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Wednesday, March 21, 2012

Gold bubble worse now than in 2010/2011? RBI ED V.K Sharma feels so

One reason why the RBI is a thought leader, is that it promptly uploads any speeches/presentations of its senior management, thereby allowing media and others to analyze and report it. And many of those uploads have been fantastic-be it the Governor's caution on value of audit, Dy Governor's views on treating customers fairly, 10 commandments for a banking career, real reasons for inflation etc. One such fantastic insight was hidden away in a speech titled The Framework for Pre-Empting Systemic Financial Risks, an inaugural Address delivered by Mr. V.K. Sharma, Executive Director, Reserve Bank of India, at the World Risk Workshop 2012, organized by R-square RiskLab at Mumbai, India, February 6-7, 2012. Now, looking at the title itself, one might yawn at another post facto subprime crisis analysis. But in reality, this speech was quite incisive, not for the old idea of a gold bubble, but for cross triangulating it and backing with facts(read it here http://rbi.org.in/scripts/BS_SpeechesView.aspx?Id=675)
  1. If one looks at the recent readings, there is incontrovertible evidence that there is yet again a huge under-pricing of risks in the financial system and, therefore, it is not a question of if, but when, generic asset bubble caused by manifold increases in balance sheets of central banks will burst.
  2. Specifically, currently the global liquidity has become a bigger concern than it was in the pre-2007 period what with ultra-low and near-zero policy rates and major central banks’ balance sheets 1.50 to 3 times their pre-2007 levels, adding about USD 4 trillion in incremental central bank liquidity
  3. the over-valuation of gold - what we can also call gold bubble - with reference to 7 competing asset classes varied from 78% against highly correlated metal prices proxied by LMEX, 62% against WTI crude, 109% against US Treasuries proxied by JP Morgan index, and roughly 230-275% against Credit Default Swap index, Dow Jones, the US dollar index DXY and the US home price Case-Shiller index 
 The table below as explained in his speech is quite self explanatory. But what is alarming is that despite the talk about financial stability, regulation etc, things have actually worsened in the last 15months. I agree that taking data for period Mar00-Feb10 may have a base effect, since the starting point was in the dotcom aftermath. But a 10yr data set looks quite robust to me. And then, one must admire the methodology he has applied(past price history). It would have been great to apply earlier data from the 90s etc but then data quality may have been an issue. 

Monday, March 19, 2012

Insights from Damodaran on Corporate Finance-II

Source:-http://people.stern.nyu.edu/adamodar/pdfiles/cf2E/mgtobj.pdf  of Damodaran. 
Aswath Damodaran(Professor at Stern School at Business) is a famous authority on valuation and corporate finance. His website reflects the richness of his practical experience, command on theory and research expertise(he's one of the few academics who uses real world data exceptionally well as his valuations of Groupon/Linkedlin etc show on this blog). Anyways, enough on him, this post reproduces a few highlights of corporate finance, which are quite insightful.Earlier, I blogged on some other insights(http://financeandcapitalmarkets.blogspot.com/2012/02/corporate-finance-some-complied-loose.html) which readers may find useful
  1. The above 2 diagrams depict the contrast between the ideal world and the real world. Most Bschools focus on the ideal world but it is the diagram on right which we should care about. The above 3 diagrams themselves can summarize tomes of corporate governance books/laws.
  2. The need for debt covenants -stockholders maximize their wealth at the expense of bondholders
    1. • Increasing dividends significantly: When firms pay cash out as dividends,lenders to the firm are hurt and stockholders may be helped. This is because the firm becomes riskier without the cash.
    2. • Taking riskier projects than those agreed to at the outset: Lenders base interest rates on their perceptions of how risky a firm’s investments are. If stockholders then take on riskier investments, lenders will be hurt.
    3. • Borrowing more on the same assets: If lenders do not protect themselves,
      a firm can borrow more money and make all existing lenders worse off
  3. Markets are not as shortsighted as they are claimed to be-There are hundreds of start-up and small firms, with no earnings expected in the near future, that raise money on financial markets
    If the evidence suggests anything, it is that markets do not value current earnings and cashflows enough and value future earnings and cashflows too much.The market response to Investment Announcements of research and development and investment expenditure is generally positive 
  4. Corporate cross holdings-alternate corporate governance in Germany, Japan, India-At their best, the most efficient firms in the group work at bringing the less efficient  firms up to par. They provide a corporate welfare system that makes for a more stable corporate structure.At their worst, the least efficient and poorly run firms in the group pull down the most efficient and best run firms down. The nature of the cross holdings makes its very difficult for outsiders (including
    investors in these firms) to figure out how well or badly the group is doing. In my personal view, this is a reason for conglomerate discount or premium depending on how the group does..