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Tuesday, September 27, 2011

Asian Electronics fraud on investors by repricing stock options

When I opened the FY11 annual report of Asian Electronics(http://www.aelgroup.com/AEL_Annual_Report_2010-11.pdf), I got a shock by looking at the options repricing resolution. Stripped of all the legal jargon, they want the shareholders to lower the exercise price of options from Rs 28 to Rs 12.6 viz Rs 17.4 reduction. These options were granted hardly a year ago(viz 31st March 2010), and now they are seeking post facto approval because. In view of such depressed level of market price of shares, exercise of stock options at an exercise price of Rs. 28/-per share became unviable for all the grantees... revised the exercise price from Rs. 28/- per share to Rs. 12.60/- per share, to bring the exercise price in consonance with the prevailing market price of the shares of the Company

This logic is flawed. Options are not meant to be at the prevailing market price UNLESS the holders intend to exercise it  immediately, in which case they could have got it from the open market. They obviously intend to hold it till Mar-15, and exercise it when the price jumps over Rs 13.

Now, these options were exercisable within 5 yrs viz Mar-2015. But evidently, the directors and employees are in a hurry to cash out. Poetic justice perhaps further reduced the share price to Rs 8 as of today, so will they pass another resolution to reduce the exercise  

So how much are they profiting from this?
  1. The 4 non executive directors are having 1 million ESOPs reprices=>a benefit of Rs 17.4 million.
  2. Other key employees are having 3,51,550 ESOPs repriced=> a benefit of Rs 6.2 million.
One can justify the need to retain employees by repricing their stock options, but repricing for non executive directors? It smacks of a Faustian Bargain 'You scratch my back I scratch your back'. One would have thought that the self described eminent professionals with experience in over all management, finance and law, who bring a wide range of skills and experience to the Board would be above doing something like this, but evidently Rs 17.4 million is the price of their conscience.

Granted that this is subject to confirmation by shareholders but I wonder how did
  • The compensation committee(all the said Non Executive directors) vote itself options repricing)?
  • The nominee institution directors agree to this?(maybe because this saves an monetary outflow)?
  • They ever think of seeking 'post facto' approval and seeking fait accompli. 
No wonder then, that Asian Electronics's reputation on the bourses is trash. 

Sunday, September 25, 2011

Analyzing banking stocks? Don't overlook this useful accounting information.

Standard banking equity analysis looks more into ratios(ROE, ROA, NIM, NPAs, CRAR, business ratios) than into any specific qualitative information. Thanks to the Indian banking regulator(RBI), all banks need to disclose standard information in their annual reports. The Master Circular(http://www.rbi.org.in/scripts/BS_ViewMasCirculardetails.aspx?id=6542) has a laundry list of information, which does some in handy at times. Do read it and get some insights of what matters to the RBI, but for now I suggest take a closer look at these ratios while analyzing any banking stock
  1. Concentration of Deposits, Advances, Exposures and NPAs:- The RBI mandates disclosing the percentage of top 20 depositors/borrowers(as % of total advances/total exposures/deposits) of the bank. This allows a bird eye view of concentration risk, and the risk of lowering pricing/bank runs. 
  2. Disclosure of Penalties imposed by RBI:-Few banks will trumpet this in their presentations, so this information is only in the annual report, and allows assessing the operational risk of the bank, and the contingent liability for later lawsuits. For instance, the RBI has fined a few banks recently for misselling deriavtives-you can be sure that the defaulting counterparties will use this as ammo in court to have those transactions declared void.
  3. Details of Single Borrower Limit (SGL)/ Group Borrower Limit (GBL):-  While this may be totally innocuous and to reputed parties(for example SBI exceeded this limit for a bluechip Reliance Industries), it does show that if the funding is suddenly reduced/withdrawn, it make adversely affect either party. Also, in case secondary market crashes affect that overextended borrower, then the bank stock may also tank in sympathy. 
  4. Disclosures on risk exposure in derivatives:- This note demands that besides MTM/Credit exposure details, the bank should also disclose Likely impact of one percentage change in interest rate exposuress and currency derivatives. This allows a very rough cut sensitivity analysis in case currency/interest rates fluctuate 
There are other useful information also, but this looks good for starters.

Friday, September 23, 2011

Some useful excel features for fundamental valuation

The old school investing story(Graham/Buffet) would be to take up a balance sheet, calculate the breakup/minimum value at large margin of safety, and then buy the shares if trading below that price. While academically found reliable, the DCF valuation used to be too computationally cumbersome. So for those well versed at mental number crunching(I still know a few of the oldschool CAs who could whip any newbie at this) or with an army of assistants, DCF was possible. Otherwise for those with limited resources and time, this was not possible. But now, with a spreadsheet on every computer, DCF is no longer that difficult, if you know the right features/methods to configure. Below are some tips for the same
  1. Assumptions in separate cell/worksheet:-This ensures that one can change them en-masse, and the linked cells(and therefore valuations will be updated)
  2. Currencies/Rounding:-For different investors or purposes, one may desire to vary the currency/rounding(crores or millions). That is possible at a click
  3. Conditional formatting:-This allows to highlight, colour or format cells which are meeting the criteria. For example, if one needs to highlight the years with negative cash flow, conditional formatting does that for you at a click. 
  4. Extend the formula across cells:-This is probably the most time saving tool. Just use relative/fixed referencing properly, and a single formula often be dragged to fill the time periods. It is then easy to change the time period/formula without much ado.
  5. Data Table for Sensitivity Analysis:-Excel's feature data table allows one to present a sensitivity analysis without much computational burden. 
  6. Writing macros for data mining:-Often, large data sets('bhav copy' etc) are freely downloadable in Excel. One can write macros to automate the daily stock screens for price, trading volume, F&O liquidity etc. Of course, brokerage houses often do this better, so this is for those investors without access to those good brokerages.
  7. Goal Seek/Solver:-For those wishing to find out a breakeven projection(via goal seek!) or to fill the cash flow statement consistently(via Solver), these tools remove the requirement for endless iterations. Personally, I've found this most useful to calculate implied fundamental values for market prices, and to fill the cash flow statement after income statement and balance sheet are readied.
  8. Cross referencing and automatic recalculations:-This ensures that cascading effect of changes are applied consistently in the calculation
  9. Facility for external data feed to update:-For those with CIQ feeds etc, this allows dynamic updation of valuations

Tuesday, September 20, 2011

What I like about CRISIL IER Reports

Concerned by the lack of analyst coverage on most stocks, NSE(National Stock Exchange) decided to commission CRISIL to cover selected stocks on an ongoing basis. Unlike conventional equity research reports, these reports do not give an explicit 'BUY'/'SELL' recomendation. Then what use is it you may ask? Well, the merits of this approach versus conventional equity research reports are
  • Transparency:-It is an open secret that the lesser known brokerage houses(and indeed some of the bigger ones) seek a quid pro quo from the companies in return for covering then. CRISIL does IER either by commissioned by the exchange(NSE/BSE) or if commissioned by the company. The latter approach is non mandatory and may lead to conflict of interest as in credit rating model, but atleast the payer is explicitly disclosed upfront
  • Differentiates between fundamentals and valuations:-CRISIL analyzes the companies on two parts-quality of fundamentals and valuation upside(viz Fair Value v/s Market Price). That is better than mixing the two up.
  • Good environment analysis-competition etc:-This section is amazingly done in general.
  • Corporate governance/risks:-CRISIL IER reports pull no punches when it comes to the corporate governance, contingent liabilities and risk management section.
  • Track Record:- The reports give the history of the past reports mentioning their fundamental grade(and then calculated fair value) along with valuation grade(and the then CMP[current market price]). Hence, an investor can eyeball that track record and see how the fair value as calculated by CRISIL, has moved with the market price. 
  • Freely downloadable:- Unlike other equity reports which are first shown to certain customers first, CRISIL releases all reports at the same time to all investors, which are freely downloadable.
  • Response to queries:-Retail investors rarely have access to the analysts. But in this case, the CRISIL analysts are available on email(I did not try to call them though!) and do respond to queries promptly.
I've read reports from quite a few brokerage houses, and can say that the quality of these reports is certainly up there with the best. You may not get earth shaking insights, but certainly these reports cut investor risk substantially for stocks less tracked. While most of this may be already available in the detailed credit report, these are often not publicly available. 

Monday, September 19, 2011

Beyond IPR-how companies protect their intellectual property

I enrolled for the elective 'Strategic Management of Intellectual Property rights' taken by the legendary Prof Anil Gupta. During the second session, while discussing the terminator gene technology, he explained that the best way to protect intellectual property is often without legal protection. This comment of his sparked off some thinking in me, and below are the examples I came up with, as substitutes for the below IPRs.
  • Patents;-Incomplete(from angle of copying) patent applications often compel wouldbe imitators to approach the patent assignee for the exact technical know how for working the patent, and theteby prevents imitation.
  • Copyrights:- Digital Rights Management(DRM) is used to protect copyrights from unauthorized use and copying. This is analogous to the terminator gene technology used to protect Bt seeds.
  • Trademarks:-This is maybe the only IPR for which law is the best protection.
  • Trade Secrets:-By definition, this cannot be protected if not disclosed. Hence, contractual forms of control are exercised to protect this as in the Coke formula.
  • Designs:- Companies like the centuries old TBZ keep changing their designs, so they do not deem it fit to register their designs. But given the high profile of their clients, any piracy is soon brought to light there.

Sunday, September 18, 2011

Poring through annual reports/corporate filings-a dying art in India?

Graham and most other successful fundamental style investors have recounted experiences where they hit upon a big investment simply by reading what others had glossed over. Whether it be Graham’s railroad stock, Buffet’s initial investments, India’s Motilal Oswal & Rakesh Jhunjhunwala; they all have benefitted immensely from reading annual reports/corporate filings/prospectuses. In the USA, while the dumbing down has reduced it, there are still websites like 10Qdetective which do this for you.
In India, there is no comparable thing. And going by the quality of analyst reports, it is doubtful whether many of them do beyond cut-paste. One may argue that the ‘unsaid/unwritten’ works more than the written word in Asia-especially India. But then, with IFRS being in from FY2011-12 annual reporting period onwards, one must note that companies can get away with murdering the accounting rules-as long as they disclose it. And this is not a far fetched case. Enron did disclose its off balance sheet partnerships for years, it is just that nobody bothered to read those notes for a long-long time. It took diligent readers to spot the error. Michael Burry made a fortune on the subprime crisis by going through bond prospectuses(each of them hundreds of pages long!). And Buffet himself prefers to avoid the information overload in mass media, by selecting his reading and then closing his sensory organs to other stimuli.
So what is the way out? Analyst training is an option, but what about the retail investor who wishes to invest on his own? Perhaps, an elective should be offered as an advanced financial inclusion module

How ‘Difficult to value’ companies are enhancing their market value

·         List in different market-Makemytrip.com chose to list in USA compared to India, which may not have given it that good a value. Conversely, Biocon chose to list in India despite being ‘new’.
·         Spinoff integrated businesses-Concoco Philips announced the spinoff of E&P and R&M in Jul-11, other smaller players expected to follow suit.
·         Delist holding company and get PE investment/sell off in full-Some Indian companies are following this policy as they are frustrated by the high holding company discounts(upto 70%-80%).  For example, Nirma’s delisting is  presumed to be due to this.
·         Accounting/Reporting:- If the companies make it easy for analysts to value them by clear segment reporting, periodic self SOTP valuations, internal arms length transfer pricing etc, then they may attract a lower conglomerate discount. ITC and Tata Investment corporation have done this to a good extent
·         Transparently communicate strategies:- M&M, Escorts, DCM Shriram and others are adopting this approach to reduce the SOTP discount/even attract a premium.
·         Marketing to correct investor base:- FIIs hold nearly 60% in microirrigation player Jain irrigation. Selling the story to foreign FII investors is easier in the present legal scenario, where FIIs+FDI can go even upto 100%.
·         Asset sale instead of spinoff:- Piramal’s strategically timed asset sale avoided legal hassles.

Why Mercator Lines is a BUY thanks to coal play.

In June-11, the CEO claimed that the expected valuation of Mercator's coal mining assets would be $150MM for 20% or an implied equity valuation of $750MM for all the assets( http://www.moneycontrol.com/news/ipo-upcoming-issues/mercator-lines-to-launch-ipocoal-division-by-year-end_561459.html). But surprisingly, the global coal prices have only risen till then, but the company's share price has fallen around 40% and the total mcap is just $140MM. Instead of screaming 'BUY' from the rooftops, I thought I'll explore the possible reasons for that, and invite reader comment on the same. For those who have not heard of the company, it is a shipping company which has ventured into dredging, coal mining and oil & gas. It essentially aims to replicate Adani. Read about the company here(http://www.mercator.in/investors/mllinvestorppt.pdf) and download its FY11 annual report here(http://www.mercator.in//investors/AnnualReport/Mercator%20Annual%20Report%202010-11.pdf). The possible explanations for it-other than calling it a case of the bi polar Mr Market of Graham fame-are
  1. Coal Mines not as promised:-The coal mines are in Mozambique(85% stake in 1BN tonnes estimated reserves) and in Indonesia(230MM tonnes). The present coal profits-around 20 crores/quarter-are derived from the Indonesian mines. Now, the CIA World Fact book shows that Mozambique is a debt laden poor company with crumbling and inadequate infrastructure. Mercator's 30yr license was to commence from last year(2010) but it is still looking for a partner to operate the mine. The fact that they have not yet found a partner  in the M&A crazy world of coal acquisitions, that too in the next big continent('Africa') speaks volumes for the asset quality-because the global majors are not that slow....
  2. Shipping business value destroying? Holding companies are valued at even less than the cash on their books(like Piraral Holdings) because investors are worried that good assets will go to stem the cash drain from bad assets/ill advised actions. But this rationale does not really hold, because the company WAS profitable till the crisis, and is still recognized as an efficient operator. 
  3. Market has priced in political risks of expropriation?:-If we content that the Indonesian export tax on coal will make exports uneconomic, then the entire coal IPO valuations stems on Mozambique. Given that the royalty is just $1/ton(sounds too low right?), Mozambique may be tempted to do an Indonesia and hike the royalty. It may even go further to nationalize the mines-but given the diplomatic relations etc involved, that seems a tad bit unlikely. 
  4. Market still views it as a shipping company:-Despite the company's efforts to change its name, market itself as a coal company etc, it is still viewed, monitored and valued as a shipping company. But whatever the value is, would it be negative?
  5. Consolidated v/s Standalone numbers:-The Jun-11 quarterly consolidated EPS is Rs 0.6 but the standalone(only shipping) is a loss of Rs 1.61. Investors who do not read beyond the fineprint and panicked at thestandalone loss, may have dumped it.
  6. Unsure IPO prospects:- Where the global markets may have frozen, investors may be sceptical about the prospects of the IPO happening. But at any EV, it is a no brainer!
  7. No clarity on holding structure:- The group organizational chart is not given, and it is difficult to ascertain the vital element of which company holds the coal mines(i.e which SPV). Mercator claims it to be housed in Singapore and ultimately Mozambique, but little clarity on that.
  8. Why have other investors not caught on yet? Maybe this stock is off their screens, and in the flight to safety this may have been ignored...
None of these reasons(except 1 and 3) hold much water. And for the huge margin of safety, I think this is a classic Graham stock, which is hurt by the distressed shipping sector valuations.  Other non financial advantages are
  • Qualified and stable management team since inception-promoter CEO is from IIT Roorkee, aptly complemented by a Chartered Accountant, the Jt MD. 
  • Loyal independent directors:-Unlike some other companies, it has not seen an exodus of independent directors in the wake of Satyam. But then, it did have a clean image. 
  • Trading at historically low multiples:- P/BV is around 0.6. 
Recomendation:BUY @ CMP Rs 25. It seems a no brainer and multi bagger.

Gems from Jamie Dimon's investor letters

For the uninitiated, Jamie Dimon has been Bank of America CEO since 2006, and had done a great job.His shareholder communication to investors(via letters available at http://investor.shareholder.com/jpmorganchase/annual.cfm) goes beyond the standard boilerplate, and gives a great window into how one of the top banking CEOs think. Some nuggets from those letters are reproduced below, which will convince you that he is indeed the Warren Buffet of banking, when it comes to letters.
  1. On community involvement:-If we were the neighborhood store, we would give kids summer
    jobs, sponsor local sports teams and support community based organizations. We operate this way..
  2. On performance linked pay:- Compensation is not an entitlement; it should reflect an individual’s and a team’s contribution to helping make this a great company.We want to be one of the best-paying companies – but only when we are one of the best-performing companies..we try to recognize when a friendly market, rather than excellent performance, lifts results
  3. On becoming lean and efficient:- It is not just about cutting costs. A company cannot become great just by cutting costs. It is about building better systems to better serve our customers. It is about paying our people not only fairly, but effectively, to help create the right behavior.It is about how we run meetings. It is about designing the right products that are also profitable. (Many companies design products that lose money, and they do not even know it.) It is about constantly improving productivity...
  4. On cost control by cost pooling:-  maintain at Corporate all of what we deemed to be “inefficient
    costs,” i.e., costs borne by the businesses without receiving commensurate benefits and costs that were dramatically higher than they should have been. Examples included vacant real estate, outdated data centers, information technology costs that were sometimes two to three times what they should have been, or staff support costs that were simply too high.We moved these costs to Corporate so we could a) see what the businesses were really earning; b) bring
    into sharp relief these Corporate expenses and put pressure on ourselves to reduce them; and c) hold the businesses accountable for clearly defined costs that they could control.

Saturday, September 17, 2011

The type of finance textbooks that we really need

While reading Stephen Bragg's Wiley US GAAP 2011 edition, I noticed that his book
  1. presents meaningful and realistic examples guiding users in the application of GAAP to complex fact situations that must be dealt with in the real world practice of accounting
  2. Explains the theory of GAAP in sufficient detail to serve as a valuable adjunct to accounting textbooks. One does not need any other 'academic' book alongside.
  3. Much more than merely a reiteration of currently promulgated GAAP, it provides the user with the underlying conceptual bases for the rules, in order to facilitate the process of reasoning by analogy that is so necessary in dealing with the complicated, fast-changing world of commercial arrangements and transaction structures.  
It is the third point which is the focus of this post. While umpteen textbooks give practical examples and clarify theory, very few give that deep insight into 'why' the rules were framed. While this may not be necessary in physical sciences where laws do not change, that insight is necessary while studying man-made rules which can change with the stroke of a pen.  As the 'old school' of lawyers, accountants and other advisory professionals have discovered to their cost, there are frequent paradigm shifts. Whether it be the shift from tangible to intangible assets, and the consequential shift from book value to fair value, or the shift from court law to arbitration with the resultant choice of convenient forums/institutions, changes can happen rapidly. And one needs to be alert for that small signal indicating flux.

Finance goes through cycles, shifts and fads, which have significant resemblances. A financial history primer which covers this reasoning by analogy, is therefore worth its weight in gold.

Financial pricing-illogical, opaque and unfair?

Return is proportional to risk taken. This basic 'tenet' of finance is honored more in the breach. How else can you explain these situations?

  1. Banks with D/E ratios and other leverage ratios>>1 pay less for their borrowings than us low leveraged individuals? 

  2. Over collateralized loan(pawn shops) cost the poor more than what an unsecured loan costs those eligible for it! The poor pay more for gold loans than a salaried person pays for unsecured loans.

  3. Microfinance, despite benefiting from portfolio diversification(and in certain parts of India-group guarantee via self help groups)[on the asset side] and priority sector treatment[on the liability side] still had very high interest rates, compared with other retail loans.

  4. The regulatory accounting treatment for derivative assets(thanks to the netting/collateral provisions) makes this a very profitable business than the less risky lending business.
What goes? Surely, the institutions involved are aware of the mismatch. But these factors play a role IMO:

  1. Even if their pricing models are 'behind the times', the final price('interest rates', 'spreads' etc) can always be notched up to charge what the market will bear. But getting internal approvals for charging a below 'model' rate(even if it is above market) is a painful process in some banks. So why not make that call on your own?

  2. Also,  the business would much prefer to have risk underpriced in their systems, so that they can  win market share by selectively underpricing, have higher 'risk adjusted' compensation figures etc.

  3. Prices often reflect the lack of competition(lead bank relationship, trust built with client, illiquid markets) or information asymmetry(complex products etc). No risk based pricing model can capture this well, necessitating the need for subjective customers. 

  4. Point (3) leads us to the conclusion that savvy clients with multiple banking relationships/finance options(greater supply) would get better terms than clients with exclusive relationships with banks. Unfair but often true-even outside the finance world. The housing finance market where benefit of lower interest rates is passed on to new clients(but not to old ones) is an example of this. 

  5. Basel II/III has made banks to explicitly consider different types of risks in their pricing/risk management-like operational, liquidity risk etc. Thanks to the dramatically different skills needed to price these risks, it has led to fragmented silos of internal Depts who all build(at times inconsistent) models to price it; and then a centralized manual process clunks out the final price. This is true for wholesale banking where relationships are monitored on an individual basis, but not for retail banking where portfolio treatment and s risk calculations

Solving information asymmetry in insurance-examples

     While reading up on the insurance industry, I noted the following clause/contract types which go a long way
     towards reducing information asymmetry issues.
  1. Utmost good faith:-Within a stipulated period, the insurer can repudiate the contract if any intentional misstatement is found in the contract
  2. Renewal discount/No claim bonus:- The lure of getting steep renewal discounts for good track record, may deter petty claims.
  3. Average clause:- This encourages the insured to go for 100%+ insurance, so that when loss occurs he is totally covered.
  4. group insurance discount/mandatory insurance cheaper since lemons problem absent.
  5. Universal insurance-Adverse selection problem is avoided here.
  6. Treaty reinsurance over facultative reinsurance(optional;- It just means that neither party can pick and choose the polices which they will submit/accept for reinsurance. This ensures that cherry picking is minimized by informed originator. 
  7. Use of insurance brokers to give confidence to both client(about rates) and underwriters(about client risk). The primary role of the broker is to inspire in underwriters, on a case-by-case basis, the confidence to accept the risk presented. Market now works on guide wordings that can be modified to suit a client`s needs. These are negotiated accordingly and the risk transfer negotiated with skill in structuring policy wordings acceptable to the insurer and providing protection to the client.

How banks price their loans and products

When I googled this title, guess how many results I got? Zero.zilch.nada. That in itself spurred me on to write something on which there is little organized information. I am not(yet!) an expert on pricing but from what I have seen of the structuring, trading and risk sides of banks, I think I can venture some informed views on this manner. More knowledgeable readers are welcome to comment on this primer in FAQ form.

  1. Every business needs to price its products. What is so exotic about banks? Other businesses may view increased volumes as a success of their pricing strategy. But for a bank, a spurt in volumes may merely mean that is pricing model is broken, and that others are taking advantage of that till the bug is fixed! Hence, risk pricing is error prone, yet important.
  2. How is risk priced in? We do not have(yet) that one universal calculator which will spit out an integrated figure for all risks. So often the systems are fragmented. Credit risk calculations are often bifurcated into counterparty(interbank/other FIs) and client risk(normal corporate transactions). And there are many ways to splice other transactions. So finally, an excel/other manual systems are needed to make sense of this mess of figures
  3. But why does not some one automate it? It is a control issue. Given the high sensitivity of prices, and the subjective adjustments needed, there is a limit to everything-even for flow trading! 
  4. We learn this in marketing 101. Do those principles apply here? Yes and no. Yes because the exact pricing decision will depend on how well the pricer knows the client, which is again related to marketing. But no because the performance management system of banks ensure that the cost of funds charged to the trader, is often determined post facto, and so there need to be relatively accurate and robust models available for trade negotiation and evaluation. And while geeks/quants can design it, the end users need to know the ins and outs of the model, including its limitations, so that for extreme cases they can use modifications. For example, while executing a large trade which will move the ALM curve and the market, the liquidity adjustments among others would need to be made upfront. 
  5. Floating or fixed rate? Depends totally on the risk appetite of the bank and the relationship/focus on that client. For example, Indian banks give fixed rate education loans to IIT/IIM/other top colleges students, while the ordinary student is exposed to floating rate risk.

Safety first-IRDA investment management regulation.

      I compiled the below analysis from the various IRDA regulations in force. Those interested are welcome to    browse the IRDA website to locate these and more. The LIC 'deficit' allegation did tarnish IRDAs image a bit but then LIC is the 800pound gorilla of Indian insurance/investing, which can get away with murder! Below are some examples of how investment managers of insurance assets are put on a tight leash.
  1. Except the role of independent investment advisor, insurance companies cannot outsource any of the investment management function. And the limited outsourcing allowed(asset class specialist/NAV calculation agent) cannot be charged to policyholders account , but must be borne by insurance company itself.
  2. While the Front office(fund manager+dealer) reports to CIO(Chief Investment Officer) who reports to CEO, the Middle office/Back office report to CFO. As both CIO/CFO report to CEO, there is some balance of control between front office and its control functions(middle/back office)
  3. Also, transfer of data   from Front Office to Back Office is 100% electronic(no manual intervention, even faulty data can only be rejected NOT edited), to avoid chance of cooking the books post transaction.
  4. For valuing quoted securities, market value is accepted only for quote not older than 30days. Otherwise, book value(net of provisions) is used. This heavy penalty would incentivize investment in liquid stocks, OR having a 'friendly broker' to trade in those shares prior to accounts closure. In contrast, SEBI permits using good faith valuation methodologies based on DCF, which incorporate the liquidity discount.
  5. To avoid the excuse of 'ratings dependence', IRDA clearly specifies(wef Aug'08) that rating is not a substitute for risk analysis(quite obvious but then the most simple things are often overlooked).

Are Mutual Fund trustees neglecting their duties?

As anybody conversant with the functioning of an AMC would know, there are ways to circumvent the statutory caps on fund management charges, expense ratio and brokerage. Till SEBi intervened, the practices were going on unabated, with the 'trustees' being passive onlookers rather than standing up and earning their fee. Atleast, independent directors of companies do resign when the mismanagement gets too much, but the esteemed mutual fund 'trustees' presided over
  1. Inflating advertising/marketing expenses of AMC to give under the table commissions to star MF agents. While this hit the AMC bottomline(as the overall expense ratio stayed fixed), the trustees should have scrutinized the expenses, which they did not
  2. Not ensuring that soft dollars benefit goes to the mutual fund. Agreed that SEBI regulations are silent in this regard, but soft dollars(non monetary credit for AMC expenses like research) offset against brokerage business, allow the AMC to post a lower expense ratio than justified, because it is paid for in higher brokerage rates(which affects net return but does not show up!). While SEBI regulations against concentration of broking business of MF somewhat contain this practice, it does go on unabated. 
  3. Championing NFOs Till SEBI intervened to stop the practice of simply relaunching existing mutual funds as NFOs, no trustee/AMC director(to my knowledge) put their foot down and refused to allow the practice. And why would they? Their fees would be endangered.
  4. Allowing opaque valuations of debt funds:- The FMP valuation controversy was whether illiquid securities were properly valued or not. Trustees should have ensured this, but nothing happened. 
MF trustees are expected to play the equivalent role to independent directors, but the extent of legal codification is much lesser for those 'trustees', who can therefore get away with laxity. While this post does not tar all MF trustees with the same brush, one must be wary before placing much reliance on their supervision.

Oil & Gas Industry-some interesting finance points

For a business plan competition recently, I chose to read the internal audit guides for both upstream(  and downstream( They are worth reading in their entirety for for their lucidity and glossary, so it would be time well spent. Some observations are below
  • Paying for information:- The owner of a well benefits by greater information when oil reserves are proven in the adjacent field. Hence, there is practice by that owner to pay bottom hole contribution to encourage the drilling of a well to help in evaluation of his own acreage or a payment made to ensure information about the result of a well drilled by another oil company. It is paid on reaching XYZ depth. Dry hole contribution is similar, but paid only when the well is proven to be dry(useless!)
  • Depletion/Depreciation/Amortization(DD&A): Probably the clearest explanation of the difference. Depletion relates to the reservoir, depreciation to the capitalised assets and amortisation to the cost of the license interest. This distinction is important during financial projections. 
  • Impairment testing asset group-field:- Impairment accounting tests often face the difficult question to determine whether assets are truly independent or not. Oil fields may consist of single reservoir or multiple reservoirs all grouped on or related to the same individual geological structural feature and/or stratigraphic condition. Hence, determining the group of assets of challenging in this case
Other general observations are about the importance of certain key financial management areas. For instance,
  • Refinery output mixes can be infinite, hence a proper LPP design is needed to optimize product mix. Reliance apparently uses 10,000+ variables in its LPP for Jamnagar refinery. 
  • The transport cost can be vital, and lead to savings at the retail level, so managing that is crucial. 
  • Given the large gap between cost incurrence and flow of revenues, the risk of assets turning bad('impairment') is quite high, for both operational and economic reasons(just becoming unviable at present lower oil and gas rates). Hence, one needs an asset level MIS to run that calculation
  • Capital budgeting needs to be top key, because the amount to bid for in a competitive scenario would not only depend on outside rates, but also one's confidence in forecasting abilities, which can only come from an objective record and evaluation of corporate level forecasting records

Analysts are rightly called analysts,not forecasters.

In James Montier's book 'The Little Book of Behavioral Finance', he paraphrases Graham's quote that “Analysis  should  be  penetrating  not  prophetic". Essentially, Montier suggests that all  investors  should  devote  themselves  to understanding the nature of the business and its intrinsic worth, rather than wasting their
time trying to guess the unknowable future. Several research studies show that few analysts achieve better results than by tossing a coin, and many in fact are much worse.

Friends of mine who have worked in or interned in buy side firms, are often visited by the sell side equity research analysts. Contrary to what we may think, the buy side analyst does not care about the final recommendation, but delves deeper into the assumptions/thought process/logic of the sell side analyst. After all, the buy side guy essentially aggregates the views/data/logic, but finally condenses them to form his own view on how the stock will move. And that is what investor should do-rely on analyst reports to make them more informed about the company, but not to attribute any superior forecasting skills to  the analyst.

Joint probability informs us as to WHY so many forecasts just get it wrong. Even an elementary DCF model has several point estimates about cash flows, taxes, discount rate, inflation, costs etc. Even assume 80% probability of getting each one right, the chance of getting ALL 5 right is just (0.9^5)=0.33. Now, one may argue that some errors may cancel out(some overstated and some understated) and so the overall forecast may still hold. In my view, analysts being the eternally optimistic beings that they are, the errors are likely to be one sided as in upward bias.

Much as we would like an all knowing oracle, that is not gonna happen anytime soon, atleast not in the public domain. Hence, we as investors should take explicitly take responsibility for our forecasts, instead of blaming analysts for their wrong ones.

Thursday, September 15, 2011

How ICAI is fast cutting the learning curve for new members

Veteran practioners have often recounted their war tales to me-of how they came to Mumbai from mofussil places to set up their own practice. Those days, unless you had a family history in the profession, setting up from scratch was quite difficult. I’m not donning rose tinted glasses and saying that entry in the profession is much simpler today. In fact, even old non Big4 firms are facing challenges to retain their growing clients and staff aspirations. Still, the ICAI is now doing a yeoman’s task to roll out a red carpet for its new members in practice, and to reverse the trend of new CAs preferring practice to service. Some examples are
·         Publications:- ICAI has published and allows free downloading of many industry guides, audit manuals, checklists etc(http://www.icai.org/post.html?post_id=6623). That facility allows net savvy CAs to download the manuals, read at their leisure and purchase only the manuals they wish. In fact, they can get entire documentation from scratch.
·         Loans:- Though open for all, it benefits newbies the most. The scheme(http://www.icai.org/post.html?post_id=6623) does not insist on collateral and is quite liberal compared to the other options out there.
·         Free  Software:- This independence day(16 Aug 2011), ICAI launched free office management software to help the firms prepare returns, ROC work, bank projections, manage correspondence etc. While there are other commercial solutions out there, having a free official version helps a lot
·         Subsidized software otherwise out of reach:- Areas like transfer pricing are not rocket science but they do require access to expensive databases. Same holds for litigation support practices(need Excus/TIOL etc). ICAI has arranged subsidized access to Tally ERP 9, transfer pricing software and other initiatives.
·         CPE Programs/Training:- While many CAs send their articled assistants to sign proxy in lieu of benefiting from it, some of these programs by industry stalwarts are really great and informative. If people go with some background knowledge, they can really learn a lot and also network with other attendees. For specialized areas like IFRS, Intl Tax, IT Audit; there are courses for  Rs 15000-30000 which do seem worth it, given the faculty profile and certification aspects of it.
·         Encourage networks:- For years, the ICAI would turn a jaundiced eye to networks of CA firms, but now it is actively encouraging its members to collaborate more and more, to be able to compete with the Big4. While few have succeeded, ICAI has spared no efforts in this regard to pave hurdles in its way.
Other reasons not quite attributable to ICAI are
·         LLP practices permitted:- These will allow CAs/CSs/CWAs/LLBs/consulting engineers to collaborate as individuals within a LLP framework, and specialize in their niche to give competition to bigger firms. While the older firms hesitate to induct other professionals, beginners can steal the march in this front, especially in new areas like cost audit(of which scope is now huge).
·         Increasing online governance/business:-Everything from corporate e-filing , tax payments, returns etc can now be done from the humble desktop. The need to suck up to the lowly departmental officers is now lesser(no chai pani for routine online work!) and now competition can be more on intellectual brainpower/experience than on decades old networks and contacts within the bureaucracy.  Softwares + cheap storage solutions allow for nearly 100% digitization, and lesser need to have huge bulky files eating up office/godown space. Hence, if not for the image, small offices are perfectly ok. 

I’m the first one to admit that ICAI is not perfect(far to the contrary) but we should admire and support its good initiatives.  So will all the above benefits induce me to enter practice? Probably not, but then that would not be for want of opportunity/support infrastructure.

Monday, September 12, 2011

LUBRIZOL acqusition agreement-some interesting features

Warren Buffet is undoubtedly one of the most savvy investors and acquisition experts out there. Hence, any M&A agreement entered into by him does bear some interest. I read through 50+ pages of the acquisition agreement signed to acquire Lubrizol(DEF14A filing in 8-K) and below are some observations.
  • Material Adverse Change definition:- While this boilerplate clause does exist, Lubrizol has a lengthy list of exceptions(generally geopolitical, macroeconomic,capital market related) which apply only to the extent such conditions have a disproportionate effect on the Company and its Subsidiaries, taken as a whole, relative to others in the industries in which the Company and any of its Subsidiaries operate. That clause makes it harder for the acquirer(Berkshire) to wriggle out, merely if the industry declines,
  • Representation as to published earnings guidance:- Even though companies routinely disclaim liability for their earnings guidance, Lubrizol assured that its the earnings guidance included in the Company’s February 2, 2011 press release continued to be reasonable, based on and subject to the assumptions stated in such release, and (ii) no event, circumstance, change, occurrence, state of facts or effect has occurred which would cause the Company to change such earnings guidance.This is a very interesting clause, because that means the acquirer can explicitly rely on that guidance. 
  • $200MM break fee:- This is payable only by Lubrizol to Berkshire(not vice versa) which goes to show the signalling effect of the latter. Even if any other acquirer buys Lubrizol within a year, the break fee is still payable, probably to reflect the due diligence value that Berkshire brings to the table
The deal is now nearly closed, but these 3 points are of interest to wannabe bankers and anybody involved in deal documentation. That is why this post. 

Sunday, September 11, 2011

Why I would still buy Educomp in this market

After the stock price of Everonn Systems crashed post the arrest of its MD, I thought it was time to go bottom fishing in the hitherto high valued education sector. To my surprise, while analyzing the sector, I found Educomp available at similar margins(P/E of 5, OPM of 50%+). The stock has  its negatives(underperformed the index for some time now, income tax raid) but the positives do seem to outweigh the negatives.

The positives in the stock are below. Investing now may seem like trying to catch a falling knife. But given the low P/B of 1.4(at Rs 165 book value), there is little downside risk.
  • High & Stable FII + promoter holding:- For ages, the promoter has held 49%+ of the stock, with little reported insider trading. Even FIIs hold 36% of the company, which does indicate some due diligence albeit with added volatility
  • Very focussed strategy:- While poring through their public filings(annual reports, concall transcripts, investor relations presentations etc) for the past 2 years, it struck me that they have segmented the market amazingly well-by age, by media(online/offline) and by need(school/vocational) etc
  • Distribution strength:-As mentioned by the CEO on one of the calls, they hope to leverage their direct reach to millions of students, to induce them to subscribe to their online properties. The ethics of this apart, the approach 
  • Capital allocation wisdom:- Unlike Everonn which invests its own capital in infrastructure, Educomp induced banks to fund its classroom equipment via non recourse securtiization. This allows them to invest that capital in greenfield school/college projects where they earn more.
  • Advisory Council:- They have set up an advisory council comprising respected professionals to give them counsel on their business and other issues. This is a very good step. 
  • Method in the madness:- I was apprehensive that they are trying too hard, and are in risk of over reachng/over extending. But given the core content and technology driven business, there are few technical issues in scalability.
  • Online portfolio investments:- Following naukri.com's approach of investing in startups/JVs, even Educomp has done the same. While it is difficult to value its JVs with the limited public disclosure, they have millions of subscribers, and therefore would attract a good sum in this inflated domestic dotcom bubble like market. Also, they committed Rs 50 crores towards a SEBI registered Venture Capital fund, which would yield some good returns. 
  • Substantial growth upside in school businesses:- As the table below shows, the bulk of their present Revenues/EBIT comes from the asset light SmartClass model, where they supply content to schools. But now, they have heavily investing in schools where the returns are just beginning to emerge. Management estimates that the grreenfield schools reach 100% capacity in 5yrs. Given that, and the famed demand supply gap for good schools(even if expensive), the growth potential is exciting.
    Rs in lakhs(FY11 audited) Revenue EBIT CapitalEmp EBIT% ROCE%
    Higher Learning Solutions 6,540.08 -2,922.74 31,731.06 -45% -9%
    School Learning Solutions 1,00,946.23 52,322.92 55,951.88 52% 94%
    K-12 Schools 13,573.21 4,765.61 1,61,285.60 35% 3%
    Online Supplemental & Global 14,030.45 -1,081.04 16,082.34 -8% -7%


Thursday, September 8, 2011

Wealth from Waste-examples of byproducts over the ages.

One person's waste is another mans wealth. Besides the wealth in recycling municipal wastes, there are less heralded examples of the same, expounded on below.
  • The invention of the electric bulb rendered kerosense virtually obsolete in the developed world, but the popularization of the motor car led to the use of the(then) discarded byproduct gasoline
  • Till evacuation infrastructure, refining, end use, tankers and high oil prices made it feasible to use natural gas, it was routinely burnt('flared off') at the oil rig itself, as it was seen to be a wasteful byproduct. But now, natural gas is the new petroleum!
  • Cement plants produce fly ash for which disposal agencies were paid, but on realizing its potential to product tiles, bricks and fertilizers; those same plants now get thousands of rupees per ton. 
  • Foreigners pay for their trash to be taken away but Indian homes routinely sell their newspapers/other junk to scrap dealers('raddiwalas') at a good price.
  • Carbon credits have given incentives to asset owners to preserve the vintage assets, which were not yielding them much anyway, just for the purpose of avoiding pollution. 
  • The egg shell is discarded after use for food processing(egg powder/omlette etc), and is presently used by companies as source of calcium carbonate. Prof Anil Gupta tells us that the inner membrane of that shell is quite valuable given its wound healing properties. 

Moral:- Production/R&D and Management accountants should work together to design a robust MIS to capture the details of their waste. This will permit periodic tactical price comparisons and 'process or sell' decisions to increase the contribution.

Why finance professionals should be marketing experts too

At first blush, marketing and finance guys seem poles apart(atleast in Bschools). Right from their MBAspeak(the finance guy talks of ROE/NPV/ROI while the marketing guy speaks of brand recall/ad impressions etc), choice of electives('number work' against 'globe') and in personal likes(market watching v/s consumer mind reading); these two seem very different. But years down the line, there will be more similarities than differences. The brand manager would have learnt to build metrics and investment case for marketing investments(ASPM) while the finance guy would have learnt that marketing the product(Yes, even banking services are increasing becoming products!:() needs that it should be tailored to the investor profiles and needs(viz marketing fundamental!).

Some examples of marketing expertise needed in the finance world are
  • Important and expensive financial sales(capital market funding, debt financing, PE sales, selling to institutional clients) happen through small group interactions like pitches, road shows, hedge fund meetings etc. There, Marketing 101 fundae apply in abundance like investor segmentation, tailoring the message to the investor; as do design fundae(slide graphics etc). 
  • Even on the retail banking side, financial products are sold more like FMCG items where hope/trust/brand ambassadors/anchors are deployed with impunity.
  • Marketing research is needed to capture customer trends and preferences, so that payoffs can be created and sold accordingly. For example, if research shows that investors are becoming risk averse, they can be sold principal protected notes(a zero coupon bond+derivative combo).
  • With intangible assets increasing making up the bulk of mcap, the corporate finance manager needs to appreciate the drivers and meaning of branding, human resources accounting etc. 
  • Nowadays, corporate communication is integrated with marketing to present a single face of the company to external and internal audiences. Hence, the investor relations guy needs to understand those marketing/Corp Comm fundae to effectively get his point across.

Monday, September 5, 2011

JJ Irani resignation from Everonn-is he fit to be an independent director?

Last Saturday, I opened Mint to read the shocking news of Everonn systems independent director Dr JJ Irani having resigned(http://www.livemint.com/2011/09/03011242/JJ-Irani-quits-Everonn-govt-s.html?h=A1). In an interview to Mint, he had said that I value my name more than anything else. I associate myself with corporate governance. A smear has been created and I don’t want to associate with a company that is being investigated. It is precisely this attitude that I take contention with.

As a senior Tata Group leader, drafter of the companies Bill 2009 and a renowed professional, Dr JJ Irani needs no introduction to those tracking the Indian financial sector. His practical and professional corporate governance experience made him perform a due diligence on Everonn and convince himself of its business mode, before he accepted an independent director's position. I'd blogged earlier(http://thescambuster.blogspot.com/2011/07/independent-directorsauditors-not.html) on this phenomenon of independent directors fleeing scam hit companies in droves. In case of Dr Irani, it is even more perverse than described in that post because
  1. As a chartered accountant, he's well equipped to appreciate and assess the merits and issues of the tax case and guide the company
  2. While directors are not bound to stick with the company through 'thick and thin', it makes no sense to appoint a director who will abandon you at the first sign of distress. 
  3. Unlike Satyam, the business model is not in dispute here, only the management integrity is. 
  4. By resigning, he has made it worst for the company when it needed the support of other investors the most. Now, even the Indian Govt(which had given 25% of national skilling program contracts) to Everonn, is worried.
  5. He had the competence, training and reputation to steer the company out of waters like how the 3 independent directors appointed later had done for Satyam. Unlike the earlier Satyam directors, this tax episode had not sullied the independent directors at all. 
As a company considering to appoint an independent director, I would certainly hesitate now because why should I pay them hefty fees/ESOPs/training if they will eventually ditch me in times of distress? As it is, the Indian Corporate Affairs Ministry(MCA) does not prosecute independent directors for routine law violations by companies, thus giving them additional security. The directors should rely on this and support the company in its kind of needs. Even the full time employees do not have a fiduciary duty to the company like how independent directors do.  This duty should be discharged when the time comes, not relinquished.  This single event made me lose my respect for persons who place their personal 'reputation' over helping investors and the companies.