerned. These fears are justified since the Budget estimates for capital expenditure in 2008-09 is down to Rs 92,765 crore from Rs 1,20,787 crore in the revised estimate for 2007-08. The adherence to the FRBM targets is taking its toll on the outlay to the sectors, which are in urgent need for expansion.

It will be interesting to watch how the Finance Minister manages his finances next year given the likely slowdown in corporate and service tax collections and the additional expense in the form of the Sixth Pay Commission payment.

Lokeshwari S.K

95) The gold rush

Gold price has been increasing for the past two decades and may touch the $1000 (an ounce)-mark anytime. Gold and dollar are closely related but move in opposite directions. When the dollar weakens, investors take to gold as a sound alternative.

With the looming uncertainty in the stock markets, gold as a medium of investment and as a cushion for security is gaining in importance. The prevailing price levels of gold reflect investor concern about the turbulence in the world economy and the global political tensions. Gold price has been increasing for the past two decades and may touch the $1000 (an ounce)-mark anytime. Gold and dollar are closely related but move in opposite directions. When the dollar weake ns, investors take to gold as a sound alternative. The Federal Reserve’s cuts in interest rates to minimise downside risks to growth has not helped the matter.

Little options
The volatile political situation in our nuclear armed neighbour; the predicted dip of the US economy into a recessionary mode; Iran/North Korea nuclear programmes; the unilateral declaration of independence by Kosovo and Russia’s reaction to it; the talk of the French taking military action if Iran goes ahead with its nuclear programme; the saga of sub-prime lending and the financial crunch it brought with it; and the tumbling dollar, leave the investor with little options to chose from the portfolio basket. This is in addition to crude oil breaching the $100 levels. The global food prices are soaring, triggering inflation and the UN is reportedly seeking additional $500 million to finance its food programme due to high prices.

Indian investors are already showing a tepid reaction to IPOs. At the global level, inflation has crossed double-digits in Qatar and UAE with China reporting above 6 per cent.

A similar situation occurred in 1979 when gold touched $850 an ounce with the US economy reeling under a double-digit inflation, Iran seeing the last days of monarchy and the Soviets flexing their muscles in Afghanistan.

As an inflation hedge
Now, the sub-prime crisis and the inability of the West, be it bankers or political leaders, to provide a firm solution to this banking crisis strengthens the claim of gold to be playing a significant role as an inflation hedge. It is reported that losses on securities linked to the US sub-prime mortgages could reach $400 billion. Donald Luskin of Trend Macrolytics, a California-based consulting firm that caters to institutional investors, says that “Gold is one of the best forward looking market-based indicators of inflation”.

To insulate their economies against the dipping dollar, the Asians, the Russians and other petro dollar countries diverted their reserves into euros boosting the capital inflow into the Euro Zone to €200 billion during the first half of 2007, as per BNP Paribas. With reports of the sub-prime plague reaching Germany, emerging economies are now turning to gold as shelter.

In the light of these developments, it is interesting to note that the Russian President, Mr Vladimir Putin, has advised the Russian central bank to increase the gold portion of its $470 billion reserve to about 10 per cent. The newly-emerging Asian economies and the petro dollar states are sitting on reserves of about $6.6 trillion. A small shift in their portfolio to gold would push the prices.

Volatility and demand for gold
On a micro level, the introduction of exchange traded funds that would enable small investors to invest in gold funds has increased the demand for gold. It is reported the holdings of such exchange traded gold funds hover around 800-900 tonnes, surpassing the holdings of many central banks. These funds enable investors to invest without the hassle of holding on to the physical commodity.

India is the largest market for gold in the world. The weakening of the dollar has not left India unaffected. The strengthening of the rupee against the dollar has raised the demand for the yellow metal by as much as 72 per cent during the first half of 2007. According to the World Gold Council, India’s demand reached an all-time high of 317 tonnes in 2007.

However, with volatility in gold reaching its peak, Indian demand for gold slumped during the fourth quarter of 2007 by almost 64 per cent, while China’s demand has increased in the fourth quarter.

World Gold Council has stated that consumers in India are waiting for the gold price to stabilise; demand has further slumped to 5 tonnes in January 2008, when compared to 62 tonnes in the corresponding previous period.
Out of the total gold processed in India, only 15 per cent comes from recycled gold indicating that there will be demand for imports once the price stabilises.

Similarly, the demand for gold from West Asia is also on the rise. China has now replaced the US as the second largest buyer of gold after India. The overall demand for gold was 4 per cent higher in 2007 and stood at 3,547 tonnes.

Concerns on supply
While the demand for gold is increasing from all quarters — governments, banks, exchange traded funds or private investors — the supply side is becoming weaker.

The mines in Africa are reporting low yields and those in Canada are reported to have passed their peak production. Costs are also increasing and affect the pricing of the metal. These indicate that the supply rate will diminish until further discoveries are made.

Again, power shutdowns in South Africa are adding to anxiety on supply . But, then, gold is a unique commodity in that more than 90 per cent of that mined so far is deemed to be still in existence whether it is bullion or jewellery.

It is not consumed in usage and the loss of 10 per cent due to industrial processing is capable of being recycled as it pays to recover and reuse. According to GFMS, precious metals consultants, China has also become the world’s largest producer of gold ending 102 years of reign of South Africa.

According to John Reade, the precious metals Chief at UBS, “The feeling is that there is a lot of money around and not much gold.”

Carlos Sanchez, a precious metals analyst at CPM Group, expects gold prices trending upwards throughout 2008. This is against an annual global growth of about 15 per cent money supply. But analysts feel that even $1,000 an ounce is equivalent to $400 in real terms, if one takes 1980 as the base year. In real terms, to reach $1,000 an ounce, the price has to rise to $2,500 which may take a while.

BMO analysis
The market now is so volatile that forecast by the US-based financial service provider, BMO, in October, 2007, pegging price at $800 per ounce while raising the long-term forecasts to $600 may need revision.

The forecast was based taking into account the fact that in 2007, gold outperformed major stock markets, broad-base metal price indices, currencies and bonds. BMO analysis includes the possibility of euro being devalued to protect trade balances with China and other emerging economies, the rising production costs of gold and the rising middle-class income in China and India.Gold and real estate

And, finally, it will be interesting to note that in Vietnam, real-estate values are equated on their value in gold and with the surging gold price, several people have cancelled their bid to buy houses.

The precious metals market is so volatile that silver too reached its peak in 27 years bringing a fall in the gold/silver ratio. This would leave options open for silver/gold cross trade.

Is gold becoming a significant factor in the current turbulent global economic situation? “Stocks are down and bonds are yielding next to nothing — so what’s not to love about gold” — David Berman

S. SRINATH

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

94) M&As: A year of adventure for India Inc abroad

A growing economy, robust financial performance and an exceptionally buoyant stock market have all supported a remarkable expansion of M&A activity, and there seems little to upset this trend in the immediate future. Overseas M&As by Indian companies have exceeded the investment by foreign companies into India.

.........

The year 2007 turned into a remarkable one for Indian M&A, both at home and abroad. Spending more money on overseas acquisitions than foreign companies did in their own market, Indian companies have made their presence felt globally. Domestically, 2007 saw another record year of deal activity, with total mergers and acquisitions (M&A) and private equity (PE) deals up 82 per cent from Rs 865 billion ($21 billion) in 2006 to Rs 1,576 billion ($38 billion) in 2007. As well as volume, both number (867 against 697) and average size of deals also rose significantly.

International acquirers have continued to account for the bulk of domestic deals at Rs 1,189 billion ($29 billion). This is 75 per cent of the total domestic deal value as against 71 per cent in 2006. But the real story of the year is overseas, where Indians bought up companies in Europe and the US, splashing out some Rs 1,367 billion ($33 billion).

Strategic investments, as opposed to PE deals, continued to dominate M&A activity with a share of 70 per cent. While the first half was marked by a few big ticket deals, with average deal size being Rs 2,944 million ($72 million), in strategic investment, the second half saw many more smaller deals with average deal size at Rs 735 million ($18 million).

In private equity, 2007 saw the entry of more of the large international players such as Apax Partners The US accounted for approximately 45 per cent of the total PE investment into India, followed by 18 per cent from Asia (ex India) and 12 per cent from Europe. The total PE investments into listed companies (“PIPE” deals) stood at 33 per cent as compared to 35 per cent in 2006.

In total, in 2007, there were 262 private equity transactions worth Rs 466 billion ($11 billion), a growth of 35 per cent over 2006. The financial services sector was the most attractive attracting a share of 33 per cent of the total, followed by telecoms with 13 per cent and media with 6 per cent.

The largest PE deal of the year was Temasek Holdings, along with ICD, Macquarie, AIF Capital, Citigroup and India Equity Partners, acquiring a 10 per cent stake in Bharti Infratel, a telecom tower subsidiary of Bharti Airtel, for Rs 41 billion ($1 billion).

Other major deals included Goldman Sachs, Swiss Re and Nomura acquiring a 6 per cent stake in ICICI Financial Services, a financial services holding company, for Rs 27 billion ($646 million); and Carlyle acquiring a 6 per cent stake in HDFC Ltd., a housing finance company, for Rs 26 billion ($643 million).

The year 2007 also witnessed a deepening of investment by other major investors in India. Blackstone made investments in Gokaldas Exports ($160 million), Nagarjuna Construction ($150 million), Ushodaya Enterprise ($146 million), Intelenet Global ($85 million) and Sparsh BPO ($16 million).

Sectors, Key deals
Unlike in the past when growth was led by a few sectors, 2007 has seen a more broadly based activity. The telecom sector overtook the IT Industry and dominated the M&A scene with a 33 per cent share in the total deal value. It was followed by finance with a 15 per cent share, cement and building material 7 per cent, oil and gas 5 per cent and metals 5 per cent. One of the emerging sectors for this year has been aviation, shipping and logistics accounting for 4 per cent of total deal value.

Telecom

23 deals, totalling Rs 514 billion ($13 billion)

The largest deal of the sector was Vodafone acquiring a 67 per cent stake in Hutchison Essar, now Vodafone Essar, India’s fourth largest telecom player. With more than five contenders, including India’s Reliance Infocomm, Egypt’s Orascom and Malaysia’s Maxis amongst others, the deal finally concluded in March 2007 after a three month long battle. Vodafone paid Rs 447 billion ($10.9 billion) for the stake. It also paid a further Rs 17 billion ($415 million) to Essar Group to secure management control of the company.

With companies’ profits from customers being squeezed by stiff competition, selling stakes in their telecom tower businesses or sharing towers became an appealing avenue for mobile telecom companies. The second largest deal of the telecom sector was the sale by Bharti of a 9 per cent stake in Bharti Infratel for Rs 41 billion ($1 billion).

Other companies that sold stakes in their tower businesses included Reliance Telecom Infrastructure and Aster Infrastructure. Recently Bharti Infratel, Vodafone Essar and Idea Cellular merged their tower businesses to form a new entity Indu Tower Ltd.

Finance
164 deals, totalling Rs 233 billion ($6 billion)

The Indian financial services sector continued to attract overseas and domestic investments, taking 15 per cent of the total deal flow by value and 19 per cent by number. The share of PE deals was over 65 per cent. The largest deals in the sector were the $646 million investment in ICICI Financial Services and the $644 million investment in HDFC Ltd.

The year also witnessed the separation of several foreign partners from their Indian joint ventures in a quest to go solo. Morgan Stanley acquired JM Morgan Stanley’s securities business for Rs 20 billion ($480 million) while JM Financial retained the investment banking business for Rs 900 million ($22 million). Similarly, ASK Investment Financial Consultants bought 50 per cent stake in ASK Raymond James Securities India Pvt. Ltd. from its foreign partner, Raymond James.

The securities broking segment was the largest recipient of the investment with a 26 per cent share. Among the bigger deals were Citigroup Venture Capital’s acquisition of 75 per cent in Sharekhan for Rs 7 billion ($170 million) followed by Orient Global Tamarind Fund acquiring a 6.5 per cent stake in India Infoline for Rs 5.6 billion ($135 million) and ICICI Venture and Baring together acquiring 32 per cent stake in Karvy Stock Broking for Rs 5 billion ($122 million).

The second largest segment to attract investors was the stock exchanges, accounting for a 21 per cent share, with National Stock Exchange and Bombay Stock Exchange attracting investments worth Rs 25 billion ($608 million) and Rs 24 billion ($576 million) respectively from various PE and trade investors. Cement and building materials
23 deals, totalling Rs 112 billion ($3 billion)

The sector made up for 7 per cent of the total deal value out, of which 87 per cent was driven by a single acquirer, Holcim. Holcim strengthened its position in India by increasing its holding in Ambuja Cement from 22 per cent to 56 per cent through various open market transactions and an open offer for a total investment of Rs 75 billion ($1.8 billion).

It also increased its stake indirectly by 12 per cent in ACC Cement for Rs 20 billion ($486 million). Imerys from France acquired Ace Refractory from ICICI Ventures for Rs 6 billion ($134 million). The average PE in the sector was 13 x (TTM).

Oil and Gas
16 deals, totalling Rs 85 billion ($2 billion)
Reliance Industries (RIL) alone accounted for 68 per cent of the total deal value with its two deals. Mukesh Ambani, along with associates, consolidated his holding in RIL through an issue of convertible warrants which, upon conversion, would increase his stake to 55 per cent in the Company.

RIL enhanced its already strong position in the sector with the merger of Indian Petrochemicals Corporation (IPCL) into RIL at a deal size of Rs 42 billion ($1 billion). RIL had acquired 26 per cent in IPCL in 2002 from the government and an additional 20 per cent through a consequent open offer. Another important transaction was by German company Linde AG. Linde increased its holding in BOC India from 55 per cent to 74 per cent through a preferential allotment of equity shares. It paid approximately Rs 6 billion ($146 million) for the stake.

32 deals, totalling Rs 87 billion ($2 billion)
The metal sector accounted for 5 per cent of the total deal values. The largest deal in the sector was Vedanta’s acquisition of a 71 per cent stake in Sesa Goa, 51 per cent from Mitsui & Co and 20 per cent through an open offer, for a total consideration of Rs 56 billion ($1.4 billion). Another major transaction was the investment of Rs 13 billion ($320 million) by Aditya Birla Group companies to consolidate their position in Hindalco Industries through a preferential allotment.

Other Sectors
The media sector (4 per cent) saw 45 deals and a lot of private equity interest with the largest deal being the investment of Rs 11 billion ($259 million) by Temasek investing in Inx Media, a TV broadcast company. Other deals included an investment of Rs 7 billion ($166 million) by South Asia Entertainment Holdings Ltd. (a group company of Astro All Asia Networks Plc) in Sun Direct TV for a 20 per cent stake and Blackstone in Ushodaya Enterprise taking a 26 per cent stake for Rs 6 billion ($146 million).

Engineering had a 4 per cent share in total deal value with its largest deal being the acquisition of Anchor Electricals by the Japan-based Matsushita for Rs 20 billion ($488 million). In the automotive sector (automotives and auto components 3 per cent) Robert Bosch acquired an additional 9 per cent stake in its subsidiary Motor Industries Co. through an open offer, for Rs 14 billion ($330 million) increasing its holding to 70 per cent. Also, M&M acquired 63 per cent stake in Punjab Tractors for Rs 14 billion ($340 million) which increased its share in the tractors market to 40 per cent. The aviation sector (2 per cent) saw consolidation with a few large deals. Jet Airways took over Sahara Airline, and Kingfisher Airlines acquired a significant stake in Deccan Aviation. Separately, the Government decided to merge operations of the two state owned carriers, Indian Airlines and Air India.

India everywhere
The year 2007 proved to be a phenomenal one for India Inc abroad. Full of adventure, it saw some exceptional deals — Tata acquiring Corus and Hindalco acquiring Novelis. This was the first year since INDATA has been recording M&A activity in India; overseas M&As by Indian companies exceeded the investment by foreign companies into India.

In all, there were 223 deals worth Rs 1,367 billion ($33 billion) registering a massive growth of 300 per cent over the previous year (140 deals worth $ 8 billion). The average deal size increased from $58 million in 2006 to $150 million in 2007. This underlines Indian companies’ readiness, enthusiasm and confidence to go global. Europe and the US, being favoured destinations, attracted 54 per cent and 27 per cent of the total investments overseas respectively.

The overseas M&A activity was dominated by the metal sector taking 56 per cent of the total investments. Its two large deals were the Tata/Corus deal and the Hindalco/Novelis one. Other sectors attracting large investments were engineering, information technology and oil and gas. The largest deals in the respective sectors were: Suzlon Energy acquiring Repower Systems for $1.8 billion; Wipro Ltd. acquiring Infocrossing Inc for $557 million; and Aban Offshore increasing its stake in Sinvest from 37 per cent to 97 per cent for $774 million.

Top Deals

The largest deal of the year was India’s steel giant, Tata Steel, acquiring Anglo-Dutch giant Corus. After a four-month battle, Tatas finally defeated the rival bidder CSN, paying a premium of 34 per cent over the original bid price made in October 2006. Tata Steel paid $12.1 billion for Corus’ 18 million ton steel capacity. The deal made Tata Steel the world’s sixth largest steel manufacturer.

Another high-profile, multi-billion dollar deal was by leading copper and aluminium manufacturer Hindalco. Hindalco spent $3.33 billion to acquire Atlanta-based Novelis, a leading aluminium sheet maker. The deal brought in the readymade cans and screw-caps market in the US with the two most famous clients — Coca-Cola and Anheuser-Busch. It also provided Hindalco with a significant presence in the automotive and transportation industry making it one of the world’s largest aluminium rolling companies.

The third largest cross-border deal of the year was Suzlon Energy acquiring Germany-based Repower for $1.8 billion. The deal was finalised only after the withdrawal by the French nuclear energy group Areva after four long months. With this acquisition, following the acquisition of component supplier Hansen last year, Suzlon has further consolidated its position in the international wind energy market.

Some other large cross-border deals included Essar Group acquiring Canada-based Algoma Steel for $1.6 billion and United Spirits acquiring UK-based Whyte & Mackay for $1.2 billion.

Looking ahead

A growing economy, robust financial performance and an exceptionally buoyant stock market have all supported a remarkable expansion of M&A activity, and there seems little to upset this trend in the immediate future. Emerging markets’ insulation, to date, from the global credit crisis suggests that domestic M&A activity, strongly supported by foreign investment, will continue, although the tightening of credit could restrain the exuberance of Indian companies overseas.

In the local market, we would expect to see a focus on vertical integration by strategic investors, especially in mining, metal and energy sectors. PE investors are likely to continue to book profits with valuations at high levels, while continuing to invest in sectors such as infrastructure and real estate. We also expect some consolidation in sectors including offshore shipping, logistic, media, and Defence, as well as in pharmaceuticals, which have been very quiet in 2007 and may well be due for a revival.

James Winterbotham

Sridar Swamy

(The authors are Partners in India Advisory Partners, an independent group that advises international companies, institutions and funds doing business in India, and Indian companies investing abroad. E-mail: sridars@iapib.com)