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Tuesday, March 29, 2011

So why do economists differ so much-specially those in academics?

While IIM-A has 'stud' economics Profs(actually correct that to 'stud' profs in all subjects!), one peculiar thing is that in the 1st year MBA program here, macroeconomics is the only subject for which different sections have different textbooks/reference material/exams, all upto the discretion of the Prof who teaches them. After enduring the 2nd(and hopefully the final) such 'differential exam', I sympathize with President Nixon who desired a 'one armed economist' because he was tired of listening to ambiguous/hedged comments.

But a closer scrutiny explains why. Unlike microeconomics which can get away with treating human beings as 'rational' profit maximizing beings, macroeconomics faces the difficulty of culling out lessons from the behavior of human beings in crowds. And this is no Brownian motion which cancels out, but often a 'herd effect' dominates. And though one may argue that 'numbers speak', different sets of numbers can be used to reach different conclusions. And given that it is a SOCIAL science, the interpretation of the context is often key. And if we presume that economists want to influence policy, they need to adopt political means. And this shows in the style of arguments. So, Nixon's wish may never be met and economists may at best 'agree to disagree'. A miracle of this subject is even after 80ys, one never knows whether they were right. Take Keynes's recipe for getting out of the 'Great Depression' of the USA. In 2010, economists still argue whether he was responsible for solving it, or(hold your breath!) exacerbating it.

Saturday, March 26, 2011

How criminals can profit from the financial markets-I(terrorists, short selling)

Today, I just finished a book 'Power Down' by Ben Coes(click here for the flipkart page). While the book theme flogged a dead horse('terror attacks affecting USA's energy security), it had a few novel elements mainly
  1. Anticipating a M&A, and planning terrorist acts months in advance
  2. Using the equity and commodity futures market to bet against the victims of a terror attack, to make profits of $20BN+.
  3. But one theme which I did not appreciate was the stereotyping of Arabs as architects of terror. Even other nationalities have reasons to hate the USA! Anyways, the novel needed a scrapegoat and in this case, Arabs were it. 
Anyways, the book got me thinking about how such a thing would work in the Indian context. Luckily(or not), most Indian securities are not traded on foreign exchanges-both stocks and derivatives. Even ADRs are pretty illiquid. So even if a terrorist manages to profit on man made disaster(say attack on the RIL Jamnagar refinery, 26/11 Mumbai attacks etc), the regulator could declare the derivative contracts void in case unusual activity spurt is noticed-specially through the PN route. Given that the erstwhile Finance Mnister Mr Chidambaram had warned of terrorists using Indian stock exchanges, it seems that the establishment is cognizant of this, and will react to any such threats.

But consider stocks like HSBC, Citi, GE, BHP, Exxon etc which trade on multiple stock exchanges in multiple countries. Energy stocks typically have dual/multiple listings and are vulnerable to such attacks. And for contracts executed on major financial centres like Singapore, HK, London etc(specially of offshore issuers), the regulatory authorities would be reluctant to go on a fishing expedition. And by the time they realize it, the positions may have been closed out and the funds transferred.

In this world of strife and uncertainty, the KYC(Know your customer norms) and sectoral position limits(step up from individual limits) become paramount. Else with an attack costing less than $1,00,000, profits may be made in the hundreds of millions. Atleast, If I were a terrorist, I would exploit the weak money laundering regime to ensure that my funding is self sufficient!!

This pithy statistic sums it up all...
Cost of staging 9/11 World Trade Centre attack=some $million(max)
Potential gain for people long oil futures======$Billions
Such outsized gains may spur 'venture capitalists'/'investors' to fund these attacks-or atleast pay for advance information on them. For that reason, the USA Govt had proposed a 'terror exchange' where public bet on the chance of certain events-so that Govt can probe further..but that mission failed.

Why finance education is increasingly broke-and what you can do about it

Last week, Prof Jayanth R Varma(IIM-A Professor)  released a working paper on how finance teaching/research should change post the global financial crisis (full text worth a read-download it here). Pointing out the limitations of finance teaching(which impacts practice more directly than research), he basically argues that finance theory is 'not broke' as perceived, but that many ideas presently in niche fields should be integrated into the mainstream. The paper also argues that finance theory needs to integrate insights from sociology, evolutionary biology, neurosciences, financial history and the multidisciplinary field of network theory. And opposing any dumbing down, he argues that finance needs more(!!) sophisticated mathematical models and statistical tools.

While the paper reinforced my slight discomfort on the way finance is taught(some notable exceptions are most IIMA Profs, and textbooks by Damodaran/Myers & Allen etc), it gave me some brain food for  how students should react to this. And these are the points which I got.
  1. Accept that Professors are constrained by curriculum limitations/class ability to understand. Unlike an executive education program where participants have more or less an equal base, the 2yr PGP program(with very few having finance background-education/work exp wise) presents challenges to Profs to get their point through in a 70min session. Instead, be aware of recent research via Google Scholar, SSRN, Research homepage of various sites like IIM-A, IIM-B, ISB, Stern etc or whatever suits your fancy. One can then bounce them off Profs/practitioners to get a better perspective.
  2. Even if not explicitly covered in class/not important from exam angle, have crystal clarity on the assumptions and limitations behind the models used. For example, MM theory of constant WACC applies only under zero tax environment, fat tail risk skews the normal distribution etc. 
  3. Respect other fields(specially those mentioned by Prof Verma) and build a more than passing acquaintance with research results in those fields. 
  4. Learn how to apply the right type of math(once concepts are clear, modelling in Excel should not be too much of a pain). Get your hands around distributions with the appropriate statistical software.
  5. Read extensively. No class can ever teach financial history in depth. It is for you to read, analyze and form your mental model to react when a situation comes. For example, those investors who panicked with the Japan earthquake, should have known from prior history of earlier earthquakes, how the Japanese economy/markets bounced back after similar disasters.
  6. Visualize and do not remember formulas. This may seem heresy but in the Google Age when you can get up formulas with a simple search/reference books, devoting valuable brain space to mugging them does not make sense, if you known how to derive them from first principles. While you may still remember them, that should be because of practice/conceptual clarity and NOT because of mugging that formula sheet on the day prior to the exam.
Phew! That long post comes to an end. I did not intend to sound preachy(sorry if it comes out that way), but with topics close to your heart(as this one), emotions do come in.

The impact of global financial crisis on estimating Beta

Whether it be GE, Samsung, Apple, Microsoft, HP, Reliance, Vodafone etc, most companies have had to make significant changes to their business mix/debt ratios by
  1. Divesting non core operations(Shell/Rio Tinto/BHP/GE Financial)
  2. Realigning reporting/organization structure as shown in segment reporting(nearly all firms!)
  3. Taking on debt to purchase battered down assets elsewhere(Bharti Airtel, Tata Steel)
  4. Using surplus cash to buy expensive assets(Microsoft, HP, Google)
And the process is still on while companies view these years as those of a paradigm shift. But why should you care? If you apply CAPM as an investor/analyst(most professionals do even if they ultimately ignore it), the traditional approach of regressing excess share price/market returns and finding the intercept, does not work when the business/debt has significantly changed. Luckily, the bottoms up Beta comes to our rescue at this juncture. As Damodaran puts it, it is , Weighted average Beta of the business or businesses a firm is in, adjusted for its debt to equity ratio. The betas for individual businessess are usually estimated by averaging the betas of firms in each of these businesses and correcting for the debt to equity ratio of these firms. This method though, needs that the industry peers have not changed much-which seems an unrealistic assumption unless those peers are public sector companies which are constrained by management from any dramatic changes.
My view:- SOTP(Sum of the parts) method would again rule the waves for Beta calculation. But before signing of on that elegant NPV calculation, ask yourself whether you can live with the limitations in the calculation of the Beta value presented to you. Expect plenty of research on this in times to come.

Thursday, March 24, 2011

Will 'search engines' or 'situation economics driven judgement' dominate accounting?

In his speech to the US Chamber of Commerce on global convergence of accounting standards, the IFRS policy head Sir David Tweetie,(full text here http://tinyurl.com/5tj9twh)  explained the concept behind 'principles based accounting standards'. I have merely rearranged those points in a more user friendly format but urge that the original speech be read in full.
  1. How are IFRS laid out? The core principles of any standard must be clearly worded. Other sub-principles are then articulated in a tree-like structure. Inconsistencies with other standards must be avoided, if possible, or fully explained. All application guidance and examples that are aimed at helping users to understand the principles have to justify their inclusion. Would anything be missed if they were deleted? If guidance is necessary, is the principle sufficiently clearly stated? Does the standard include bright lines and arbitrary limits? Why are these necessary? Does the transition follow the normal pattern? If not, why is a change proposed?
  2. How does this help prevent 'window dressing'? The use of principles eliminates the need for anti-abuse provisions. It is harder to defeat a well-crafted principle than a specific rule that financial engineers can bypass. A principle followed by an example can defeat the ‘tell me where it says I can’t do this mentality’.
  3. Impact on financial engineers:-  If the example is a rule, then the financial engineers can soon structure a way round it. For example, if the rule is ‘when A, B and C happen the answer is X’, the experts would restructure the transaction so that it involved events ‘B, C and D’ and would then claim that the transaction was not covered by the standard.  The abuse of unconsolidated special purpose entities, are an example of how well-intentioned rules present opportunities for financial engineering.
  4. But how would the system then work? A principle-based standard relies on judgements. Disclosure of the choices made and the rationale for these choices will be essential. If in doubt about how to deal with a particular issue, preparers and auditors should refer back to the core principles. The basis for conclusions should also include, in particular, the question of whether there is only a single view on how to tackle the economics of the situation. Often there are competing views—is one deemed to be more relevant? If so, the reasons for choosing that particular view should be explained in the basis for conclusions and the reasons for rejecting the others should be clearly stated.
  5. In litigation prone checklist driven regulations, can principles based IFRS work? Risk mitigation can be achieved via  careful generation, collection and retention of documentation and by seeking of expert advice and the views of professional colleagues throughout the life cycle of transactions. Above all, defend those who make such judgements, document them and make an honest and fair attempt to meet the principle. 
We humans are hardwired to defy authority. So if rules are proposed, 'search engine' type mentality looks for a loop hole to violate the spirit while obeying the letter. While a principles based approach, by its sheer ambiguity, would compel skilled professional judgement seeking to reflect the economics of a particular situation.Given that IFRS is an idea whose time has come, hopefully more rational(and well disclosed) choices will be made, equipping investors with tools/information to critique/appreciate that accounting.

Wednesday, March 23, 2011

Meeting food security IN Africa(not FROM Africa)-does this reduce Karuturi Network's risks?

Karuturi Networks is the world's largest exporter of uncut roses, with a 9% market share in the European uncut roses markets. Rather than merely resting on its floriculture laurels, it began to purchase agricultural land in Africa much before it was fashionable to do so. The intention is to cultivate cereals on these lands, presently 3,00,000+ ha of them. Their strategic rationale for the same(as expressed in investor relations presentations) was that contrary to the popular perception of Africa as a water starved desert, many parts DO have a strong agricultural competitive edge with Only a small portion of arable land in production, good access to water, incentives for investment, lower input prices and favourable supply/demand dynamics.

And their rationale for local sales is interesting. They figure that with a Ethiopian domestic market of around 85 million people there is ample scope for local sale Also, they plan to exploit the preferential trading area COMESA (The Common Market for Eastern and Southern Africa), stretching from Libya to Zimbabwe.
Below is the map of their target markets.
One might wonder whether they are biting off more than they can chew. But what is going for them, is their earlier successful globalization of the cut roses business where they have successfully set up rose production/export hubs in Africa, and plan to do so elsewhere. Their awareness of the global food market does seem astute, even if they are operating on the present low scale.
Floriculture Business graphic, 2011
My take:- While local sales do reduce the expropriation risk(as happened in Zimbabwe where white farmers had to offload their landholdings at fire sale prices), it may widen their operating cycle if payments are delayed. Also,  while the political environment in Ethiopia is stable, the perceived political risk around it(its neighbours) may weigh adversely on the stock.

Tuesday, March 22, 2011

Will Asian/African despots now flee global financial markets? Implications for global markets.

As any observer of global events would have noted, the anti-incumbency movement has overthrown the Egypt regime, has turned Libya into another Iraq, and is rapidly spreading to Yemen, Bahrain and other nations. While this is too early to characterize these as 'pro democracy' events, I note the following common threads in the inception/course of such movements
  1. Buoyed by the natural resources(mostly oil but also minerals in case of African nations), a small ruling elite clings on to power with large military spending. Concessions are doled out to keep the influential forces in line(like say Pakistan/Indonesia where military has many business interest).
  2. The population either is suppressed(like Nigeria) or has a broad social compact(Gulf nations) where they get a welfare state(subsidized food, education, healthcare etc). 
  3. Macroeconomic price movements(lower energy rates/higher food prices) adversely affect the economy leading to breakdown of above equilibrium. Dissatisfaction soars
  4. Viral marketing(internet, mobiles, press) rapidly spreads this dissatisfaction( or as claimed by some affected nations, there is an opportunistic attempt to stage a coup with support from abroad). 
  5. As the movement spreads to civil society, defections happen and civil war breaks out. At this stage, the West freezes sovereign assets 'to keep them in trust for the state'. This cuts off the source of funds for the incumbent Government. Note that this happens only selectively, where the West(USA/UK/Germany etc) support a regime change. For example, this was done in Egypt/Libya and not for Yemen(with worse human rights violations). 
  6. The regime falls or reaches a compromise, at which stage the funds are unfrozen. 
Now, imagine you are an African/Asian despot whom the West tolerates due to the TINA factor(maybe you possess strategic assets) or they fear the country falling to the Left. Earlier, you could park your funds in Swiss accounts(even earning a fancy return in the process) or set up your own SWF(Sovereign Wealth Fund) to invest directly in Western assets. SWFs played a prominent role in bailing out several financial institutions during the sub-prime crisis. Their promoters would atleast expect some gratitude from the West instead of actions like sanctions, asset freezes etc. In the wake of asset freezes, they'll need to build a strategic safe asset base, ring fenced from political actions.

So which assets fit the bill? Certainly not currencies, stocks, bonds etc(whose ownership can be traced thanks to anti money laundering laws-even in 'offshore banking jurisdictions'). Commodities like gold, platinum and silver would fit the bill quite well being easy to store. But another commodity easy to store is narcotics, which would achieve both convenience(storage/availability) and retribution(flood the markets of the nations which attacked you).

So what actions can we expect in the medium term(1-3 yrs) from natural resource rich countries with little political freedom?
  1. Stock piling precious metals. This may boost mining stocks.
  2. Building strategic stocks of food grains, and increased social spending. Food stocks should zoom.
  3. Subject to sanctions-purchasing arms/faster push for nukes to achieve Pakistan type immunity
  4. Increased action in the drug trade. 
  5. Exodus of money from financial markets, to fund the above. This may hurt banks. 

Monday, March 21, 2011

Geodesic-the next multibagger like Onmobile?

What drew me towards this company is NOT any stock screen/analyst report(very few of them actually!) but its quarterly financial results press release(available here). While other companies use this as a statutory compliance tool, Geodesic uses it as a marketing tool to state two entire pages of achievements during the quarter. This does reflect the company's innovative and upbeat approach, and that prompted me to look further. And a perusal of their annual reports/other documents only stoked my interest further. Consider this
  1.  NOT a geographic information systems company:- The name certainly evokes that sentiment in me(and I suspect I'm not alone). They are into the following businesses 
    1. Communication/collaboration:- like Cisco
    2. Mobile VAS:- under the Mundu brand
    3. Electronic computing platform:- They have developed Linux based handheld device GeoAmida, which is used in several E-governance projects. The UID scheme may boost these sales, as may the increasing IT usage in both State/Central projects
    4. Financial products/services:- Like most other IT Cos
    5. Content:- Chandamama brand but also they serve as content aggregators.
  2. Attrition rate well under 5% for the past 6 years-a commendable feat in any industry specially IT.
  3. Berkshire Hathway approach to managing subsidiaries- operate as an aggregation of separately-managed small and medium- sized businesses, most of whose decision-making occurs at the operating
    level. They would rather suffer visible costs maybe of a few bad decisions than incur invisible costs that come from decisions made too slowly – or not at all.
  4. Infosys style conservativeness with cash;- They prefer security to high returns on cash/investments.
  5. Transparent tax planning:-The company discloses(Pg 29 FY10 AR) that Geodesic Holdings Limited (GHL), Mauritius  primarily acts as the Holding Company for all subsidiaries of the Company outside of India.This is to streamline the processing and operations of outside subsidiaries!! 
  6. Owners of iconic brand Chandamama:- This mythological based magazine is expected to break even in FY11, and has good content library value
  7. Marquee client list:- They have vastly successful client relationships(Apple/HDFC etc) and their Ipad app Mundu TV is the No1app on Apple India store.

But every rose has its thorns. The negatives:-
  1.  Their tax exemption expired in Mar-11(like for all other IT companies in EOUs), but given the export dependence(98%+ sales) , their effective tax rate may still be lower.
  2. Non transparent segment reporting:- Despite the plethora of business activity description and their 'hands off' approach to operating subsidiaries, they have not chosen to disclose any breakup. This is counter productive in terms of valuations because they do not get the rich valuations that Onmobile gets. This incidentally, is the biggest hurdle to fairly valuing this company.
  3.  Investor Relations seems a bit weak
    1. Have stopped posting the conference call transcripts after 4Q'10. I do not know whether they even hold it an analyst conference call or not.
    2.  The analyst research reports(downloadable on the investor relations homepage) are quite old, indicating that possibly the coverage on this stock has ceased.
    3. They had to send a corrigenda to the FY-10 Annual Report(albeit minor detail) which does not reflect favorably on the financial reporting process. 
To my mind, the EV(Rs 590Cr Debt+Rs 730Cr Equity) of Rs 1380 crore does not do justice to the company's growth prospects, management and brand. The share is trading at just over book value(Rs 80/share) which is surprising-but maybe due to the non disclosure of segments. But why my comparison with Onmobile? Even Onmobile had a strong content base, good management and initial analyst apathy. Also, Geodesic's mobile apps foray(and apparent success) does make it comparable(though we do not know to what extent). Given the superior operating parameters of Geodesic(sales, margins) v/s Onmobile, the valuation gap looks to only narrow here on.

To my mind, upside triggers for this stock are:-
  1.  Aadhar Project:- This may boost the demand for GeoAmida, as would other E-governance projects
  2. Apple Store launches:- If they can continue the run of successful apps, market may reward them.
  3. Improved reporting/visibility:- If the conference calls are held more often AND segment details published, valuations may improve.
  4. Possible M&A-given the very high FII holding, the stock is ripe for a hostile acquisition. Of course, the high FII holding is also a chance to pick up the stock at fire sale prices if FIIs start exiting India en masse. The promoter holding of 20% is quite low....
    Ownership Pattern

Sunday, March 20, 2011

The simillarity between cloud computing and malls

In his excellent article in the HT Media weekly supplement 'Brunch'(full article can be read here) the noted foodie and journalist Vir Sanghvi explains the rise of restaurants in malls by rationalizing that the restaurateurs have found a way around the restrictions imposed by India’s corrupt real estate scene. The development of shopping malls all over the country has made it possible for restaurateurs to function without having to worry at all about dodgy landlords and corrupt Municipal officials. Moreover, the basics – water, electricity, security, air conditioning etc – are all guaranteed. Nor do restaurateurs have to spend money on marketing and advertising to announce their presence. At the malls, the customers are there for the taking.

This article reminded me of why Cloud computing is thought the way of the future. When the storage, processing power and software can all be obtained on a pay-per-use basis, fixed costs turn into variable costs. No longer does the entrepreneur need to fuss about technology cycles, IT Depts etc. Instead, he can use cloud computing to set up a virtual company online without much risk. Though spending on marketing will be still needed, Google Adsense allows even that costs to be variable(as opposed to flat rates for mass media). And while customers are not 'for the taking', sudden spikes/downturns in their number can be easily adjusted for in changed capacity, rather than facing the classic newsvendor/OM optimization problem. 

Granted that the above largely holds for 'digital businesses' like media, writing, IT etc. But even small conventional businesses seeking to have an e-commerce presence, will have an option beyond EBay. So like malls, cloud computing serves the same economic function of leveling the playing field for industries.

The corporate governance discount-why Lok Housing's valuations are rock bottom.

A friend suggested that I look into Lok Housing And Constructions Limited(LOKHSG) where he has an investment. What further triggered my interest was the low enterprise value of the stock(market cap Rs 104Crores and around Rs 56 crore debt; total EV=160 crores). For a company with several interesting projects
  1. After repeal of Maharashtra's land  ceiling control law ULCRA, land of approximately 3,29,704.64 sq. mtrs. at Ambernath in the suburbs of Mumbai, has become available for development
  2. 49% stake in redeveloping  around 30 acres of land (362 buildings and over 8000 tenements in the prime location Kalbadevi in Mumbai's C ward, involving demolishing these old and dilapidated buildings and in their place constructing  high rise structure in the ear-marked plots. Approvals have come and construction would start soon. Pilot project of 30acres is expected to increase to 232 acres.
  3. On-going projects such as Lok Mansarovar, Lok Prabhat and Lok Nirman.
  4. As one of the schedules show, they have 86.17 lakh sq feet work in progress, work in progess valued at around Rs 390/sq foot. Given that developers usually get a profit of around Rs 2000+/sq feet(conservative), this amount can only rise. 
 Then WHY is the mcap stagnating at this low premium? I had a look at their FY10 annual report(download here) and some earlier ones. And this is what I noticed(also note the nonperformance v/s Sensex)

Index Comparison
  1. Independent director Mr BC Jain(renowned Chartered Accountant) appointed in Mar-10, resigned in Nov-10 itself(see here). As a professional, he has a lot to lose by remaining on a board of a company with doubtful antecedents, and so his resignation should be viewed in that light
  2. They have debt of 56Cr but operating cash flow of only about 3Cr/yr. Repayment is difficult, and in fact they have defaulted on the Rs 42Cr debt from SBI. In the post LIC Housing Finance era, it will be difficult for them to raise funds from banks, to complete their projects. Other channels like PE funds are expensive demanding an IRR of 18%-20%+
  3. As my friend Miheer Desai pointed out, there are accounting irregularities. In 2008-09, they had to restate their debtors/inventories because they had accelerated revenue recognition on instalments which they were unable to collect. Though this was an industry wide phenomenon, it affected Lok the most relatively. On the socalled doctrine of 'relating back', they has the accounts revised
    for FY 06-07 and FY 07-08. This can be viewed favourably(honest enough to revise) but also draws doubts on the accounting/audit quality
Inspite of all this, the upside factors for the stock though can be
  1. Bigger fool theory:-In May-10, Promoters were allotted 5 million shares @ Rs 40/share. They have an incentive to boost the share price to above that. 
  2. Land bank valuations when monetized AND success of the redevelopment project. If they can sell off/partner with bigger builders, this can be beneficial.If we look at the stock price performance, it has tracked sales/profit(as it should) WITHOUT considering option valuation of landbank.
    Performance Chart
  3. New political alignments. The Mumbai share bazaar gossip places Lok in the company of the Hindu right wing party-Shiv Sena-which controls the Mumbai municipal corporation but which has been out of power for the past 6yrs+ in the State. Given that lucrative projects need the co-operation of both State and local Govts, realignment with the Congress/NCP(parties in power at the State level) may boost the scrip
  4. Clarity on debt repayment:- Once this is repaid atleast substantially, stock may go up.
 Only fools go where angels fear to thread. In a stock without any institutional presence, and with such serious issues, investing needs a leap of faith. But then, the returns can be exponential.

Friday, March 18, 2011

To err is human but to keep erring is inhuman_how a coding error blew up $217MM of a quant fund

To protect trade secrets, quantitative investment managers often isolate their complex computer models from the firm's compliance and risk management functions and leave oversight to a few sophisticated programmers. This  secretive structure and lack of oversight of quantitative investment models, may be used  to conceal errors and betray investors. That is what happened at a quant fund of AXA Rosenberg Group LLC, as outlined in this SEC complaint. 

This  institutional money manager(specialized in quantitative investment strategies) concealed from investors a material error in its computer code. The error was made in Apr-07 and eventually fixed in Jun-09. But, due to a top management directive, the CEO was not informed till Nov-09. Also, while reporting performance to clients, the model's under-performance was ascribed to market volatility rather than the error. Before the fix, clients were voicing substantial concerns about the under-performance of their portfolios, and were expressing dissatisfaction with their portfolios’ industry overexposure(a factor partly controlled by the wrong code). But this misreporting gave them a rosy picture of the firm's risk management and coding skills. This erroe happened because the firm failed to conduct sufficient quality control over the coding process before putting that model into production

So what can we learn from this incident?
  1. The need for having more audits/sanity checks on the models
  2. Disclosing your mistake(and facing risk of fund exodus) rather than being punished later
  3. In India, the applicable laws would probably not allow for restitution of investor funds as happened in this case. So Indian investors, BEWARE of investing in quant funds...

Wednesday, March 16, 2011

An amazing graphical business description-an example of Royal Dutch Shell

 Energy companies are difficult to run(heavy regulation, political risk, uncertainty, natural resources constraint), and even harder to value(due to real options, volatility and cyclical nature). Recognizing this cyclical nature, and their heavy dependence on oil, leading energy companies have  diversified downstream into petrochemicals, energy etc. This makes the task of investors even harder. So when a company simplifies this task, it is to be commended, not least because(hopefully), other companies can attempt a similar depiction next year.  Below is how Shell depicts its businesses.  At first glance, some features are clear
  • Suitably chosen pics(like gas station) depicts nature of operations
  • Process flow like approach gives an idea of linkages
  • And lastly, the 3D diagram used is just amazing to give a 'birds eye view' of the organisation.
 The independent directors and investors of Shell are quite lucky for such an user friendly reporting. For those interested in the whole document, you can get it here on the SEC website.




Sunday, March 13, 2011

Renuka Sugar's Brazilian focus-time to change auditors, listing & valuation norms?

While reading the Sep-10 Annual report of Renuka Sugars(available from the BSE site here), I noticed some indicators about the company's growing presence in Brazil(both on assets and revenue front. Given the supply constraint on Indian cane, the bulk of the physical cane production/crushing will continue to come from Brazil. 

This is further brought out by their revenue, cash flow and asset concentration as in the table below.  It is surprising that such a reputed listed company is not having the Indian auditor verify its Brazilian assets.
Shree Renuka Sugars 2009-10 Audit Status INR Million
Audited by             Revenue Cash Flow Assets
Indian Statutory Auditor 12230.06 -2627.94 7050.63
Brazilian Auditor 12457.89 3536.59 97142.12
Total 24687.95 908.65 104192.8  
Though the company does not disclose geographic segments, it seems quite likely that Brazil would make up a sizeable chunk of the overall valuation. Given that, and the geographic separation of Brazil from Indian investors, it may make sense to go for a Brazilian ADR, and appoint a global auditor(Big4/BDO etc) who have presence in both India and Brazil. This will allow
  1. Better valuation/price discovery for Renuka Sugars via hopefully better informed Brazilian investor base
  2. The audit opinion to get a better credibility. In my view, the audit opinion(specially based on such partial data) is not that reliable. I'm no fan of global auditing firms but in such circumstances there does not seem an option.
  3. Also, we should consider using SOTP approach to value Brazilian and Indian arms separately.

Wednesday, March 9, 2011

Temptation Foods-special assets situation. Should one invest now?

All the facts here are sourced from the 2009-10 Annual reports(here)
  • Exercise price of 2,56,000 Stock options granted in Aug-08 was revised in Aug-09 from Rs 150 to just Rs 40. That is a gain of about Rs 2.75crores for the top management(Note 21 Pg 92 AR09-10)
  • They did not renew the Employees Group Gratuity Scheme with the Life Insurance Corporation of India(LIC) and are shopping around for quotes. 
Accounting issues are
  • Note 15c Pg 89 AR09-10- Writing back the 'excess gratuity provision' since the LIC renewal notice had a lesser amount of accrued provision. This accounting treatment while permitted is aggressive since the company should not dip into its pension reserves to inflate its earnings. The amount taken to P&L is small(around Rs 5Lakh) but reflects badly on the management discretion
  • Aggressive revaluation of the fixed assets situated at Jejuri/Sonepat-possibly overstated by Rs 20Crores. . Rs 8 Cr and Rs 12 Cr respectively was revalued in 2007/2009 respectively. Despite the worsening economic situation in 2008 and beyond, the company did not book an impairment charge.
 The good thing however is that there are no significant related party transactions.So the chances of siphoning funds from the company is low(unless it is another Satyam). The promoter does seem sincere and competent despite the moral issues at play here. So if we can trust the balance sheet, then this does seem a stock to buy

Set a thief to catch a thief-the way to plug India's regulatory loopholes

The appointment of UK Sinha as SEBI Chairman got me thinking as to why we do not have more regulators who are from the private sector. Unlike Mr Sinha who was heading UTI AMC(a private sector body), the previous SEBI Chairmen were generally career IAS officers. The argument against allowing private talent into such senior regulatory positions generally is
  1. The revolving door between public and private sector may reduce the independence/objectivity of the regulators. Restrictions on private sector appointments are not really enforced..and then one cannot debar 'consulting' and other assignments
  2. Demotivates the career cadre regulatory officers. 
  3. The in house staff may have seen a wider range of issues/scams than anyone working in industry
While the above arguments are valid, past evidence may swing the pendulum towards industry professionals. For example, the first SEC Chairman Joe Kennedy was a noted market manipulator but the security laws he wrote have stood the test of time.

Industry bodies are unlikely to propose changes which adversely impact them yet it is the industry professional who knows the loopholes and how they are played. The question is-who will relinquish a plum industry post to enter regulation? To that, a post retirement post could be created.

Monday, March 7, 2011

Google people's antecedents before investing or repent in leisure

Temptation Foods is a company ever in the news whether for
  • a failed takeover bid(for Kohinoor Foods)
  • an income tax raid(resulting in 9Crores+ additional accepted tax demand)
  • Failure to pay the EMI for acquired company(Karen Anand foods)
  • Doubts of windowdressing the books due to rapid growth(to its credit the company is clean..on paper)
  • Its annual report-full of irrelevant drivel, pictures and quotations. 
  • Its MD's flamboyant lifestyle(it IS none of my concern but has affected the company as appears below).
But when I thought  the company could sink no lower, the MD is arrested for his involvement in the home ministry bribery scam, and is accused of supplying call girls(!). He had nominated his girlfriend as an independent director  Another blogger & renowned trainer Gaurav has covered this here in amazing depth.

But having an independent director/key management personnel with doubtful antecedents is not unique to Temptation Foods. In several other Indian companies, you see some/all of these features
  1. 40-50yr olds, part of the key management, drawing salary<10Lakhs(or at times even below 5 Lakh Rs). And this is without any options...
  2. Independent directors with irrelevant expertise(for this purpose I would justify business expertise(in that industry), supplier/client experience, financial, legal and tax expertise as relevant). How can actors, ex police officers etc add any value?
  3. Directors independent in name only where a cursory internet search throws up details of their friendships with the promoter/CEO. I do not say that the two should keep an arm's length, but the independence is compromised due to friendship. 
  4. Not disclosing the remuneration statement of employees drawing>Rs 2Lakh/month-the shareholder must demand it from the company.
In all the above cases, Googling would help you
  1. Run a sanity check on industry pay scales to justify the low pay for KMP
  2. Resignations of directors(past and recent)
  3. Arrests/Tax Raids/Litigation against the company/its management
  4. Bulletin boards devoted to pumping and critiquing the company-BOTH are quite helpful specially the ones on moneycontrol, Rediff Money
  5. Blog posts written on the company
 Takeaway:- If we accept the hypothesis that a company's key to success is its people, then the cursory profile in annual reports do not tell us much about the company's core assets-its people. In this era of Linkedlin, Facebook, web media etc, we do not have an excuse for ignorance on this aspect.

Friday, March 4, 2011

Why economic slowdowns actually help industry leaders.

In her book, 'The Indian Media Business', the noted journalist Vanita Kohli-Khandekar expressed in her foreward that the economic slowdown was one of the best things to happen to the E&M(Entertainment & Media industry) in India because
  • Too much free equity flowing in during the boom, made it remunerative(cost wise) for steady, conservative business models. When actors, directors, staff etc wages go up 2-3 times due to new entrants without corresponding revenue growth, then incumbents have problems
  • So, the exit of these new players allows strong business models to come back
I draw the analogy with difficult exams. Exams like CAT/IIT JEE are difficult and more able to filter the prepared candidates from the rest, when compared to exams like MAT,CET etc which become more a test of speed and luck. Similarly,tough times seperate the best from the rest. That is why incumbents welcome tighter regulations/barriers because they are better placed to navigate them

In retrospect, I could notice that industry leaders like SBI, HDFC, ICICI, L&T, Airtel etc have outperformed their peers(stock price returns wise). So the panicked reaction of selling off industry stocks as a whole, may be bad. If you are an investor in an industry facing a downturn(say real estate at present), shifting investments to the industry leader may be a good bet. In the Media context, firms like Onmobile may make sense in this current period when telecom/VAS stocks are being beaten down, but thats a topic for another post.

Why option grant dates matter in ESOP pricing.

In SpiceJet's 2009-10 Annual Report, they have disclosed(page 6) that they use Intrinsic value method for finding the fair value of option. So far OK(since BSM model not that sound for equities). But the note is a shocker. 
  • 1,804,884 options granted on October 05, 2009 (‘Grant 2’), value per option as per this Intrinsic value method  was  Rs 24.85
  • 5,422,954 options granted on December 23, 2009 (‘Grant 3’), value per option as per this Intrinsic value method  was  Rs 46.25. 
 Now, intrinsic value for a quoted security IS generally the fair market price. As per the BSE website, the historic share prices for SPICEJET in that period was as below
Month Open Price High Price Low Price Close Price No. of
No. of
Total Turnover(Rs.) * Spread (Rs.)
H - L C - O
October 2009 35.00 42.40 32.40 37.05 92485890 181131 3,519,030,105.00 10.00 2.05 
November 2009 36.90 49.20 33.40 46.80 79011946 178373 3,447,075,951.00 15.80 9.90 
December 2009 47.45 59.40 47.40 56.75 76860494 194337 4,172,800,886.00 12.00 9.30 

Now, the pricing would have been decided before hand. But the intrinsic value(as opposed to merely the market price) would not have changed that dramatically within 2 months. Due to market fluctuations, the option value dramatically rose under the intrinsic value method. While under BSM(Black Scholes Merton) model, this volatility would have been slightly toned down in the pricing formula

Conclusion:- For high Beta stocks(like this one), intrinsic value ESOP valuation may result in casino like ESOp expense figures.

Thursday, March 3, 2011

A look at the internal audit system at India's largest sugar producer

BHL(Bajaj Hindustan Ltd) is a Shishir Bajaj group company, and is the largest sugar producer in India with an overall share of more than 20% of the Uttar Pradesh production(As at Sep-2010). For an Indian company, the risk/audit disclosures are exceptionally lucid and detailed and deserve a mention. I detail below their internal audit measures with my comments in italics. It is sourced from 2009-10 Annual Report.

I notice that they do not really have controls set in for the power plant. Maybe they will update their next year's annual report to take care of that. Another control not mentioned here is the check on raw material procurement price. After all, if mill procure at less than the State Advisory price, they may be legally liable for penalties. These instances do not seem captured but otherwise the controls do seem robust, and more than that, the company's confidence in disclosing that is to be commended.

General Measures
These are done by any decent internal audit firm and include

  1. Checking of Accounts vouchers on test check basis
  2.  Physical verification/analysis of inventory and of  Surplus, Discarded and Non moving stock
  3.  Checking of Store Ledger with respect to timely accounting of Receipts and Issues of Material
  4. Reporting on overdue debtors  of Sugar, Molasses, Press Mud & Organic Manure
  5. Review  of  Statutory  dues and  timely  filing  of Returns
  6. Checking of Excise and Service Tax Reconciliationsfor timely availing input credit in eligible cases. Umpteen companies are mired in this litigation for credit. They are taking preemptive measures.
  7. Pre Audit of Purchase and Work orders issued from units & Post Audit at Corporate office Noida. It is good that they are following good capital budgeting practices of pre audits. 
  8. Verification  of  system of  recording  all  incoming materials including freight incurred thereon
  9. Review  and  reporting  on material  sent  to  outside parties for repair/ Jobwork
  10. Review of Inter unit and Inter Company Material in Transit cases
  11. Checking and reporting on Employee’s  Imprest debit balances.
  12.  Checking and reporting on Excess Interest chargedby Bank on OD/ CC Accounts

Sugar Industry Specific measure

  1. Reconciliation of Empty Sugar Bags-I guess this would be with the packaging material consumed
  2. Checking of Tools & Tackles issued to Employees &Contractors.
  3. Surprise checking of dispatch of Sugar, Molasses, Bagasse and Press Mud on Sample basis. Dispatch being Govt controlled, compliance with schedules are necessary
  4.  Surprise check of Cane Centers, records maintained thereat and review of Cane control, checks & MIS reports. This guards against tendency to delay updation of records. 
  5. Checking of Safety measures and civic conditions of Sugar Godowns at Units. This is not merely a quality/Production issue since it carried operational risk.

How IT/BPR has revolutionized the Income Tax Dept

The Budget documents give interesting nuggets. And the document on fiscal policy strategy was no exception(available here). There, the use of information technology in the BPR of the IT Dept was explained. I was aware about the drastically improved processing speed of the Dept(assessments finished quickly, appellate tribunals backlog reduced etc) but these points explain why it has happened. The Centralized Return Processing Centre(CPC) at Bangalore now processes 1.5 lakh returns/day(or 5.4 crore returns/yr). By May-11, two more CPCs will be operational in Manesar and Pune, with another planned in Kolkata by 2012.

This automation(mostly of retail individual tax payer returns) applies the retail banking approach(low cost high technology low touch) approach to tax. This Budget will nearly do away with most salaried tax payer returns so the high risk business/professional segment will be focussed on. And this may improve tax compliance, reducing black money in the bargain.

Information flows have been shifted online(e-returns, e-TDS, electronic reporting of high risk transactions) and human interface has been reduced(automated refunds etc). One of our IIM-A professors was associated closely with this project and had shared with us the benefits of this approach.

Wednesday, March 2, 2011

When eagles crash-the sorry tale of Rajat Gupta

The IIT-D and HBS grad-Rajat Gupta is a professional consulting legend for having reached the pinnacle at McKinsey. After that, he had founded a PE fund New Silk Route which has several investments in India. His independent directorships at the most esteemed organizations-P&G and Goldman Sachs, indicate the high esteem that his peers held him in. Given that, the SEC charge against him for 'tipping' was a shocker, considering that he had no financial reason to do so.

The SEC press release(available here) is damming. While a lot of other evidence can be dismissed as circumstantial, this accusation is hard to defend(para 18)' A Special Telephonic Meeting of the Goldman Sachs Board was convened  at 3:15 p.m. on September 23, during which the Board considered and approved a $5 billion preferred stock investment by Berkshire in Goldman Sachs and a public equity offering.  Immediately after disconnecting from the Board call, Gupta called Rajaratnam from the same line.  Within a minute after this telephone conversation, at 3:56 p.m. and 3:57 p.m., and just minutes before the close of the markets, Rajaratnam caused the Galleon Tech funds to purchase more than 175,000 additional Goldman Sachs shares'(emphasis added)

The financial gains were non insubstantial(around $16MM) but were they enough to cover the reputation risk for Mr Gupta? As a consultant, keeping confidential information secret is must. The SEC release has effectively brought his consulting career to a close. Maybe he thought that he would not be caught but the long fishing net of the SEC caught even this large fish. The takeaway is that in this digital world, there is a permanent record of one's actions which may rebound later. So either be upright, or take immense precautions to escape.