Monday, May 18, 2009

Country Risk Premium – Technical name for Investor Sentiment

9.57 am. (My Heart was beating 80 times at this minute)
9.58 am…
9.59 am. (120 times…I’m going mad…Gosh)
10.00 ----> Counter opens and closes in a whisker

No this time I’m not in the booking queue of the latest release of Karan Johar – Sharukh Combination…It’s the Sensex , which has made most of the portfolio managers cry in joy when the markets opened at 10 in the morning..Opened with a gap of 11% over its previous trading close and was halted in a few seconds because of upper circuit (First time in the history of Indian market an upper circuit has been implemented on the market while opening)..Then opens back at 11.58 for the next show(err..For trading) and guess what…another open circuit.This time markets raised about 350 points and the trading has to be halted for the day.

The entire markets traded for about 27 seconds and the total returns on the market was 18% ..This converts to an annualized yield of 6307200%!!(Dear Oh Dear…All these days I was thinking the purpose of so big numbers in mathematics was only to explain physics concepts like speed of light!!)

The smiles of the portfolio managers told it all …One of my friends apparently told me that his portfolio manager was “jumping in joy” seeing the upper circuit on the market…These markets are crazy – “They make us Cry, they make us laugh…They even make us dream”(If you feel good abt those lines credit to me for wonderfully using it, otherwise criticize Karan Johar for such bad lines on the title card of Kuch kuch hota hai :) )

What happened to the market all of a sudden? Why has it to rise so much in a day..
Is this what the efficient analysts/fundamentalists call the efficiency in the market or as Harsha Bhogle puts it “Whatever way the runs come in the slog overs you have to collect it” kind of returns. My take is strongly in favor of the former.

Logic goes like this – Unlike we believe it is not the average investor who drives the market up and down .Its driven majorly by the bigger players like FDI , FII and the institutional investors ..So for them the country risk is a major factor in the investment. Country Risk is one important factor which drive up or down the valuation of an individual stock or in our case the market.

In the traditional form of valuation model (Discounted cash flow) two factors are very important..Btw Discounted cash flow model is nothing complex…It is just putting the simpler version of truth “Today’s money in hand is worth less tomorrow” with a complex name

1. Net Operating profit after tax (NOPAT) – This constitutes the numerator in a discounted cash flow model.
2. WACC – Weighted average cost of capital.This constitutes the cost of debt and cost of equity.(This forms the denominator figure)

While calculating the cost of equity through CAPM model – one also estimates the country risk into account. So if the risk of country is perceived to be more then the cost of equity is driven up..Generally for developing countries the country premium tends to average around 5%. So it doesent matter if the company is a AAA rated company or a CCC rated company it is equally affected by the country risk. Increase in the country risk drives the valuations down).
For a moment , think what if Left had won around 200 seats( I don’t think they competed in as many…Just a hypothetical assumption)..Now the FDI’s and FII’s believe the developmental policies will be stalled in the country and the country will not be favorable for investment. (Note: I’m not taking a stand against Left..But just wondering what could have the FDI and FII’s perceived abt the market). So they would argue why should we invest in a country which is not so investor friendly..Rather they’ll invest in other emerging economies like Brazil, China or even in their own back yard – USA which they claim to be safe (USA safe - That is like claiming KKR can pull of a victory in the ongoing kidding).

When they think the country is loaded with risk, this drives up the equity premium (country risk) which in turn drives down the valuation.

Hence this time around they believed the stable government without the Left will do a world of good for the investors and the development of the nation. Hence the perception of country risk has come down. Hence markets have gone up. (Note: The numerator of the equation i.e. the cash flows has still remains unchanged. Hence it is nothing to do with the company or the projects it is doing).

Wednesday, May 13, 2009

Tug of War – The technical view vs. the fundamental view of the market

This article tries to bring out the essence of technical and fundamental views in trading through a hypothetical discussion between a fundamental analyst and a technical analyst.

Place: Fundamentalist (Fund) and Technicalist (Tech) in their office during a normal working day

Fund (Seriously doing stuff with his excel…may be a DCF valuation??)
Tech (Passing through Funds desk)

Tech – Arrey…So serious these days…What happened?

Fund – I’m trying to calculate the value of this firm which looks like a potential takeover target for us..Currently it is quoting in the market at Rs.50 per share and I’m trying to estimate the premium for the synergy!!

Tech – Don’t worry (Idhar dekho…he logs into some software and shows some charts) – As per this chart, your potential target looks like a good buy..There is a stiff resistance at Rs.55 and Dow pattern indicate there is reversal in the offing. Hence don’t pay a premium of more than 5 Rs for the S-factor (He is not able to pronounce ‘Synergy’ properly)

Fund (stares at him)—Pagal hogaya kya??… I have been collecting the inputs, discussing with the management, consulting experts , doing calculations for the last six months ,, but all of a sudden u show me some lines which are moving up and down (purposely avoids using the technical jargon price-volume relationship) and end up saying that this stock cannot be paid a premium of more than 5 Rs

Tech(stinged by Funds comments) – I agree that we work on charts and we try to understand the future from the past…Don’t you guys work for more than a year on such M and A deals…Then why does half of the Mergers fail..Even you are also not able to properly predict the value….Now come on ..Show your Excel (Seriously observes the excel sheet) ….Control Premium 3 billion…Now what is that figure?? How did you get this?

Fund (Stutters)..Con..trol..Prem..ium…..(In a characteristic style of ‘DDLJ’ Sharukh, Fund tells to himself : I hate technicalists!!)

Tech – You will not tell it ..All that you guys do is to have a acquisition price in your mind..Try to come up with complex excel models which nobody can understand..and then finally if there is a mismatch between whatever price you have in your mind vs. the model , you’ll include that in a factor called Control Premium(Tech takes pride in the fact that his 6 Lakh investment in MBA has not gone for waste and he is also able to use some technical jargon)….

The fight continues…
Technical and Fundamental view of the market are totally contrasting opinions. Both have their own strength and weakness and definitely one cannot complement another. It’s like the difference between the legendary Gavaskar and the big hitter ‘Yusuf Pathan’. You cannot ask Gavaskar to play blinder of a knock in the super over; neither can you ask Yusuf to play a patient innings of 70 in a seaming track to save a test match.

Fundamentalist look for long term value of a stock. They try to understand the business, try to predict the future cash flows, riskiness of the firm and try to value the firm. As Warren Buffet preaches “Don’t buy a stock…Buy a business”.Buffet never invests in a business which he doesn’t understand. But definitely there are draw backs associated with this approach. Predicting the cash flow and riskiness of the firm may be easy to propagate in theory..But they are the most difficult things.Who would have predicted the collapse of the financial system..All the fundamental analysts were predicting that markets has the potential to go up to 30000 as the P/E was not so high either(when the market was at 21000) ..But after the fall the markets came down to 8000.Did anything change fundamentally .Even if one goes on to say that the turnaround will happen in the next couple of years, then the valuation(according to the future cash flows) should not be affected by more than 10-15%...But why does a market fall by 60-70%. Nevertheless as my guru Damodaran puts it across “In a market fall, most of the time valuations also fail you…But at least you understand your current situation and avoids panic selling by the investors (who stick on to the fundamentalist view). Fundamentalists strongly believe that “Markets are efficient” …When stocks are mispriced no sooner than not investor will cash in on the opportunity…

Technical analysts on the other hand believe in charts and patterns..They never believe that “Markets are efficient”..They predict the movement of the stock prices based on the past movements. There are a lot of indicators, theories which aid the analyst..For example Dow Theory which is one of the age old pattern formation theory is a handy tool for technical analysts to identify a reversal pattern happening in a stock. Technical analysts don’t get into the depth of understanding the business. They don’t try to differentiate company based on their name or product , or their financial ratios…All they are bothered about are the curves which move up and down…They also take hints from some of the other factors like mutual fund ratio(whether MF’s are holding or selling stocks) , some of the momentum indicators and the likes..

PS: The above article is just through the theoretical understanding, through some of the discussion with my friends who are doing Summers in Fin profiles.So it might be prone to error..

PPS: The article is not intended to hurt either Fundamental or Technical traders…I have the greatest respect and my first inspiration towards finance: Warren Buffet is a believer in fundamental strategies (fundamentalist) and an equally good amount of respect for George Soros-Derivatives Guru.

Monday, May 11, 2009

Standard Deviation – Is it the right way of measuring risk

6.38, 6.36, 6.37
Don’t this numbers look familiar to you? If you are a cricket fan you might think this could be the fluctuation of required run rate across three overs or an avid bond trader will definitely bet these numbers to be the yield of a 20 year T-bond. But at least for me, it’s these numbers which are driving me to think and do something different in my final year of MBA to save myself. Yes, these are my GPA numbers in the first year of my MBA program. Had I been a bond, there will at least be risk adverse investors who will be ready to take me. But placement in a MBA program is a different phenomena, the corporate requirement is that they want high returns at a low standard deviation!!(Very cruel indeed) …More often than not everybody would have ended up with a question in interview like “Why have your performance not been consistent or why has it been so mediocre”…Did we ever ask them to give high returns at a low standard deviation? If that is the case no company can issue securities in the market and there cannot be scaling up of business!!…

In the heat of the moment (my third sem results were out yesterday), I’m deviating too much from what I initially thought of presenting in this article. Is standard deviation the best way of measuring an inherent risk? Look at the performance of the Sensex and bonds across the last ten years. The equity market has garnered a premium of over 6-7% over the bonds in the past because of their inherent risk.But risk is measured by the factor called standard deviation which is given by
Sqrt (Summation ((x-x bar) ^2)/n)

Now just like all other statistical measures, this measure also sees the performance/returns over a period. Say in the last ten years markets have a standard deviation of 20%. If you go on to observe carefully this 20% would have been largely driven the fact that markets collapsed in a given year or markets raised heavily in a year. These outliers have a huge effect on the market. Wonder if I could remove these outliers and calculate the standard deviation, then the numbers will be all the more comfortable for a risk adverse investor. Now the problem with such outliers is that they push up the expectations in the market and portray a less risky security to be more risky. Now for example the long term standard deviation of the equity markets would have gone up by the fact that the markets plummeted by about 65% in the last one year . Now this will make the expected return on the market to be so risky (Now for example an investor in the market would claim that he will expect a return of 10% with a S.D of 20%-which is not true). Now this definitely misleads us because observing historically the markets have not gone down continuously in two years. Or to make myself sound more professional, the probability that the market will go down continuously in two years is negligible. Hence this essentially makes the security risk free for the investor who is currently holding. But just the fact that the standard deviation is high makes the cost of equity paid to be high and hence the companies have to look for projects with high pay off. This generally drives up the prices all round, when it could have been easily done away with if the investors had been rationale. On similar lines investor who is holding on to the stock after two or three years of nominal rise is at a heavy risk because he can claim the same returns as the investor who was holding it currently (after a big fall), but faces tremendous amount of risk because it might be more or less certain that the markets will fall.

My argument will not be valid if the same investor holds on to the stock for a prolonged period and sees in terms of the real economic growth and hence sets rational expectation. But how many of us really hold on to a stock for more than for a period of say 2 -3 years. So the person who really has a risk (holding it 4-5 after a fall) loses money and person who doesn’t have the risk (holding the stock during the first year after fall) will definetly gain money.
So contrary to the beliefs of financial pundits, is risk really bad? Or is there a better way of measuring risk?

PS: Through this article I have vented my anger towards the Standard deviation which is the defining variable for a normal curve (which in turn decides ones grade in a subject) .Contrary to stock markets where the samples near the mean are defined as safe, in a college grading system samples who are near are the mean are the most punished.

Monday, May 4, 2009

Finance vs Cricket

I’m a diehard fan of Chennai Super Kings. Right from the day this team was selected and Dhoni was announced as the captain I have been following my team very passionately. I had a passion for cricket during my younger days, following every match of India.Cheering every run scored and every wicket taken..But that child like enthusiasm was somehow lost in the recent years.Thanks to the boring matches all round the year. But this new format of the game: IPL has brought that enthusiasm back in me and I have enjoyed every victory of Chennai.

I thought it would be an interesting experiment to explain some of the finance concepts through my teams IPL players …Don’t know how it’ll shape up…You have to comment on it !!

Suresh Raina: Once you see a company or a business idea, the way they operate you immediately get a feeling that this organization is going to be the next money spinner. You would not have even seen it earning revenues, but you still believe that this company and its model will definitely succeed .Hence it’ll be operating at a high P/E (Price/Earnings ratio). P/E ratio is nothing but the hype surrounding the company.It is the belief that the particular organization has the potential to earn in the future. So it trades at a very high price compared relative to its current earnings. Take the case of Educomp when it issued IPO in the market few years back it traded at a P/E of 440!!(Once reason being low equity exposure, but more because of the belief that it has good earnings potential)..Similarly Raina is a high P/E player. As soon as he came into the international scene ,there was so much hype surrounding him and I remember him hitting two cover drives and he was immediately praised to be the next Tendulkar…(I now wonder how much would Tendulkars P/E would have been when he first came into the international arena at the age of 18!!)

Mathew Hayden: Investing in Mathew Hayden is like investing in a high paying equity at a low risk (Now doesn’t this defy the logic of Risk return model where basically high returns come with high risk!!).When he comes on to bat the opponent is terrified. He creates the sense of terror in the bowler and he is one among the few players who has a high average at a very high strike rate(current IPL series strike rate of 160+ and an average of 40+) ..This in finance terms is like companies having a very high Sales figure and yet is able to maintain that profit margin levels. I have seen many companies which compromise on their profitability when they increase their sales (nothing wrong with them, as that is the way of doing the business. The reason being the working capital requirement like your Receivables turnover and your bad debts starts increasing with increasing sales)..But there are also some companies like Microsoft, Google which never compromises on its profitability because of being the leader in the market, because of the innovations they bring into the market. These are the stocks which you’ll always strive to have in your portfolio irrespective of their price (who cares about valuation here…Wish Damodaran does not read these lines J )

Dhoni: The Glamour Quotient…These are the kind of stocks which I would say fetches a high EV/EBIDTA ratio. EV is enterprise value (which is nothing but the market value of debt plus market value of the equity) and EBIDTA (Earnings before interest depreciation tax and amortization).Again as I explained for the P/E ratio this kind of stocks trade at a high value because of the perception.When Dhoni made his international appearance he made it with a bang, two big 150+ knocks and that coupled with his being cool as a captain :20-20 world cup victory , victory in Australia , Newzealand , has risen his market value…So both the market value of equity and market value of debt(yield being very low : Don’t we observe it in the current series , with hardly any runs coming from his bat compared to the money paid for him) is very high. So in simple terms these are mostly stocks with good potential but more or less overvalued and correction can happen anytime in the near future.

Joginder Sharma: These are what I call as junk bonds (not in the literal sense though…Junk bonds by definition will yield very high returns but at a abnormally high risk…But Jogi is a case where there is high risk and low return…Now Markowitz will have a tough time explaining this logic!!) ..But these stocks gets listed into the market somehow (SEBI regulations require the companies to have consistently performed in the last three years with good bottom line before being listed) . But there are some companies which make it just because of the backing of the parent company (One example being RP). If I see such a stock without the parent company backing it up it would be just another junk company (I know it hurts telling RP to be a junk , but will a company with zero sales figure trade at such a price in the market during the listing ).Jogi is one such player who deserves not even a Ranji berth , but plays for the Indian 20-20 side just because he can li** the a** of Dhoni . Such stocks never can perform consistently in the market and you’ll be a big loser if you go on to hold such stocks for a long time

Albie Morkel and Jacob Oram: These stocks are always fancied in the market since their product portfolio is diversified .Hence even in a recessionary scenario such stocks can survive one way or the other. These are companies which have revenues from different business segment (in the balance sheet you can observe the revenue from the segments). But being into variety of activities somehow makes the critiques point “the core competency agenda against them”. I would love to test these players similar to the Modigliani Millers theorem of “Dividends really don’t matter”...MM proposed that irrespective of whether companies provide dividend or not, value of the company does not change. Similarly I would argue that irrespective of whether he is an all-rounder or a batsman or a bowler his value does not change.Just like when MM argues that giving dividend reduces the current price of a share, I would argue that being an all rounder reduces your potential in batting and bowling as well. Hence the value of the player remains the same. But there are also critiques who argue that dividends are a strong signal to the market. (So when a player claims himself to be an all-rounder, be ready to differentiate between a Kapil Dev, Imran Khan and Ajith Agarkar)

Jakati : I started writing this article on 2nd May and due to infrastructure problem I could not post it then ..But couple of days later when I’m about to post this I cannot do it without the inclusion of this guy who has picked up 8 wickets from 2 matches and has turned a star bowler for Chennai . These are companies which have rapid turnaround in their performances and don’t give an average investor an opportunity to cash in on the opportunity. For example observe the graph of some of the Lloyd group of companies which was relatively an unknown stock initially and when it started rising it was a sharp rise that it never gave an average investor to benefit. There are some companies which have huge debts on their balance sheet and their profits will be more than eaten away by the interest component that they have to pay ..All the profitability ratios and the interest coverage ratio would have looked bad for that company .. But there could be some quarter or an year when they would have gradually wiped off their debt and they’ll start rising their heads above the water.Once they rise their heads above the water there’ll be people who can observe it quick and fast and purchase those shares to benefit (No sooner will the stock be perfectly placed on the Security market line)..Look out for such stocks and hold some of them in your portfolio as it is like a lottery(low cost) , the probability to achieving a turnaround might be very low , but once they achieve it , then it’ll be a great bonanza for the investors..

Hope you enjoyed reading this article…

Saturday, May 2, 2009

Real estate companies and their ‘love’ towards debt

Why do real estate companies mostly operate on debt.If we go on to observe the books of real estate companies we can find that the real estate companies are levered to a great extent as compared to the other sectors. I have tried to intuitively reason out few of the possible sector specific nature of the business.
Sector specific reasons
Collateralized loan – Banks and other lenders will be ready to give their loans when there is a collateral against the loan (called as collateralized loan). So if we can observe companies which contains low capital assets in their balance sheet also will have less debt. Also lenders will be wary of providing loans to R and D related activities, service business (observe the balance sheet of Infosys.Zero debt!! …It can’t get cleaner than that).This helps the companies go in for more debt rather than equity (This is just a theoretical argument and hence we are not getting into arguments regarding CDO, MBS, Lehman and the other reasons of financial crisis)
Premium Requirements according to CAPM: Real estate prices are highly volatile and it is hugely driven by the economic scenario. Hence even if the investors try to diversify their risks by buying a portfolio of real estate stocks (Portfolio theory), they cannot get away with the undiversifiable (also called as the systematic risk).As per the CAPM model investors expect a premium for the undiversifiable risk (risk of the individual stock that is correlated with the market) and in this case it is quite high . Hence we observe the Beta of the real estate stocks to be on the higher side. So the premium required on the real estate stocks compared to other stocks is quite high. This implies cost of equity for a real estate stock is quite high. This drives the real estate companies to look for private placements or to look for debts at affordable interest rate (either collateralized bank loans or commercial papers depending upon the length of the project or based on the cash flows associated with the project).
PS: One reason for high beta is due to the fact that these companies take huge debt .But we can safely ignore that assumption because the changes in beta because of increasing levels of debt is quite negligible compared to the other risks associated due to the macroeconomic changes and associated changes in the market returns .
Easy to manipulate : One important ratio which the banks observe while they give loans is the interest coverage ratio(There are other profitability measures like Operating profit margin , Net profit margin which is being looked at, but interest coverage ratio is all the more powerful way of looking at a debt serving capacity).This ratio is given by the formula
Interest coverage ratio = Earnings before interest and tax/Interest expense
The cash flows of the real estate companies can easily be manipulated. The revenues as reported in the balance sheet essentially does not means cash is flowing into the company (Accrual method of accounting).Hence real estate companies will use different methods such as percentage completion method , cost recovery method to report the earnings in the balance sheet . These figures depend upon the discretion of the management. (How much can a auditor question when the management says it is very sure about its cash flow!!). Hence Interest coverage ratio can be inflated to higher levels so as to get higher and attractive loans.
Note: One way the lenders try to avoid this trap is to see the operating cash flow to the Net income ratio. If this ratio has been consistently less than one, then there is certainly something wrong with the company and its business
Loss of management control: By pumping in more money, the promoters have to forego some of their control and for each and every decision they have to be approved by the shareholders. Hence in order not to lose the control of the management, the promoters normally try to go in for debt rather than equity. Though this fact is common to every other sector, this assumes even more significance in the case of a real estate company because their corporate governance and their pricing policies have not been the best(Take the case of DLF , Unitech which has been bombarded with corporate governance issues for some time now) . Hence they would want to avoid all the regulations, investor questions regarding policy decisions and the likes (Ouch, am I making a bias here by considering only few real estate companies??!!)

PS: My next article will be a study on the corporate governance policy across the real estate companies in India, which will give clarify whether my last argument is just a bias or is it real.