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).

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