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Tuesday, December 20, 2011

How to learn 'finance', investing and trading from scratch

Thanks to my background(CA student, CS/CWA ranker) and being the lone commerce student among a bunch of engineers, I'm often asked questions by juniors and peers alike about how to understand the aforementioned subjects. While I do not claim expertise in any of them-indeed I think the day someone stops learning is when he does that-I've read/invested/traded/learnt/done a reasonable amount to identify what works for a learner-and more importantly what does NOT work. So without much ado, I present below some points for someone from a non commerce background, to approach the field of finance. As many of the points would show, I'm  a great believer in the value of self education.
  1. Finance is not one huge homogenous entity: Take some time to appreciate the huge variety from asset management to corporate finance to investment banking. Whether you like finance, marketing, operations or HR, chances are that finance needs someone like you.
  2. Get familiar with the jargon by reading good financial papers:-And no, I no longer consider Economic Times a good paper, due to the overdose of commercial content and tendency to confuse reporting with merely reproducing corporate press releases. While their supplements are good on Sundays/Mondays, that is the best that can be said. Instead, I would suggest sticking to Mint-that sleek orange published by Hindustan Times
  3. Distinguish between learning and certifications:-Certificates are for the CV while learning is for your career. Stuff like NCFM/CFA is for the CV while mock trading/FRM is for the career, in terms of the learning value
  4. The utility of NCFM:-NCFM modules are a good introduction to the financial markets, although they do depict an overly good-goody picture at times. Unless you need a certification for your work like some stock brokers/bolt operators do, the certificate itself is of doubtful utility even as a signalling mechanism
  5. FLIP/other industry centered courses:-These often use multimedia, are current and practical oriented. Get feedback from other users/online forums, but these often are worth their price
  6. Which qualification to pursue-CA/MBA/CFA..:-Assess yourself, match your abilities and objectives, also the time you have(can you take a full time break) and which degrees/schools help best for what. For example, FRM may be best for an aspiring risk manager, while a MBA from IIM Indore may be best for an Operations career and so on. This would need doing a lot of ground work, but no pain no pain.
  7. Read Investor Letters/Transcripts/newsletters of experts:- Cisco's CEO John Chambers is renowned for his ability to 'call' the technology markets, Oaktree's Howard Mark's investor letters are the stuff of legend, and of course we have all heard of Warren Buffet's annual shareholder letters. But these are just the tip of the iceberg. In every field, be it self publishing or cooking, there are bound to be  experts who periodically share their expertise for free-even if on a time delayed basis. Use Google to find them, and then bookmark them.
  8. Follow websites/blogs:-Thanks to their focus and independence, they can often give better analysis than any mainstream writer featured in the press.
  9. Read financial history:-Books by Sorokin and a host of others, outline the history of crashes/booms/burst in great detail, and make the reader realize that this too will pass.
  10. Don't forget finance is NOT the main driver: Even for banks/M&A advisory firms, offering finance is often just the first step/qualifier. It is technology, operations, marketing, strategy that makes the difference. Firms who have boosted their ROE with clever financial engineering(as a basic DuPont analysis would show!) have often left their shareholders holding the baby. Clever financial acumen is NOT a substitute for good business judgement. If you are a LBO fund, then maybe it is under the originate and breakup model, but not if you need to run the firm.
  11. Get to know the faces/products behind the stock price; I cannot stress this enough! Many a time, a blue chip has stumbled because its leaders got arrested(Ansal/Everonn/DB Realty/LIC Housing Finance/Money Matters), management decided to spend on things like planes(Crompton Greaves) or merely because it was propped up by market manipulation(K10 stocks). And even the products/services matter. Because devoid of a clear market differentiators, that company will inevitably lose cash, and the management will have its ostrich head too deep in the sand to realize it, by which time it may be too late(like Money Matters).
  12. Get a brokerage/demat account with Edelweiss:- I name Edelweiss-not because it is founded and owned by an IIM-A alumnus-but because it offers a great dashboard for seeing the fundamental parameters of a stock-and that too for free! Plus its data tools beat anything I've seen yet-and al that for free! Opening an account would get access to better functionality plus hopefully encourage them to keep those dashboards/tools free for others!
  13. Identify your niche:- Some of us are great with words, others with numbers, yet others with that quick intuitive grasp of business or pattern recognition skills..the list can go on endlessly. For each of those skills, there is a great niche. For example. those good with words and a legal understanding, can pore through legal filings/notes to accounts to uncover value, as done by such sites(http://10qdetective.blogspot.com/). Those good with numbers can use DCF to good extent, those with business grasp can pick midcaps with growth potential/become VC investors, while those with pattern recognition skills can make their fortunes in technical analysis. All these are not only hobbies but great careers in themselves.
  14. Do mock trading and maintain a trading diary:-In retrospect, we can rationalize to an amazing extent and even convince ourselves that we infact predicted events/did right things when we did not. Having a written record helps track those decisions, and base your faith in judgements on past empirical data. That said , past does not reflect the future as in those famous mutual fund disclaimers BUT note that even CAT/other objective exam preparation institutes suggest using past data on mocktest performance to refine test taking approach. So nothing wrong in it.

Sunday, December 18, 2011

Lessons from Whitney Tilson short position in Netflix

For those who read Seeking Alpha and other investing websites, the public debate between Whitney Tilson(a self professed 'value investor') and those bullish on Netflix, was very evident. Netflix is the pioneer of streaming unlimited movies via cable for a fixed monthly subscription. And till the last quarter, it was the darling of the stock markets, with its fans refusing to see any competition from cable TV, Amazon, Coinstar etc. It took a brave hedge fund manager Mr Tilson to go short on the stock. But after racking up tremondous losses, and perhaps under investor pressure, he decided to close his position, and swung to the other side!  While the next 2months price movement proved his exit decision right as the market went up even more, his original thesis was validated when Netflix lost nearly 80% of its value and closed at $78 or so. Those interested int he whole story can read it below

The lessons learnt from the episode are quite instructive, and have not been covered in depth on the web(atleast not in any resource I saw).
  1. Market remains irrational longer than you can remain solvent:-Netflix stock did not correct till the company demerged its divisions AND increased the prices. That proved Tilson right, but too late in time as he had closed his positions
  2. Being too ahead of your time is like being wrong :-Tilson closed his positions 7 months before the shares hit bottom! That time difference proved him wrong
  3. Other people's money adds leverage but also pressure on you:-Tilson was not investing his own money but that of his investors. In theory, he did have the absolute power to remain firm, but given the investor pressure to cut his losses, he probably decided to throw in the towel
  4. Social Media/scrutiny/discussion can influence adversely: Unlike other hedge fund managers who restrict their arguments to filings/offers, Tilson decided to write articles and give wide publicity to his idea. While that did invite comments and feedback to refine his view, his letter on closing the position, said that he was influenced by those arguments, which in hindsight were proven wrong. So is this the poster child for not making investing rationale public? I can't say but transparency did hurt in this case.
  5. Friendships sometimes make us do weird things:-Even while attacking the company, Tilson did not attack the CEOs competence, who (coincidently?) was a friend donating to the same charities. While Tilson must have convinced himself of his objectivity and impartial nature, the fact remains that his Feb-11 letter closing the position, referred to the Netflix CEOs letter. Since when did short sellers listen to the company CEO plugging the stock? That is what Tilson did.
All these, especially #1-#3 should be quite instruc

Saturday, December 17, 2011

Zynga and Google-more simillar than different?

Many of you would heard of Farmville/Cityville. The company which produced those games('Zynga') recently had an IPO at a $10bn valuation, riding the dotcom bubble. To be fair, the company has been making profits though. At first blush, nothing seems to link Zynga and Google except that Google was a pre IPO investor in Zynga, and has been linked to takeover attempts/bids. But on a closer reading of the Zynga prospectus(http://sec.gov/Archives/edgar/data/1439404/000119312511341923/d198836ds1a.htm), quite a few similarities pop out. The small text is a direct quote from the Zynga prospectus, and the text in normal font is my remarks.
  1. Free:-All of our games are free to play, and we generate revenue through the in-game sale of virtual goods and advertising. Even Google does the same, with only enterprise applications being priced, and that too selectively.
  2. Network Effects:-Because the opportunity for social interactions increases as the number of players increases, we believe that maintaining and growing our overall number of players, including the number of players who may not purchase virtual goods, is important to the success of our business. Google search results are 'intelligent' and improve from each search. Also for applications like Gmail, the network externalities are good. 
  3. Data driven:-gather daily, metrics-based player feedback that enables us to continually enhance our games by adding new content and features.We continually analyze game data to optimize our games. We believe that combining data analytics with creative game design enables us to create a superior player experience. Google is also a famous analytics fan, which it uses to inform decisions.
  4. Dual Class voting shares:-Zynga has a triple class voting share, which gives the founder around 36% voting power post IPO(1 share of his Class C shares=70 votes of Class A shares). This structure was held by Google as well.
  5. Cloud Computing Dependence:-Zynga uses Amazon Web Services, while Google is all about cloud computing especially for Google Docs
  6. Hiring through acquisitions: We have historically hired a number of key personnel through acquisitions, and as competition with several other game companies increases, we may incur significant expenses in continuing this practice. It is a lesser known fact that many popular Google applications like Orkut, Picasa and the like were acquired through early M&As. 
  7. Letter from founder in IPO document:- Actually this is more like what Amazon did! But since Google tomtoms its principle especially 'Do No Evil', I thought there was a similarity there.
Still, one should not stretch the analogy too far. Google has survived multiple crisises and competitors, which Zynga brokeven only in FY10, and has yet to survive  extreme competition. But one must admire the essential freemium similarity in the business model. 

RBI Governor critiques ICAI on CPE, seeking monopoly, forum representation

Its a habit of mine to read speeches by RBI Governor/Dy Governors to glean some insights into their way of thinking, and also generally to know what issues are generally concerning the economy. And while reading the RBI Governor's speech on Challenges to the Accounting Profession Some Reflections as an inaugural speech (http://www.rbi.org.in/scripts/BS_SpeechesView.aspx?Id=642), I was not disappointed. The Governor faintly praised the ICAIs efforts in helping the RBI perform its regulatory role, but remarked that
  1. Continuing professional education cannot be a mere ‘tick in the box’ or determined by participation in number of hours of education or training, but should be evaluated by way of outcomes - upgradation of relevant knowledge and skill sets. 
  2. Needless to say, the process of selection of persons for representing the Institute in international forums should be strictly meritocratic and transparent.  
  3. So far, you have enjoyed a monopoly position in respect of certain areas of work, for example, the audit of financial statements. The easy way out to seek and expand opportunities would be to agitate for continuation of this monopoly position. I believe this will be a mistake. Rather, the profession needs to identify emerging opportunities in the market place and develop the skill needed to exploit them.  
  4. It makes much more sense for the profession to sharpen its skills in the area of concurrent audit for which a need exists than to agitate for retention of work which does not add value. Similarly, the profession has shied away from the responsibility for prevention and early detection of fraud. The need for such a service exists and if the profession does not fulfill that need, other agencies which can provide this service will displace auditors and deprive them of a potentially expanding opportunity. This statement was given in the context of reducing branch audits for PSU banks, which ICAI has opposed. 
All these points are valid, and ones where the institute has been lacking. My views on them are
  1. I have blogged earlier about how the CPE hours system is gamed, or backloaded towards year end to meet the mandatory commitments. While WIRC/ICAI have been trying their best to persuade members to spread the attendance evenly instead of only in December, I do not think the efforts are much good. And as long as the practising members view these CPE sessions as a place for good food and networking, things will not change.
  2.  Regarding the process of selecting people for forums like IASB/IFAC etc, ICAIs representatives have been invariably Past Presidents/leaders of the profession. But is there anything wrong in advertising the vacancy transparently, so that those interested can apply? Such a process would be more transparent  than the back door lobbying which may be otherwise suspected.
  3.  About seeking more opportunities for its growing members, well that is what ANY professional association is bound to do in the interest of its members, whether or not it be in the public interest. Why else do ICAI office bearers meet the new entrants of MCA(secretary/minister) soon after change? Why else has ICAI pushed for accrual accounting and public accounting reforms? I would say ICAI lost the first wave of opportunities in investment banking/corporate finance to MBAs, and now is in fear of losing it to programs like CRISIL CCAP/ICICI-NIIT MBA-which substitute full time professional education for on the job training.
  4. To be fair, ICAI has been introducing certificate courses and training at a rapid pace, and also educating members about different career opportunities. But if such an eminent personality like the RBI Governor has such an impression about ICAI, then maybe we should speed up the process of change, and demonstrate tangible value addition in the services where we do not have monopoly. 
I would welcome comments from esteemed members on this topic, in a constructive light. It is better to hear the warning signals now, than wake up when the danger is at the door when it would be too late.

Karuturi Global Africa agriculture foray-goldmine or landmine?

Earlier this year, I blogged about Karuturi Global's foray into Africa and its professed noble goals of meeting African food security etc (http://financeandcapitalmarkets.blogspot.com/2011/03/meeting-food-security-in-africanot-from.html). Since then, many things have changed which I thought should be highlighted in this post, for readers to take a balanced view
  1. Water Wars:-The 5 upstream nations sharing Nile waters, entered into a treaty to improve their share of Nile waters, contrary to the historical preferential rights of Egypt and Sudan. While Egypt and Ethiopia are trying to resolve this(http://www.upi.com/Business_News/Energy-Resources/2011/09/23/Egypt-Ethiopia-mull-Nile-dams-dispute/UPI-28691316789638/), there is bound to be disputes and lack of clarity, which would hit investor sentiments
  2. Land grab accusations grabbing momentum:-Karuturi's deal is held up as the perfect example of a sweetheart deal by activists, who overlook the capex it has to incur. But in case the Arab spring reaches Ethiopia resulting in a regime change, then I would not be too optimistic about the fate of Karuturi. Even its MIGA guarantees will not compensate much for loss of profits. 
  3. Investors shunning risk:-With the turmoil in USA/EU, Karuturi would be hardpressed to find financing for expanding in the way it wished. Ditto for getting JV partners for food processing and storage. The way things are going, its completed sowing may be the peakk output
  4. Climate risk:-Karuturi lost its first corn crops when around 12000 acres were flooded this year. The loss of $15MM was around 1/5th of the company's market cap at that time(http://www.ethiopianreview.com/content/34462) . Given the rising risk of climate change, such shocks may only increase in the years to come. 
Of the 4 risks, I would rate expropriation and climate risk as the main two factors, and it would be interested to see how the company deals with these risks. 

Thursday, December 15, 2011

Mr Sunil Behari Mathur earned Rs 1.27 million for attending 1 meetingof HDIL

While reading the latest annual report of HDIL(http://www.hdil.in/pdf/annual_report_2010-11.pdf), it struck me that Mr SB Mathur(ex Chairman of LIC), now on 12+ boards, had attended only 1 out of 5 meetings held in FY2010-11. While he got sitting fees @ Rs 20,000 just for one meeting, he earned the same commission(Rs 12.5 lakhs) as the other directors did.  And to top it all, he had not attended the previous AGM. He is thus a poster child for a serial independent director, less interested in the company than in fees.

Now, one can argue that AGMs are anyway a waste of time as are board meetings where management decisions are just rubber stamped. If that is the case, he is an extremely expensive rubber stamp earning Rs 1.27 million for attending just 1 meeting. And lest you think this is an exception, he had attended just 3 of 5 meetings in FY2009-10, acceptable but not stellar by any stretch of imagination. Given that he's on the board of a realty company considered to be in a murky sector, one would have thought he will pay extra care to that company as opposed to other financial services companies etc. But no, he got away with attending just 1 meeting, and was reappointed as well. So what can investors do about it?
  1. Shame:-For starters, bring a resolution seeking that for the above reasons, the director should not be reappointed. I agree that illness etc may have prevailed, but that attendance record should have certainly been explained to the shareholders, which was not done. 
  2. Voting:-Casting a negative vote, especially by institutions would have sent a strong message. 
  3. Keep track:-Read the annual report and keep and eye for such things.
Now, I have nothing against Mr Mathur and admire the work he has done while in LIC. But such conduct as an independent director of a listed company, does not befit his reputation. If I'd invested earlier in HDIL, I would have brought a shareholders resolution before the AGM itself. But I guess that would need to wait till next year now. If any reader thinks I'm being too harsh, then feel free to comment civilly below,.

Tuesday, December 13, 2011

What economists can learn from weather forecasters

In a speech to the Australian Business Economists Association, the Australian Reserve Bank Governor Mr Glenn Stevens compared weather forecasts to economic forecasts and made some interesting points. One can read the complete speech here(http://www.bis.org/review/r111129d.pdf). Some points he made were
  1. Weather forecasts are based on understanding the big forces. that day's dynamics and explictly state their margin of error/give a range. Also, these are based on huge masses of data
  2. Economic forecasts are similar but do not generally explicitly state margin of error.
  3. Decisions based on economic forecasts may alter the outcome(like policy making, saving, spending) and so the process of economic forecasting is much more difficult. 
 Many financial authors and investors(in particular Mr Howard Mark of Oaktree) have trashed economic forecasts because they are often wrong, because there is little amity among forecasters, and because they have wide margin of errors. In contrast, despite our jokes about the weathermen, their short term forecasts are usually correct.

But to satisfy the logical side of us that hates ambiguity, forecasts are essential. So how to improve economic forecasts? Apart from not forgetting the big trends, having and using huge data masses of stock price/economic indicators should improve the accuracy. But most importantly, like how auditors are careful to word their audit reports to reflect the limited scope/margin of error, even economic forecasters should do the same, to bring more credibility to the profession.

Saturday, December 10, 2011

Fixed credit rating fee cap model for some issuers-is CARE heading for disaster?

CARE had issued a draft prospectus earlier this year(http://www.sebi.gov.in/cms/sebi_data/attachdocs/1317804515879.pdf), and being a credit rating agency, I was sure that its prospectus would make interesting reading given the recent macroeconomic turnmoil in EU/USA etc. And I was not mistaken. It was interesting, but for another reason. Risk factor 7 reads as follows(emphasis added is mine alone)
As a part of our efforts to compete effectively, we have adopted a fixed fee cap model for certain clients for a particular duration of time. Once the fee cap is exhausted, we are, as part of our terms of engagement with such clients, restricted from charging them any additional fees for additional debt issuances or bank loans or facilities availed for the duration of the period agreed. If we are unable to negotiate fee caps with these clients at appropriate levels and if we exhaust the fee cap, we will be required to continue to perform our services in accordance with the terms agreed with such clients for no additional fees. If this occurs with a large number of clients, our business, results of operations and profitability could be adversely affected

The issuer pays model by itself has inherent conflicts of interest, which competition would address to some extent, by ensuring a check on quality. But such an agreement implies exclusivity and tie in, because no issuer will rationally use different credit rating agencies, when it can get a 'free' rating from CARE once its limit is exhausted. Yes, CARE may get pissed but it can't even tinker with the rating to get even! There may be a tendency to cut corners by using the earlier work as the basis to rubberstamp opinions for fresh issues. After all, given the option of working on new mandates versus working on no-extra-fee mandates of the client when cap is crossed, which one would YOU prefer? the client would not care less, but users of the rating would. One can only hope that SEBI Code of Conduct is applied in letter and spirit, to ensure that fees do not affect the quality if miscalculated wrongly.
Discussions with those in the industry inform me that this is now a standard practice, especially for frequent issuers. So maybe I was too harsh on CARE.  

Muthdoot Finance pre IPO trademark poison pill

While reading the draft prospectus of Muthdoot Finance(http://www.sebi.gov.in/cms/sebi_data/attachdocs/1323411962927.pdf), I noticed an interesting thing that though the company had the 'Muthdoot' trademark registered in its own name(which it had been using since inception), the promoters filed a rectification application in Oct-10, not contested by the company, where they required that the ownership of the trademark revert to them. The company will still be allowed to use the trademark for a fee of 3% PAT, as long as the promoters continue to hold 51% in it.

Now, the rate of royalty does not seem unreasonable compared to other trademark fees like of the Tata name etc. What is interesting is the timing of the application. The promoters must have decided that they might as well as milk trademark fees from the newly listed entity, as corporate governance norms will minimize any potential for siphoning funds. Also, this does act as a slight deterrent to corporate raiders. I'd blogged earlier about this being done for personal services businesses, but it seems Indian promoters are now becoming more IT savvy, and cautious about losing it in the event of a takeover/sale of pledged shares.

Friday, December 9, 2011

20months cash cost breakeven-the dangers of DishTVs strategy

Now, none of us would like to be classed as 'average', and I'm the first one to admit that there are quite a few pitfalls in that. Still, for the purpose of analyzing aggregate data, that would serve fine. To further appreciate the rest of the this post, read the DishTV presentation(http://www.dishtv.in/Library/Images/DishTVInvestorPresentationOct.2011.pdf) and my brief primer that follows
  • As one knows, DTH companies spend heavily to get the customer to buy their set top box
  • DishTV defines subscriber acquisition cost as, set top box subsidy+commission to dealer who sells/installs it + 80% of marketing spend! Now, one may argue that 80% of marketing spend is nothing but arbitary overheads allocation. Even if that maybe, the fact is the spend would be taken with that outcome in mind, so if the company expects 80% to earn sales, so be it. SAC is between Rs 2100-2300 at present.
  • ARPU(average revenue per user) is internally split by DTV into amount attributable to service charges+FTA channels(presently Rs 100) and the balance for pay channels. ARPU around Rs 150 levels, expected to touch Rs 160 due to more HDTV etc. 
Now, all busineses have marketing costs and I daresay if FMCG/ITES sector calculated their Customer Acquisition Cost as conservatively as imputing 80% of marketing spend, then those figures would seem high as well. But going with what we have, the trend I noticed is even at improved ARPUs, the breakeven period at gross ARPUs of Rs 152(net Rs 114 after content costs) will be 20months to recover the subscriber costs of Rs 2232.


Of course, DishTV expects their ARPUs to grow exponentially due to HDTV revenues. But this graph(should not be much different for other plays) shows that DishTV is playing a numbers game to retain their 30% market share.  

But the danger in that, is DishTV themselves introduced a device card to make any STB of other operators, compatible to receive signals from DishTV. While DishTV packages this as Dish Freedom(http://www.dishtv.in/dish-freedom.aspx), this equivalent of mobile number portability for STBs may unleash an industry war, with players deciding to compete on content. After all, if DishTV can attack the installed base of other players, so can they. But like how MNP failed for mobile phones, DIshTV can only hope that subscribers will stick to the incumbent. But if the competitor comes and offers this device for free to hook DishTV subscribers, then it is a whole different ball game.

So what does the market think about this? Dish TV has gained 42% in the past one year, spurred no doubt by growing ARPUs and dominance. And its market cap of nearly 6500 crores(versus debt of just 1200 crores odd) for a 13million STB base, speaks of an implied valuation of Rs 5000 per STB, which is nearly twice the acquisition cost! Can this eyeballs game continue for ever? As CAs, MBAs and other professionals maybe we should think about the prudence of this approach for our clients.

Want to avoid writing down your assets? Use a merger scheme like DishTV

Suppose you sold an asset worth Rs 80 at that value, but you had paid Rs 100 for it, you would expect to take a loss of Rs 20 in your P&L(and naturally then in your equity). Even if you decide to keep that asset with yourself, AS-28 requires you to book that same notional loss as an impairment loss, since its value is permanently eroded. But Dish TV managed to keep the asset in its subsidiary AND avoid routing the loss through P&L(though even they could not escape the balance sheet effect)

While reading the FY11 audited consolidated accounts of DishTV(India's largest DTH operator, which is still lossmaking), the italicized portion of the audit report leapt out at the page, since it was nearly 50% of the report. Intrigued, I read further and found that they had transferred non DTH assets to a subsidiary, presumably to maintain 'core' business in the holding company. Seems fine, except that the transfer was done at below book value, and the loss was taken to the General Reserve. Why did they not follow the standard route of transferring the assets at cost to maintain tax benefits? If that was done, the eventual asset writedowns would have been upstreamed to the consolidated P&L. This way, they managed to get the court approval to treat this as a merger induced one time writeoff, worthy of being routed to the balance sheet directly without passing through the P&L. Ideally and following conservative accounting practice, the asset should have been written down first before being transferred to the subsidiary at a loss. That is what AS-28 on impairment would have demanded.

So what is the impact? Rs 175 Crore of impairment loss was directly reduced from equity, without also reflecting in the consolidated loss. One can read the original audit report here(http://www.dishtv.in/Library/Images/ConsolidatedAuditedFinancialResults.pdf). For once, a Big4 auditor BSR(an Indian affiliate of KPMG) seems to have done its business well, to point it out to the investor. But I must admire the ingenuity of the DishTV Corporate Finance team. They did stumble upon a good trick to use court sanctioned merger schemes to avoid taking accounting losses, which for a loss making company is a substantial benefit irrespective of the other business merits of the decision.

Thursday, December 8, 2011

Understanding how do banks work-some FAQs for investors

The inspriration for this post came from the fact that banks are difficult to understand, and even more difficulty to invest in. For this, I referred publicly available documents like RBI master circulars, NCFM banking sector module(http://www.nseindia.com/content/ncfm/ncfm_bsme.pdf) amongst others.
  1. What does a bank do? The basic functions are intermediation and payment services. Any other services like advisory etc are icing on the cake.
  2. What do investment banks invest in? They do not themselves invest(atleast thats not an essential attribute) but act as an intermediary between issuers and investors, for which they can often get fees/commission from both
  3. Why do banks eventually become conglomerates offering A-Z financial services? Though banks claim that this allows them to service the customer better/have all services under one roof, the real reason in my view is the benefit of cross selling, economies of scale and the wider scope for knowledge management. For example, a commercial bank may have an excellent knowledge base on some industries, which can be leveraged into good research reports for the investment banking/broking arm. Or the same online banking platform can be used as single sign on login to give the customer access to other services, without incremental customer acquisition cost. And more the products per customer, the higher should be the customer retention rate. 
  4. Explain the CAMELs model to evaluate a bank's performance: This model is implicitly used without acknowledging in many banking analyst research reports, but I notice that they often miss out on the liquidity and asset quality aspects, which came back to haunt the sector in the later part of 2011, with power sector NPAs, defaults in farm loans/student loans, more CDRs etc, all culminating in the downgrading of some banks by the credit rating agencies. Anyways, CAMEL is
    1. Capital Adequacy;-This is a measure of financial strength, in particular its ability to cushion operational and abnormal losses. It is calculated based on the asset structure of the bank, and the risk weights that have been assigned by the regulater for each asset class. Post the subprime crisis, I think we should give bonus for "Too Big to Fail"
    2. Asset Quality:-This depends on factors such as concentration of loans in the portfolio, related party exposure and provisions made for loan loss
    3. Management:-Management of the bank obviously influences the other parameters. Operating cost per unit of money lent and earnings per employee are parameters used. In Indian context, I think implicit government guarantee for PSU banks, is a +ve here.
    4. Earnings:-This can be measured through ratios like ROA, ROE, NIM
    5. Liquidity:- In order to meet obligations as they come, the bank needs an effective asset-liability management system that balances gaps in the maturity profile of assets and liabilities. However, if the bank provides too much liquidity, then it will suffer in terms of
      profitability. This can be measured by the Loans to Deposit ratio, separately for short term, medium term and long term.
  5. What does financial inclusion imply for bank business models? It means that if the banks want to open more branches in metros/cities, they better focus on the unbanked. This is over and above their 30% lending requirement to priority sector
  6. Basel III/Volcker rules:-A classic example of bolting the stable after the horse has escaped. It makes banks hold more capital, measure risk more conservatively, cap their pay and a whole host of measures to ensure banks bear some of the costs they impose on others. This debate is clouded with acronyms and technicalities, but that is the essence of it. To avoid regulatory arbitrage, major financial centres should implement these measures consistently, and that is what holds up the implementation of these rules.
  7. What differentiates NBFCs from banks? They do not have access to cheap bank deposits from the public (in the form of savings account, current account etc.although they can accept fixed deposits. Their cost of funds being higher than banks, their lending is costlier.
  8. Why do people borrow from NBFCs at costlier interest rates? Because they are unable to mobilise funds from banks, or to fund their requirements beyond what banks would give. NBFCs are particularly active in consumer finance and personal finance, as they are flexible, have laxer credit standards, and often give higher loan to value ratio on secured asset financing(cars etc).
  9. What are scheduled banks? Banks which meet specific criteria are included in the second schedule of the RBI Act, 1934. These are called  scheduled banks. They may be commercial banks or co-operative banks. Scheduled banks are considered to be safer, and are entitled to special facilities like re-finance from RBI. Inclusion in the schedule also comes with its responsibilities of reporting to RBI and maintaining a percentage of its demand and time liabilities as Cash Reserve Ratio (CRR) with RBI.
  10. Why this whole debate on government stake in PSU banks falling below 51%? Other sector PSUs do see this. Even in other sectors, the privatization debate is kicking and alive as the respective sector ministry sees the PSUs as their turfs to implement populist policies, promote loyalists and generally display their power. In banking, while the finance ministry(the owner) itself favours divestment, others do not because that would reduce the power of government and politicans to direct PSUs on lending, CSR etc. For example, no private sector bank would have given Kingfisher Airlines such a long rope as SBI had given, some attribute this to the political influence of the owners. Even industrialists prefer PSU banks for their riskier loans! Of course, the arguments against this are couched in terms of valuation, affecting financial inclusion etc.
  11. Why SBI has not merged with its subsidiary banks? There are labour issues because the main SBI staff have better terms of service than those of the subsidiary banks, and hence integrating the workforces is an issue. This issue had cropped up in AI-IA merger also.
  12. How big are Indian banks versus global banks? Not very big in terms of assets. But then, they are more profitable and 'safe'.
  13. Where do I get reliable data on the Indian banking sector? The RBI releases reports and statistics on the sector, which can be downloaded from its website. For example, the FY11 reports are available at this link. Generally, Mint and other financial newspapers analyze those reports on the day of/soon after their release.
  14. Why are voting rights per shareholder capped at 10%, what would this imply for the valuation? Well, the RBI and other financial sector regulators do not want economically important entities like stock exchanges, banks, insurers etc to see concentration of ownership. Hence, the 10% rule leads to broadbased ownership. While there is no study on what is the valuation impact, one could argue that the voting stake beyond 10%, should be modeled as a Differentiation Voting rights share with economic benefits w/o voting rights! That model would invariably lead to a discount. 
  15. What is this whole financial inclusion furore? Thanks to challenges of geography, income inequality, logistics, technology etc, it is not practicable to profitably operate one branch in each of India's 600000 villages. Instead, it is proposed to use para banking(MFIs, banking correspondents, NBFCs) and  existing retail outlets( post offices, village knowledge kiosks) as outlets, use multi-language technology platforms via mobile phones etc. An unsaid fear is that while moneylenders can counter populist politician calls to voters of not to repay loans, banks constrained by the code of conduct and slow legal process, are helpless in the event of such political interference, which brought the MFI industry in Andhra Pradesh on its knees. 
  16. What are priority sector lending norms? Why does that encourage specialized institutions like MFIs and gold loan companies? The RBI currently mandates domestic commercial banks operating in India to maintain an aggregate 40.0% (32.0% for foreign banks) of their adjusted net bank credit or credit equivalent amount of off-agriculture, small enterprises, exports and similar sectors where the Government seeks to encourage flow of credit for developmental reasons. Banks in India that have traditionally been constrained or unable to meet these requirements organically, have relied on specialised institutions, better positioned to or focus on originating such assets through on-lending or purchase of assets or securitised pools to comply with these targets.
  17. What are the larger implications of the sector? Money talks bigtime. One of the obstacles cited for slow growth of organized retail/farm credit etc, is that farmers are indebted to the traders/landlords/rich farmers for their personal loans/crop loans, and are thus compelled to sell their produce to them for lower rates, and buy inferior inputs at higher rates. It is hoped that micro loans and rural credit will break the financial dependence of small farmers. Once this is done, one can explore reforms like rural warehouses for grains, retail reforms etc.
  18. How do many big banks manage to release their audited accounts before even a month elapses from year end? Thanks to the multiplicity of audits(concurrent, internal, inspection, RBI inspection, systems), the bank internal control systems are generally current. And the existence of core banking and sophisticated internal control systems ensures that the records are reasonably uptodate. That is why balance sheet audit of just test checking major accounts balances/revenue streams is in vogue.
  19. Non fee income:-More is better as it insulates a bank from the competition induced squeeze on NIM. But if these profits come from derivatives trading, then the quality of earnings may actually be lower and thus the bank riskier! Unfortunately, few banks disclose the true extent of their non fee income dependence on such activities. 
Phew! that ended a longish post. Depending on the response and my time constraints, I'll follow this up. 

How you can lose money by solely relying on moneycontrol.com or brokerage sites for your financial analysis/data.

For a retail investor, these sites seem a godsend. Multiple years data, covering income statement, balance sheet, cash flow and other information(notes to accounts etc), often downloadable in Excel. And depending on the site, one can read the latest annual report online, see graphically displayed ratios or do peer analysis. Little wonder then, that one may see little utility in the laborious process of downloading the annual report from company/NSE website and then poring through it. Ordinarily, I would agree with you on that, but after some near-mishaps from using that data,  I realized that if not careful, one could base the decisions on wrong information and lose a chunk of money. Below are some pointers to keep in mind while using these sites. In all fairness, I must admit that websites like moneycontrol.com/Edelweiss have a good interface and address most of this. But it is for the investor to be aware and confident.
  1. Standalone or consolidated data? Some websites may update standalone data by default, even if the company releases consolidated data. While this would generally conservative(as subsidiaries should be profitable), this may understate the real profit for companies in lossmaking growth areas etc. Hence, be aware of the data especially for book value and profits. It also affects infra companies like RInfra whose profits are centred in the operating subsidiaries.
  2. Income from continuing operations/restated data updated:-When companies divest their main arms like how Piramal Healthcare did a year back, the common practice abroad is to release a 5yr proforma data of the remaining continuing operations. While Indian companies do not do so, remember that the dramatic improvements in the ratios you see on the website, maybe simply because the company divested its lossmaking operations/did some corporate restructuring to take it off its books.
  3. Whether latest book value updated:-Some websites do not update the book value despite the 1H'12 earnings release containing a brief snapshop of that;albeit unaudited. That makes a material difference for companies like SKS Microfinance, which announce a sizeable loss every quarter!
  4. Is the EPS data for FY11/TTM:-For the P/E ratio, do check whether the EPS data is for the previous completed year, or trailing 12 months
  5. Definition of ratios:-Before relying on unaudited non GAAP numbers like operating earnings/EBITDA etc, try to match those numbers to the income statement, since each website typically has its own definition.
  6. Adjusting shareprice graphs/data for splits/rights issues:-This is a very common source of mistakes, where a share post 10:1 split may trigger a stock screener for losing 80% of its value within 1yr! While a glance at the graph would make it clear to any savvy investor, be alert for such events while analyzing stocks which have lost enormous value in that year. 
 This list is just the tip of the iceberg, and investors should take due care remembering the maxim of 'garbage in garbage out'

Tuesday, December 6, 2011

Why DCF fails on valuing banks

In his research paper on valuation of financial firms(http://people.stern.nyu.edu/adamodar/pdfiles/papers/finfirm.pdf),  the NYU Stern Professor and renowned valuation authority Prof Ashwath Damodaran gives a few insights on why DCF is not practical here. Besides the heavy regulatory dependence(on revenues, costs, leverage), banks also suffer from the handicap of classifying cash flows. Simple looking metrics like interest, capex, debt all need to be abandoned or redefined in case of banks.

But DCF has been the holy grail of valuation, so even if we abandon it how can we take anything else without some base? Well, for a going concern, the book value is the very minimum that the share price can fall to. Not coincidently, one of the most common metrics used is price to book value, where the excess>1 is defended based on intangibles, earning power, P/E and other factors. But it is agreed that these all are relative, and you won't see a DCF for a bank anytime soon. So is that model fundamentally flawed? Given that valuation is inherently subjective, this is not too bad a bargain.

Saturday, December 3, 2011

The dangers of investing in cyclical stocks

While reading the Uttam Gawla rights issue document(http://www.sebi.gov.in/cms/sebi_data/attachdocs/1322823696255.pdf), I stumbled upon a good explanation of the sugar cycle, on which I build upon to explain the dangers of investing in cyclical stocks.

Domestic sugar industry typically follows a 4 to 6 years cycle. Profitability of sugar manufacturing units  depends largely on the stage of the cycle witnessed by the industry.Years of low production and declining sugar stocks may be followed by years of excess production that result in over-supply of sugar to the domestic markets, causing a decline in sugar prices and industry profit margins. Higher sugarcane and sugar production results in a fall in sugar prices and non-payment of dues to farmers. This compels the farmers to switch to other crops thereby causing a shortage of sugarcane, consequently an increase in sugarcane prices. And then, when limited supply causes sugar prices and industry profit margins to increase, sugar imports are usually liberalized. Import of white sugar then becomes an attractive option and which, in turn, would drop domestic prices and thereby impact sugar mills financial condition. But while the MSP of sugarcane is quick to increase with rising sugar prices, it is NOT adjusted downwards when the prices correct. Hence, the mills have it bad both ways.

So at its peak, with great earnings and profits, the valuations may seem attractive by any measure(P/E, P/BV or  dividend yield), but then when the peak slides, the same stock may look overvalued. But does data back this seemingly logical view?

Take a look at the graphs below. If the above view was to hold, then the cyclical commodity stocks should have seen intersections where high P/E accompanied a slide in the index. But that is not the case. Only once in Apr-09 did the blue P/E line cross the green index line, viz rising sharply after the index decline. Otherwise, it would be difficult to make out one chart from the other.

 So why is this happening? Is it because the various commodity cycles cancel out each other and bring the overall index to that of a reasonably broadbased level? Or is it because of survivor-ship bias etc? Since the data does not seem to back my analysis, I must now look for alternate explanations instead of discarding the analysis. Or else, do that analysis at the stock level instead of going into sector/broader perspectives.