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Saturday, July 30, 2011

Do banks have that alpha in managing/profiting from commodities market risk?

While reading HSBCs Global Market's business May-11 strategy day transcript(http://www.hsbc.com/1/content/assets/investor_relations/strategy_day/2011/110511_strategy_day_cust_group_transcripts.pdf), I noticed that they had collaborated with Total(French oil and gas company) for a product where Total manages market risk and physical delivery and HSBC manage the sales and offering and the credit risk. That is, each party remains in its core competency zone. Given the recent blockbuster IPO of Glencore, one of the few independent commodity processors, I thought this trend needs some elaboration on.

Unlike most traders, Glencore has a substantial physical presence in procurement, processing, storage and shipping. That is why besides financial arbitrage apart, it can exploit physical inefficiencies(like say crude oil trading at less than the refined price-GRMs). Also, by being in the spot market, its on the ground intelligence would be more than even the most intelligent financial markets trader.

When I spoke to a few commodity traders/structurers/risk managers, my suspicion was confirmed when they said that the oil majors/commodity majors were not their preferred customers, margin wise, as they were likely to be informed traders, resulting in a negative NPV transaction for the counterparty.  Still, because these majors rarely speculate, they do not pose problems/competition for banks. Still, banks do recognize this talent pool, and snap up leavers from those companies.

Moral:- If you want to be the best commodities trader/structurer/risk manager out there, you are probably better off starting your career with a company in that sector(preferably one like Glencore), than an investment bank.

Friday, July 29, 2011

Analyzing financial statements for investing? Read this first

1.       Prefer consolidated numbers(including subsidiaries) over standalone numbers. However,  calculate the ratio of Consolidated/Standalone(especially for earnings). If C/S>>1, it may indicate an increased risk of accounting errors/fraud during consolidation. While if C/S<1, either the company is booking losses through subsidiaries via transfer pricing hoping that investors will ignore it, or that the new ventures(SPVs) are not doing well.
2.       Go through atleast 4 consecutive quarterly reports(and the related notes to accounts) to identify any seasonality trend disclosed, company’s reporting pattern etc.  This also holds for conference call transcripts/investor presentations(if any). In some cases(like of Religare Financial Services), one hits gold by finding strategic disclosures etc in earlier reports.
3.       Remember that most ratios stress on operating numbers.  Hence, deduct non operating income(interest/capital gains) and assets(investments, excess cash etc) from the numerator/denominator of the ratios calculated. Nearly everyone does it differently, and you should understand how it is done. For valuations using P/BV, EV/EBITDA etc, these adjustments are quite material/
4.       Whatever be the corporate governance spin etc, the ratios reveal the true picture, and one can check whether they are consistent with the management disclosed policies/spin. For instance, if a FMCG market leader claims to treat its vendors/suppliers fairly, but consistently has net negative working capital(compared to positive working capital of other competitors), then it is probably gouging its competition. Also, if a management attributes increased profits to better performance but a DuPont Analysis shows it to be due to higher leverage, you then know that someone is trying to pull wool over your eyes.  
5.       Preferably read multiple company documents from the same industry, so that you can distinguish the MD&A spin and understand who is bullshitting and who is talking straight. For instance, a real estate company which does not mention risks of inflation/interest rates, is probably not disclosing enough. Also, you get to know/expect a minimum level of proforma disclosures(like realization/sq foot, land bank etc) which you can compare.

Wednesday, July 27, 2011

Evaluating Indian listed companies promoters competence and investor friendliness-some pointers

Open any investing treatise, especially on fundamental investing, and one of the golden tips you get is to assess management quality/competence. Now, this may sound irrelevant, given that the listed company which you are wanting to purchase is alive, listed and functioning. Also, chances are that the company would post a profit(atleast in nominal terms, or in proforma terms!). So should not the results speak for themselves? In this case no. Despite that famous adage that 'past results are not indicative of future performance', promoters are merely people(like us) and likely to behave in the same way. So this analysis serves purposes of 'Forewarned is forearmed'. Some points to note are
  1. Performance of group companies:- In IPO prospectuses, this information is easily available. Otherwise, one would need to extract the list of associate companies from the annual report, and then Google them to see what crops up. This does reflect on competence. 
  2. Performance/Investor Communication in bear markets:- Nobody is perfect, but one would expect management to 'tell it as it is'. If a promoter has survived a bear market cycle and retained investor confidence, then chances are he will do well in any market. Ajay Piramal is a classic example, so it is surprising why investors are valuing his cash stack(from sale of pharma business) at less than the cash value itself. 
  3. Treatment of past investors/lenders:- Certain Indian industrial groups like Essar would delist at rock bottom prices, make losses in listed companies(but rarely in unlisted group companies), repeatedly go for restructuring of bank debt without proper risk management, not rewarding shareholders adequately etc. Grizzled veterans of Indian stock markets would probably be the best ones to share war stories, but otherwise Google(extensively) would help a bit
  4. Can Board check generational decline? :-When otherwise well governed companies like HCL, Wipro, Asian Paints, Glenmark catapult family members to top positions where not justified by age/track records/achievements, then one should worry about future performance. If there are independent directors who have good track records in business/service, and not dependent on the company for substantial portions of their incomes, then one may rest a bit
  5. Mergers of associate companies into listed companies:- These valuations often favour the promoters, who would own nearly 100% in the associate company. While reputed firms perform the valuations, even they know what side their bread is buttered, and would err at the higher side of the valuation for the selling company-while avoiding too perverse a valuation. 
  6. Related party transactions:- This note is one of the densest and foggiest notes, along with pension/derivatives notes. But it is a must read, because even blatant ethical issues can be camouflaged there. For instance, Reliance had substantially funded Mukesh Ambani's gas pipeline project with debt, but now pays him thousands of crores in carriage fees. 
  7. Non compete agreements/promoter entities in related businesses:-Without non compete agreements, the chances of promoter firms taking lucrative investment opportunities, is quite high. In infrastructure companies, this is an especially high risk
  8. Odd compensation structures:- In a leading Indian infrastructure conglomerate(which gave blockbuster returns in FY11), the CFO has been voted a compensation of 2Cr+/annum plus a commission upto 2% net profits. At its maximum, the commission could be 50Cr+. For a company with a promoter CEO/MD, this raises questions of whether this is a payoff for something else.
  9. Repeated issue of preferential warrants:- Promoters love preferential warrants. For a premium of just 25%, they get a 18month call option on the stock, AND the premium is adjustable against the strike price if eventually converted. Of course, the obvious solution would then be to issue warrants at strike price=133% of current market price. Then it would make sense to convert as the premium becomes a sunk cost. While promoters argue that rights issue would take too much time/costs, no other investors get these sweet heart deals. While this tactic has backfired in the bear markets of today, this tactic is investor unfriendly. 
  10. Rights Issues at around market price;- This is a clear indication that management wants to boost its stake without paying extra for preferential allotment. So the easier solution is to issue rights at around market price, no investor will pick it up, then promoters can subscribe to the unused portion. 
This is all I can think of for now.more later!

Standards as public goods-the case for free downloads.

In the good old days, only doctors, lawyers and accountants were considered professionals. Now, every service businessperson clamors to be recognized as a professionals. Right from actuaries, investment professionals, valuers, risk managers etc, associations of professionals establish institutes like CFA, FRM etc, and then attempt to get monopoly status for their members. Now, nothing per se is wrong with this attempt, though one can argue on how successful these 'professional associations' are in terms of value added to their members and society. After all, skilled work does benefit from licensing and discipline.

Now, professional standards not only propogate 'best practice' in the area, they also educate the users of what to expect from their licensed professional. So, charging a fee for those standards reduces the dissemination not only to members(unless purchasing them is tied in with the annual membership fee), but also to students and the laypersons(public/journalist). And this reduced circulation would impact analysis, dissemination and critiques by those not able to pay for them, especially in emerging economies.

Now, one may argue that nothing which comes free is ever valued. That is why one can follow the path of the international accounting standard setter(IASB, responsible for IFRS). It is a non profit organization dependent on its members for funding, but which aims to self sufficiency. Therefore, the standards themselves are free, but the value added guidance notes/interpretations are not free. The rationale being that only experts/professionals would require those, and can very well pay for them. There is special pricing for students and academics, while journalists have free access.

Or one can follow the path of the Indian accounting regulator(ICAI) with more than 10lakh students+members. It uploads all its publications in PDF format on its portal, thus allowing knowledge to spread freely. In a country like ours where knowledge is valued(but purchasing power is low), such a approach will work wonders in the years to come.

Tuesday, July 19, 2011

Adani Group AGMs lasting maximum 45min-a travesty? Not really.

Adani has 3 listed companies-Adani Enterprises and its two subsidiaries Mundra Port & Adani Power. While reading their annual reports, it struck me that all have scheduled their AGMs in the same hall on the same date. Evidently, they do not expect the AGMs to extend, nor any activist shareholders to attend.
  1. Mundra Port  is holding its 12th AGM on Wednesday, 10th  day of August, 2011 at 9:30am. at J. B. Auditorium, AMA Complex, ATIRA, Dr. Vikram Sarabhai Marg, Ahmedabad – 380 015.
  2. Adani Power is holding its 15th AGM starting 10:15am
  3. Adani Enterprises Ltd is holding its own AGM at 11am, at the above venue
 One part of me wants to salute the group for saving costs and leveraging economies of scale by finishing 3 AGMs within 2.5hrs. Also, given that analysts/investors would overlap, it does seem logical to hold all 3AGMs together, so that travel costs are minimized for both management and investors. What I take issue with, is the short time, and the rather bold move of not having other standby venues in case shareholder questions/motions hold up the AGM. I do not have personal knowledge of the venue, and it may so happen that they may have smaller halls within the venue itself, but I doubt that.

Anyways, given that the AGM is being held just across the road from IIMA campus, I may even buy 1 share in each of these companies and attend. It would certainly be an interesting experience. Still, the way they are shepherding 3 AGMs of big companies(in their own right) does not portend well for corporate governance. AGMs are meant to be a place where lay investors can meet the management and have their queries resolved, as against analysts who can use calls/just drop in. And this being held in Ahmedabad, I would really have expected better attendance/participation than just 45min(that too it will be effectively 30min excl start/end formalities). If I do attend(exams/etc willing), I'll post my experience on the same.

I attended the AGMs of Adani Power and Adani Enterprises, which lasted 30min and 15min respectively. To be fair, that was sufficient time, given that the company gave ample time and oppurtunity to ask questions-but despite the turnout of 200odd people, there were hardly any questions. So the companies may be given the benefit of doubt that given the Ahmedabad shareholder profile, they do not lose much by clubbing the 3 AGMs on a single day. Maybe cos like Zydus, Welspun etc can take a leaf from this book.

Why 'single share' owners will still prevail post digital annual reports

Barring Infosys and some other paragons of excellence, Indian companies are not exactly known for being shareholder friendly. Dividends are low and far paced, annual reports get lost in the mail(if they were sent at all), voluntary disclosures are skimped on (segment reporting, impairment testing, last quarter results, consolidated results etc). But ever since the MCA permitted companies to despatch their communications in electronic form, companies have leapt at the chance. No points for guessing why.

Assuming the printing cost of an annual report to be Rs 100(for a good company it will be much more say Rs 200-300), and even a small shareholder base of 10,000 share holders. Rs 10lakh-30Lakh per year, is not to be scoffed at, when it can be achieved by just sending emails and uploading the document on the site. What SEBI failed to achieve through years of Clause 49 circulars, the MCA achieved it within months with a simple circular.

Now, though most demat account holders would now have an email ID linked to it, given that most brokers offer a Rs 50-100 rebate for electronic demat statements etc, but the MCA circular permits them to ask for hard copies of annual reports. And for complex companies with voluminous disclosures, shareholders may still demand the annual report, though psychological studies show that with the inertia element kicking in, some will just grin and bear it.

Another reason to seek the annual report is that if you want to know the details of high paid executives(over Rs 2lakh/month), then most companies send it to shareholders only on request. Hence, holding that token share comes in handy then. 

Many mid cap/small cap investors used to purchase a single share of many companies, merely to get that prized annual report copy. Now that it is available online, they may still retain those shares, merely for the opportunity to attend the company's AGM where they can get snacks/gifts, quiz the management and network with fellow investors. Unless AGMs are made open to all, this tendency of single share owners will continue. And some companies are plagued with them. For example, Wipro has 5010 of them as per its FY 2010-11 annual report

Sunday, July 17, 2011

How vunerable are banking jobs to being replaced by technology?

A famous quote reads 'Lead, sell or get out of the way'. In today's world, that would probably be 'Lead, sell, risk manage or get out of the way'-considering the immense workloads on compliance, audit, risk, tax etc. Industries like type writers, travel agents, brick and mortar book sellers have virtually been wiped out by the internet/technology alternatives-which have essentially replaced recurring operating expenses(opex) by covert capital expenditure(capex). I say 'covert capex' because few capital budgeting calculations can accurately capture all relevant costs like training, business disruption, maintenance, redundancy etc.

Like how media enhanced the reach of sporting/entertainment superstars(thereby ballooning their incomes), technology amplified the reach of the banking super stars(traders, sell side investment bankers), who could now access more markets, trade more asset classes, do cross border huge mandates etc. All that did lead to the increase in compensation, compared to retail banking, where the technology led to more customers going the online/contact less banking route thus lowering the need for staff.

In my view, the only functions which cannot be replaced by technology are sales, general management, technology support and creativity. Analytical/Administrative functions are at risk of being replaced by technological alternatives. In my view, some at risk functions are
  • Daily report preparers
  • Arbitrageurs
  • Stenos/secretaries-unless they upskill to becoming executive assistants. 
  • Flow traders.
So how to prevent your role from being truncated/cut? Well, my two bits on this would include
  • Coming up with creative ideas and implementing them-with net profit/cost savings to the company
  • Embracing efficient technology solutions for personal work-Google Docs, apps etc. 
  • Building strong relationships-internal and external
  • If in an analytical role, being in the 'tacit knowledge' domain as long as possible-which would imply coming up with new and better ways of number crunching. 

Thursday, July 14, 2011

FAQ on Basel II

1.     Why do the developed countries care so much about global capital/accounting norms? Should they not keep that competitive advantage with them? It is NOT a competitive advantage for a single country per se, unless everyone else adopts. Else it becomes a source of competitive advantage, where some national banks may need to set aside less capital than others, and may report higher profits also due to different accounting rules.
2.     Why would some assets have a risk weight over 100%(for example 150% risk weight when provisions are less than 20% of the outstanding amount of the loan)? After all, is not the maximum loss 100% of exposure? Well, when there are derivative positions, liability to fund cash calls etc, then the maximum exposure can top 100%. That is why the weights are there.
3.     How to convert off balance sheet items to credit exposure equivalent? Use credit conversion factors(CCF). These use behavioural finance and subjectively estimated caps.
4.     Why do wholesale banks care so much about accounting? From the capital perspective, banks raise very little capital organically and so depend heavily on capital markets for raising debt/equity. These capital markets look at the financial reporting numbers since that is what they have access to. Other industries(barring highly levered ones) can sustain on organic growth w/o capital markets funding but banks cannot. On the demand side also, areas like hedge accounting affect the type of transactions which risk averse companies will authorize their Treasury function to enter into. That is why banks take an active interest in IFRS.
5.     Why treat the same instrument differently in banking book/trading book? It IS illogical but the presumption is that there are significant constraints on the ability of banks to liquidate banking book positions and value them reliably on a daily basis, and so capital treatment should be difference. Also, the intention driven IAS 39 would account for these instruments differently, and from a risk perspective, market risk is presumed to impact trading book more than it does banking book.
6.     Why do home regulators look at the entire consolidated entity? Is it not going beyond their scope? Not really, they need to capture the risk of the whole banking group for which they need to regulate a consolidate entity.
7.     Why do new banking models initially allow for lesser capital requirement(albeit with a lower cap)? structured to provide incentives for banks to  adopt more sophisticated practices quicker and voluntarily.
8.     Among Potential future exposure (PFE), expected exposure (EE), and expected positive exposure (EPE), why is EPE preferred? By using EPE, transactions with CCR are given the same standing as loans with the goal of reducing the capital treatment’s influence on a firm’s decision to extend an on-balance sheet loan rather than engage in an economically equivalent transaction that involves exposure to CCR.
9.      What is the logic of alpha and Beta scaling factors while converting EPE to EAD? To be consistent with the Revised Framework for credit risk, the EAD for instruments with CCR must be determined conservatively and conditionally on a “bad state” of the economy. To accomplish such conditioning in a practical, pragmatic, and conservative manner, the internal model and standardised methods proposed in this note scale EPE using multipliers, termed “alpha” and “beta”, respectively. This proposal sets alpha at 1.4 for the internal model method and beta at 2.0 for the standardised method

Fair Value 101

FAQ On Fair Value
1.     What does fair value mean anyway? Simply put, it means the price which you could sell an asset in an active market to an unrelated party
2.     Why do we want all assets to be at mkt value? The high P/B ratio shows that there are several off balance sheet assets like intangibles, human capital, fixed assets at market value etc. The attempt to have fair value tries to capture the holding gains(due to inflation) and the market value gains
3.     But why do organizations oppose it then? Firstly, valuation is specialized work needing accountants, valuers and auditors-all of whom charge hefty fees. Secondly, companies are exposed to market volatility even for assets they do not intend to sell(brands, goodwill, fixed assets, long term financial isstruments). Next, not all markets are equally active-the framework mainly relates to the Anglo Saxon financial markets model. Lastly, if the market moves against them(as in the subprime crisis where financial instrument holders had to take heavy losses on their securities inventory), those organizations WILL object
4.     What is the way out? Increase the proforma information(some cos are doing this for brands,  fixed assets and people). Secondly, have a few broad impairment tests to ensure that risky assets atleast approximate their conservatively estimated fair value . Essentially, Separate valuation from accounting.
5.     But liabilities value can only fall(since liability is capped). Why do we use fair value there? See, companies love fair value for their liabilities because discounting will only reduce the value. Also, if the financial position of companies worsen, thus making it likelier that they will default(viz increase in own credit risk), they can reduce the value of their debt-thus increasing equity accordingly. Read ‘credit value adjustments for more details’
       As an user of fair value accounting, what should I realize? Unless the asset has an actively traded market(listed securities etc) AND the entity is both willing and able to dispose it off, there is no sense in informing investors the fair value. This applies more so in the case of closely held companies, where even if the minority investors know that stakes in listed group companies/factory land etc alone much exceeds the current market cap, they cannot compel the management to liquidate and return the cash to them.     How reliable are these valuations? In the mecca of investing(USA), the same valuation firm felt that $2 and $10 were fair prices for Bear Sterns, in the space of weeks. This is not an unique incident, valuation is nothing but a story agreed upon by valuers, operational management and accountants. Even market quotes sometimes are to be taken with a pinch of salt, especially if the reporting entity is itself a major market player/maker. 
       But won't this spur investor activism? Maybe-but only if there is a sufficient free float. Otherwise, promoters will see their holdings value rise, without even taking corporate actions.

Monday, July 11, 2011

Why is Reliance Infrastructure undervalued?

 During the May-11 conference call discussing the FY11 audited results, the RInfra MD boasted of a solid balance sheet and net worth stating that Our net debt is zero. Our total net worth on a consolidated basis at the end of FY11 is Rs 23,965 crores which gives us a book value per share on a consol basis of Rs. 958.

Yet, the share price is just Rs 580, implying a P/BV of just 0.4, at a market capitalization of Rs 15,518 Crores. Ok, granted that neither P/E nor P/BV are good metrics for an infrastructure company, which ideally should be valued on SOTP(sum of the parts basis). Still, Book Value is a conservative measure of company valuation for non financial companies, so it is surprising that the P/BV<1 for a self confessed 'solid company'. Various theories hold such as
  1. Bear attack on R-ADAG group:- Anil Ambani(chairman and promoter of the Reliance ADAG group cos including Rinfra) is no saint, but recently, ADAG stocks saw a concerted sell, from which they have not fully recovered. Whether this was informed trading or mere vindictive attack, is something which only time will tell
  2. Anil Ambani 'hex':- Though the public and capital face of Reliance Industries Ltd during the life time of his father Dhirubhai Ambani, Anil Ambani has not pleased investors equally. The RPower mega IPO inflicted mammoth losses on investors, which even bonus shares have not helped recoup. Old time investors in Reliance still idolize Anil's dad but not him. No wonder then, that even the best investor relations effort(like this presentation http://www.rinfra.com/pdf/RInfra-InvestorPresentation-May11.pdf) has left them unmoved. 
  3. Conglomerate discount:-Rinfra straddles the infrastructure spectrum with roads, metros, power, airports, EPC etc. Each has different valuation metrics-for example road projects can be valued on annuity basis, power projects/EPC can be valued using P/E. Non disclosure of adequate information may lead the market to assign conservative metrics. Maybe, spin off of subsidiaries OR accounting bifurcation with separate audited accounts, may reduce this
  4. Holding Company Discount:- RInfra holds 38% in RPower, worth around Rs 12579 crores, even at today's depressed prices, which would imply that 81% of RInfra's capitalization alone is due to its holding in RPower. Of course, this won't be divested anytime soon and so we apply 'holding company discount' of maybe 50%. If RPower was an independent company, this discount would not hold. 
 Considering that Rinfra has a decent size operation(Rs 1000 crore profits p.a) independent of RPiower(http://www.rinfra.com/pdf/quarter-fc/RInfra_Mar2011_Annual%20AuditedResults.pdf), it is quite illogical as to why it is valued LOWER in market cap than RPower. Every company feels that its shares are undervalued, but Rinfra is entitled to feel so.Unless of course RPower is overvalued, which is not discussed in this post, but certainly a possibility. But surely, the holding company discount for that 38% stake in RPower, should also be adequate to adjust for that.

One may raise concerns over the opacity of Reliance's earnings disclosure(like overuse of the 'Other Income' category while reporting quarterly revenues), balance sheet quality(due to pileup of regulatory assets which essentially represent tariffs recoverable in future from consumer), evasive behaviour during analyst conference calls(by directing some 'awkward' questions to be answered offline by some other company employee) and inadequate disclosure(on pending litigation, project wise cash flow break up).

Therefore, I would welcome comments from the readers, as to their ideas of why this difference is there. I picked RInfra because it has less debt(debt free on net cash basis), profitable on both standalone and consolidated basis, and has little execution/industry/regulation issues. Maybe this applies to other R-ADAG companies, about which I have lesser idea.

GTL-a value pick despite everything?

  • The group is present across the entire telecom value chain except VAS. But the risk of 'tunneling' revenues/profits/cash flows outside listed subsidiaries exists. As mentioned in their global group presentation, the promoters are also in businesses like tower manufacturing, active infrastructure provision, which may be sold to the listed companies at non arms length. Investors will have to rely on the auditors/tax authorities to ensure that this does not happen.

  •  The GTL Aircel deal signed below promised a Rs 2750Cr/year revenue potential. Of that, Rs 1250Crore was deployment related, which is contingent on network expansion, which is muted across all operators. But assuming that even 40% of the other revenue materializes @ 25% EBITDA, we are looking at  a gross profit boost of Rs 270Cr per annum, which even post 20%tax, will boost bottom line by Rs 216Crore.

  • GTL Infrastructure has a Mcap of Rs 1465Crores(as per closing prices on  11 Jul 2011), with Rs 5040 Crore debt. While GTL has a mcap of Rs 878Crores, with own debt of just 2374 crores, with much better earnings quality/stability. But, unless the unwary investor realizes that GTL guarantees the debt of its 'associates'-GTL Infra, GPAL & GNRL(latter 2 alone add up Rs 750Crores), he will be suckered into thinking GTL is safe, till the lenders have a margin call. I have blogged upon this in my other post here(http://thescambuster.blogspot.com/2011/07/gtl-group-corporate-governance-sham.html)

  • The reason I would consider investing in GTL Infrastructure is that  the company is the towers business. Even at Rs 30lakh/tower(not unreasonable assuming that the Aircel Deal closed at Rs 48 lakh/tower), GTLs 33000 odd towers would be valued at almost Rs 10,000Crores EV. This is nearly double its existing debt, and leaves ample amount on the table. 
  • GTL has a decent earnings visibility, and Aircel deal is promising but is burdened by debt, intercompany transactions and guarantees. 
Conclusion:- If there is any movement in the corporate governance and structure of the group, I would consider GTL(both companies). It is a pity to see value destruction but since the tunneling/group company risk is too high here, only rumours/concrete restructuring actions will see any movement. Perhaps, it may bounce back like how SKS(post MFI bill) and Money Matters(don't know why).