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Maintaining an Optimal Capital Structure

Capital Structure : In simple terms it is nothing but the propotion of various sources of financing . Generally capital structure signifies the Debt/Equity ratio of the company(because debt and equity are the major source of financing for a firm)

Why is it important : To give you a background , equity source of financing is costlier than debt source . Hence companies prefer debt as a source of financing . But there is a catch here . Equity though it is costly , it is just a notional value(meaning we never really pay anybody except in the case of dividends , which is also not mandatory) . But, debt, eventhough it is cheap , is a fixed cost .Hence while looking out for financing through debt , it is important to understand the debt repayment capacity of a firm(Bankers use Interest coverage ratio in case of balance sheet financing, or Debt Service Coverage ratio in case of Project Financing) . This basically sees whether the company has stable source of income to repay the debt it has incurred.

Advantge with Debt : Now as i said debt has a lower cost advantage ; it has the tax benefit - meaning the company does not have to pay tax for the interest component . This was a theorem proposed by Miller-Modigilani V(Levered) = V(Unlevered) + T.D

But the drama does not end here . These guys also say that whenever a firm increases its debt the perception of the riskiness associated with the firm increases which leads to what the academicians call as 'bankruptcy cost'.

So whenever a firm starts increasing their debt in propotion to equity , the overall cost of capital reduces till a certain point and then it starts to increase back . The inflection point is the point of optimal capital structure . The firm should maintain the capital in that particular ratio as the valuation of the firm can be maximised at this capital structure.

But the optimal capital strutcure is not same for all the firm and it varies generally across the industries . That is the precise reason why some firms thrive on more debt(like construction companies) and some firms take very less debt on their balance sheet(software companies - zero debt).

My next post will be on intutive arguments as to why each industry is having a particular D/E ratio.

A primer on Analysis of Banks – Part 1

Recently I had a chat with one of my fellow junior..He asked me what is the significance of ratios like “D/E , Accounts payable , Accounts receivable ratio” for a bank…I had to elaborate what we learnt in Commercial bank management course in about half an hour…Here is the summary of our discussion

Function of a bank: Every organization has some reason for its existence. They benefit the owner, his relatives and to a certain extent a society at large..But the existence of banks is driven by the societal motive (Not that every owner wants to do it so, but the very design of a banking system makes it so!!)

If I want to put in simple terms the role of a bank is to borrow money from who have surplus and lend it to somebody who has deficit. This very definition of the bank makes its financial analysis different from companies in all other sector..

D/E ratio does not have any significance: How often have we heard analysts cribbing about the fact that the D/E of the company is almost reaching 1 which is a danger sign..But have we ever thought about the D/E of a bank..It’ll be approximately 10-12..Thats a very big number..It means the owner has put around 8 rs from his pocket and has borrowed 92 rs from outside..

As I have already said this is the business of a bank..They borrow it at a cheaper rate (through the deposits – fixed, floating …inter bank borrowings, borrowing from other agencies, borrowing from RBI) and lend it at a little higher rate..Hence they make a profit margin out of this transaction.

So can a banks always borrow and lend (with no money of its own) : Luckily there are stringent regulations (??!!) concerning the amount the owner of the bank needs to infuse in order to be complaint . We call it the capital adequacy ratio. Capital adequacy ratio, in simplified terms , is the amount of equity that a bank needs to hold given its balance sheet size..Now the Basel II regulation for banking assigns risk weights according to asset subclasses and according to the risk weighted assets you have to maintain a capital..and this ratio has to be atleast 8%...Let me clarify risk weight with an example..If the bank lends out to a AAA borrower like Infy it entails a risk weight of 50% meaning if he gives out loan of 100 rs to Infosys then the bank need to have 4 Rs(8/2) as equity capital..In the same way if it lends a housing loan , which entails 150% risk weight then it has to maintain 12 Rs(8*1.5) for every 100 Rs of loan it lends out..With every default that happens it is the equity capital which absorbs the losses..Hence if the equity capital goes below zero then the bank is said to be bankrupt(even if the bank might have 90% of its good loans still in the market)..

P/E ratio will also be closer to one: Turn into any newspaper and the first ratio that an analyst speaks about is the Price earnings ratio of a company..I was surprised yesterday to see a company with a P/E of 800..A company quotes at a P/E at such high levels because of the expectations of its future earnings..It means that the assets in the balance sheet of the company are worth much more than what is quoted..But if we observe for a bank it’ll be closer to 1..This is because of the fact that the bank has just interest income and interest expense..Hence there is nothing which is being quoted at a wrong value..All the assets and liabilities are quoted at proper values in the balance sheet(I don’t want to confuse you with the HTM , AFS , HFT concepts)..


Hope the part 1 has brought in some clarity..I will discuss some of the major risks faced by a bank and concepts like VAR in the part 2….

Risky Assumptions - Lessons on Risk management learnt from the financial crisis

Through this article I highlight some of the assumptions on risk that investors, companies made which has terribly backfired on us/them during the recent financial crisis

Mean reverting characteristic

The first assumption in any standard book on risk management is the mean reverting characteristic of the risk variables..Let me explain this with the help of my favorite variable sigma (standard deviation)

When companies underwrite on securities(even during volatile times) they believe that the volatility(SD) will return to the long run average…Quite a decent assumption as long as the companies are able to stand the test of time..For example some of the companies/traders (who were short) were completely wiped out on a single day when the UPA government was elected because the volatility increased to a life time high of 75(VIX figure – source: NSE)

In the time of crisis the company’s liquidity takes a big beating which gives them no other choice but to wind off their positions at big losses.

Again I’m not completely supporting the mean reverting characteristic. During complete structural changes in the financial market in a country the variables change a lot and it will never come back to its historical mean.

Do we really STRESS the conditions?

The regulators and companies were smart enough to devise a system(even before the crisis) called as stress testing wherein they will simulate extreme scenarios and try to see what would be the impact on their balance sheet/profitability..

But what we/they failed to understand was the behavior of the market when conditions are stressed..So we merely do a scenario analysis of projecting different variable to extreme cases (example: Interest rate moving by 5%, volatility jumping by 100% etc)…Recently my friend gave me a hypothetical scenario – a really stressful situation and asked me how will I behave in that situation …My answer was ‘I don’t know’..He was surprised at the answer and asked me why I myself did not know..Simple because I have not experienced such a situation in my life and I myself can’t predict my behavior under such extreme conditions..So I said since I’m a very kind and nice person during normal circumstance does not mean I’ll be the same forever..Situations can drive a person crazy…Projection of the behavior is not the way out here..
Lot of the assumptions that we have taken during the normal market conditions fail terribly during stressed condition..One such important failure was the increasing asset correlations. Any global manager with significant exposure in various countries would have thought his positions to be safe because of the diversification..But during the financial crisis the asset correlations increased substantially that all their assumptions regarding correlation went for a toss..

United we stand – Says different risks

True to the proverbial statement which says ‘history always repeats itself’, there have been various individual cases of bank failure in the past due to individual risks which triggered the other risks and caused the collapse of the entire bank. For example it was a rogue trader (operational risk) who collapsed the billion dollar organization ‘Barings’ in no time. It was unacceptably higher levels of hedge fund investing (Liquidity risk) which triggered other risks and eventually caused the collapse of LTCM (long term capital management- A very famous hedge fund).It is entirely the banks and the financial institutions to blame who did not give the due respect for such historical incidents and went ahead doing whatever they were aggressively doing. The root cause of these problems lies in the fact that the organization failed to see the risk management from the enterprise perspective. Hence we infer that though there are different names for the risks (market risk, liquidity risk, credit risk, reputational risk) – they generally occur together

We use VAR:(Value At Risk)

VAR – Simple but an effective tool in identifying the pile of risk that you are sitting upon..Many companies were proud about the fact that they were using complicated models of VAR as the risk management tool and they knew exactly their risk..

But the problem with VAR is that it does not focus on extreme events..Regulators for banks say that the banks have adequate capital for their VAR with 99% confidence level…But what if the risk is only after the 99%..What if the magnitude of risk is exponential in nature after that 99%..Go ask any option writer and he’ll be able to explain this better (I luckily/unluckily being one among them)..

So using VAR is just a hygiene level..If companies want to identify the real risks they need to go much beyond what VAR suggests!!

An interesting hypothesis about a career in finance

As I have experienced some practicalities of the market in the past , have had a formal knowledge of finance , seen few people who succeed and few who have failed in the field of finance , I wanted to hypothesize the ‘could be’ reasons for being successful in finance

I would attribute the success in finance to only three factors..
1. Knowledge of economics
2. Risk taking ability
3. Understanding people

Knowledge of Economics: The mother of finance..The field of economics has been existing even before the existence of money …A thorough understanding of this subject is necessary to master finance(Be it trading , be it corporate finance or Structuring of products in a IBank , Assessing the credit risk in a bank loan portfolio)..

Just look back , if there was some rationale while designing all the ‘structured finance products’ like CDO’s , would there have been a financial crisis..Is it the greed of some of the wreckless bankers to blame or should we pity the ignorance of those bankers who were not able to understand the basics of economics and thought the prices of house will always go up(Or where they believing fools theory will work always…)

It is like a Value at Risk for options …The so called traders earn lakhs every year only to lose crores on a particular point of time , finally ending up with less than risk free rate of return..The most rational(who understand economics) always expect little more than the risk free rate(to compensate for the risk that they take) and earn them consistently..

Risk taking ability :

This is one another important aspect to be successful in the field of finance..How much of a risk can you bear in your belly??

I was the first guru to my friend ‘Manikandan’ to do trading during the third year of my UG at CEG..I was pretty comfortable with most of the technical terminologies , was able to predict the market movement etc…At a time when I was trading with 5000 , mani pulled out a 1.5 lakh rupee loan from the bank and started trading(that was a real surprise for everybody)…After a year ROE for both of us was around 20% …Obviously the difference showed up in the magnitude of profits…(not to mention that his taxes last year was in lakhs!!)

Both were rational..Both understood the market…The only difference which separated us was the risk taking ability..It could have gone either ways for him..But it was that calculated risk taking which made him succesful..

Buffet bought stocks which were shunned by investors ..There were stocks like GEICO which dropped to the point of near bankruptcy and almost every investor sold it off...but Warren Buffet invested billions in that stock during that time believing in that stock..That is risk taking ability...

When i mentioned the example of my friend , I don’t mean to say that you have to leverage through loans every time…When you believe in something, when you think that you are not investing the essential money for a risky proposition(essential money – money that might be needed to fund your college fees , or to pay your house loan etc), then go invest that money without any second thoughts…

Understanding people

Be it structuring of a product and selling it to a client or giving a loan to a client under CCC category or managing the wealth for your client , ‘understanding people’ becomes a key asset..
When I was reading credit risk measurement topic , there are a lot of complex things done to finally arrive at the probability of default and the expected loss out of the default…This is done through models..If i give a model(KMV , Merton..what else??) to the most knowledgable finance guy(with a formal education) and let me compare his predictions with my friends father who has been in the loan disbursement section for about 15 years (no formal education in finance)…I can bet 9/10 times my friends father can judge the credit quality of the person with just five minutes of interaction with him…The complex models are just tools to substantiate our beliefs..They are not the ‘panacea’..

PS: The above are the three factors for being successful in finance according to my hypothesis..In case if you wish to differ from me you are welcome to do so…

PS: For Gods sake dont interpret this as a propoganda against formal education in finance....I'm a die hard fan of academic finance and still consider studying finance in a great campus like IIML being my life time achievement!!

Swap - A concept to remember

Couple of weeks back we went to ‘Kaminey’...Not a very exciting movie, I would say, except for couple of facts..One – Priyanka Chopra, who is becoming more beautiful with every passing day …Second – I got an example to explain the concept of ‘Swap’ in financial market...

Definition:
Two parties in the financial market enter into a swap agreement when they feel the agreement can bring in mutual benefit to each other (which would not have existed individually)…

Example: Shahid Kapoor vs Shahid Kapoor..

Group of Mafias would be searching for Shahid Kapoor 1 in the movie (elder of the twins) and the police would be searching for Shahid Kapoor 2..Now each of the Shahid kapoor will get caught in the hands of the wrong party (ie SK1 in the hands of police and SK2 in the hands of mafia)…Now assume if both the parties (police and mafia) had to take the trouble of getting the other person, it’s going to cost them huge resources , time , money….


But once they get to know the whereabouts of the Shahid Kapoors they enter into a private agreement (Rule no 1: Swap is a private agreement as opposed to futures or options) , to exchange the Shahid Kapoors..

Very easy right…This is all what Swap is about…

Example 1 in financial market: ICICI wants to raise Euros to serve its High net worth client(say maruthi …because maruthi has some parts manufactured from Britan and hence has a liability in Euros)..And a bank in Europe say Bank of England wants Indian currency to serve its client (say an FDI who wants to invest in India and hence needs rupees)..


If ICICI wants to borrow Euro the cost would be somewhere around 5% and if BOE wants to borrow Indian Rupee it would cost them around 10-11 %(approximate figures)..But if ICICI wants to raise money in India it is just the cost of deposit for them which would be like 7-8%(or even in debt markets around 9%) and for BOE it would be around 3% in their own backyard for raising Euros..

So both of them enter into a private deal..You raise money in your country and I’ll do it in my country and we’ll swap it amongst ourselves..ICICI will be able to get euros from BOE at say 4%(a net saving of 1%) and BOE will be able to get it at 9% from ICICI(around a percent of savings)..Both of them will mostly enter into a deal such that the mutual gain for each of them are equal(but not a necessary condition..depends upon the bargaining power)…


Example 2:Another case could be when one bank within the same country is trying to raise fixed rate loans because of its balance sheet structure(I don’t want to confuse you by introducing the technical terminologies) and another bank wants to raise floating rate loans . But they are able to give loans in the other way(floating and fixed respectively) ..Now they enter into a swap deal so that it benefits both of them…First bank gets the fixed loans and second bank gets the floating loans

So simple right….All finance concepts are very simple…It would be denefitly a concept which we would have unconsciously used in some time in our life..Just that they are embedded into complex names: P


PS:If you are further interested abt swaps just go through existing literature on ‘valuing swaps’…I promise you that it’ll not take more than fifteen minutes to understand how is a swap valued..It is interesting as well!!

Standard Deviation – Is it the right way of measuring risk

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: This was a post which I wrote about 4 months back and posting it after a long time . So I found the answer to my own question!! ..There are models like GARCH , EWMA which forecasts the risk based upon the past risk patterns and also factoring in some estimates of future outcomes . In fact Value at risk has been considered to be one of the best measures of quantifying risk(which again is derived from Standard deviation and mean estimates)

CVR(Valuation) project : Some useful inputs

Following are some of the practical difficulties that you might face while doing valuation and I have mentioned some ways to resolve it…

High Debt/Volatile Capital Structure: In case your firm has high D/E ratio, it has a very volatile debt structure then use Capital cash flow method to do your valuations..
Comparables: In case you can’t find data for the comparable company (To calculate Bottom up beta, to compare various multiples) in the industry or there are no real comparable company in the particular sector then expand your horizon..Move to closely allied sector and pinch some comparables from there..You can even get to pick some global companies and use them as comparables(Chose countries such as Brazil , China which have comparable growth rate as India or your sector should be in the same life cycle in that particular country)..This is little complicated stuff…I would not recommend to go to this level for an academic project (But just in case you end up in a valuation based role, impress your manager using this funda!!)

Choose the right model: In case your company is in a high growth stage: around 20-50%) then chose a three stage model..Two stage will not work in this case because you assume the high growth rate to be say 30% for 5 years..You can’t suddenly assume a stable growth rate of 7% from year 6(Because your growth will not fall so steeply)..So three stage model assumes a linear fall in growth from high growth rate to stable growth rate…And try to restrict yourself to three stage model..Going beyond three stage model will complicate things too much..Also when you are taking a three stage model make sure that you make different assumptions for the beta , ROE , ROA (Refer some typical examples in Damodaran Text book in FCFE chapter)..

Bank Valuation: In case you are amongst those poor souls valuing a bank , then the only thing I have to tell is that don’t go by the traditional methods of valuation like FCFE ..You have to be concentrating on factors like NIM for the projections (I don’t know how to do it!!)

Relative multiples :
· Ignore the value/ratio if you end up with a negative number
· In case of valuing ratios using fundamental values (Ke,g.payout) be clear that there are two different formulaes that are applicable: One for stable growth companies and other for companies in the high growth period..Use the appropriate formulae based on your company
· Use ratios which will make sense to your industry..For a technology company PEG ratio is a bare minimum and so is P/S , V/S for a FMCG
· In case you are picking numbers from database be clear which earnings figure they have used to calculate the ratio..(That would be the first q from the audience or from your boss when you present a multiple)
· In case data for a particular comparable company is not available, then don’t use that company in the ratio..Don’t do the mistake of comparing the ratio of your company in the current year with the ratio of the competitor in the previous year(It’ll make no sense..That too in the current scenario where the ratios have halved over the last one year)

Be clear with all your assumptions for your inputs:Valuation is a very subjective exercise..Hence you can take any number for your inputs..But make sure that every number you enter into your model is thoroughly backed up either fundamentals, analyst estimates, management discussion (directors report etc)..

Refer NSE website to get information regarding publicly traded bonds (to calculate the cost of debt of your bond: use the YTM of the bond if it is traded) and also to find the current RFR

Capital expenditures assumption
The projection for capital expenditure can be done in either of these ways a) Assume your Capex to be in proption of sales as in the previous year b) If there are some management estimates of the capex c) If there are some discussion about a big acquisition going to happen in the near future, then factor that into your Capex figure (Just a guesstimate!!)

Capitalise your assets/liablities
In case of an FMCG firm/Airways, don’t forget to capitalize the operating lease..You’ll end up with a figure which will be approximately 20% higher than the actual..Similarly capitalize R and D of a pharma company.

Derivatives – ‘He who must not be named’

It was almost the same time when I started reading Harry Potter and also started trading in derivatives..It was way back in 2005, third year of my college. 4 years since then, the villain of the story - Voldermot is already dead and the derivatives market – He who must not be named in the financial parlance , has collapsed the entire financial system….Was there a fundamental problem with derivatives as a concept or was there a problem in the so called innovative products into the markets..Lots and Lots of debate goes around in the financial circle.This article will not get into all such debates..This is just a primer to the world of derivatives

There are lot of derivative instruments which are used to hedge risk. I’ll introduce the most prominent among them: Forwards & Futures, Options.

Forwards &Futures: Turn into the first page of any derivative book or type in Forwards and Futures in Google and the first example you would find is,
Assume a farmer who is planning to plant some crops and is planning to harvest in about three months. He is worried about the price fluctuations that can happen to the crop prices . Hence he would like to lock his price at the current market price. So he enters into a contract with a buyer promising him to sell at a particular rate.. This rate is called the forward rate. What determines the forward rate??

Let me try explaining forward through a cricket example.Assume if Dhoni price tag (as per his current form) in a IPL auction is 6 crore.This will be the spot price for Dhoni. Now assume there is a series in Newzealand and South Africa before the IPL begins.Now the team owners make a prediction that when Dhoni plays on such true pitches he loses his form and he would be in pathetic form before IPL. Hence his forward price would be less than 6 crore.So he would not buy Dhoni at 6 crore, but rather he will be willing to pay a price of less than 6 crore. And forward contract is just a promise to buy in the future and upfront payment is not made.
Why would somebody want to sell under a price less than the current price? Because you’ll not be able to sell everything in the spot market as in the case of a farmer..

Generally forward price = S*e^rt

This is nothing but the compound interest formula which we studied in our 6th class. This version of the formulae indicates that forward price should quote at a compounded value of the spot rate at the risk free interest rate (This does not take the market conditions I spoke about)
Futures is similar to forward, the only difference being it takes place with a lot of regulation and intermediation..Forward transactions will normally happen for avoiding a risk, but generally futures transaction will be on speculation (Of course, I have made a lot of over simplifying statements here!!)


Options:

I was looking for a house for rent when I was in Bangalore. I found a house through a broker for a rent of 8000 per month. I liked the house very much and the rent was also at very much affordable levels.But we wanted to search other houses as well.
Hence we didn’t want to shift to the new home immediately..We wanted to take a chance. We wanted to delay the option of shifting, as well as we wanted to have the option of getting into the new home. As the prices in Bangalore were skyrocketing at that period(hypothetical) , if we were to come three months later the rent would have been double what we had to pay currently . Hence we devised a strategy..We said to the owner that we’ll pay three months of token advance immediately and will occupy the home after three month at the current rent. Now the house owner (who had an exactly opposite view of ours) thought that prices will fall in the next three months , immediately agreed to our strategy and got the three months advance from us…
Now we had the right to take the rental option three months down the line at the current price. But luckily all four of us got into top rung B-schools and hence we didn’t need the house anymore. Hence we didn’t have to use our right and hence we lost our 3 months advance ….
This is all about options... Two parties have differing view about market..One perceives the market to go up and the other perceives it to go down.Both of them think the other person to be a fool. The person who takes the risk is called the option writer and he gets an income for taking the risk..The risk for him (in our case the house owner) is that the rentals can skyrocket in the next three months but he is bound to give it at a much lesser price for us. So in order to have that option we gave the advance, which in financial parlance is called as option premium.
As we saw with the above example, we four had the right to buy something …This option is called as a call option.Exactly opposite to this is an option to sell which is called as a put option.

PS:I would have ideally liked to cover swap also through this article, but I generally try to restrict my posts to less than 1000 words. I promise you a post on swap in the forthcoming days…
PPS: There have been quite a lot of simplifying assumptions behind my example...These are just for illustrative purposes and might slightly deviate from the actual technicalities involved in the concept. Hence I would request the financial purists to resist from quoting comments on my examples.

Strategy vs. Chess

Chess is the only game I have played in my life seriously and I was a national level player in chess. In case if some of you have been deceived by the fact that I often quote lot of things from cricket, I confess at this point that I have not played cricket at the competitive level :)
This article is an attempt to compare some of the concepts in chess to strategy in business..Let’s see whether it works..


Don’t Channelize your resources to your weakest area: In chess every piece is important..Losing a single extra pawn can cause a lot of difference at the competitive level..Hence while playing chess we would start concentrating on every single piece. A lot of times a particular pawn(Soldier) will be under threat and in order to safeguard that pawn three of your major pieces(rook , queen) will be put as guard…It gives the opponent to time to develop his pieces , it gives him time to settle down..Precisely the same thing happens in business..When companies start channelizing their resources towards their weakest area, you tend to lose out on other areas..Your obvious question would be ‘how will a company overlook such a simple thing..’..But the sad reality is that the companies believe they can turnaround a failing business , the top management has a strong ego(they want to be number one in every field) which makes them invest in a activity which would reduce the shareholder value . I was recently reading the book by Mckinsey on Valuation...They gave an example of restructuring activity wherein they divested a business just because of the sudden realization of the fact that this particular business was eating away their productive resources and not earning according to the expectations of the shareholders.


Counter attack: This has become a cliché term amongst the management students!! ..I remember my own game in a state level tournament where I was playing against the most fancied player..I was playing the traditional game of chess developing all my minor pieces, doing a castling and then taking the game forward to the middle game...My opponent suddenly attacked me on my king side and in the process his king was exposed in the middle. Now I had two options: one was to get back and defend my king side..For this all my pieces have to rush to the safety of the king...The other obvious choice was to attack his king , which would take him by surprise. I went for the counter attack and finally won the battle..Relating this to business scenario , when your opponent attacks you , if you get onto a defense then its advantage – opponent ,because he would have clearly anticipated your move and he would be ready with his next move as well….Instead counter attack..In case the competitor starts a price war in your premium product, then take him by surprise by launching a new product which would compete in the middle segment..Since he would not have anticipated a counter attack its advantage – You..



Play to your strength : It’s a known fact that Vishwanthan Anand is one of the greatest player in Sicilian defense opening and Kasparov generally plays a Queens gambit(which is a attacking game)…Now Anand always plays according to his strength rather than falling to opponents strengths..A direct mapping can be done to the business environment..In case you skill is in manufacturing then do only that activity …outsource other activities...Just because your competitor is vertically integrated, you don’t have to do activities where you don’t have strength..We read recently about TCL electronics in a case study where I understood they had a clear vision that they should be the number one TV producer..They were also competing to become the market leader and they were also earning good revenues in the market but they limited their vision to be the number one ‘producer’...This was because they knew clearly they didn’t have any strength in marketing or distribution or even in R and D activity..They were good only in manufacturing..They played to their strength and did well in the market..Expanded to different nations...Had a tie up with firms which gave them the complementary skills…This is strategy for you!!


Look for that loose bricks: When my strategy prof told me this, I immediately remembered my chess masters analogy ‘Whenever you need to break a dam, you’ll start striking on the weak point’..So he always insisted me to look for that weak spot…Our first case on strategy was on Wal-Mart competing against K-Mart and becoming the market leader...In fact Wal-Mart did not play heads on with K-Mart..But they searched for those loose bricks...They set up the stores in small cities ignored by K-Mart..They did not spend too much on advertising unlike other competitors and hence was able to sell at a cheaper price…So they found such loose bricks and capitalized on it and became a giant…

Hope you enjoyed reading the article….

Finally ,the third umpire has pressed the green light

I know it will happen..That was the amount of confidence I had in my own preparations...Finally CFA has announced it officially .I have cleared level 1 of CFA and I’m all set to think about the next level.
I understand that lot of my friends are going to take up CFA level 1 coming December...So I thought I could share some of my preparation strategies which might help them..
Start Early: There have been some exams during my engineering days which I will not be able to study completely even if I spend infinite number of hours...Because the subject would have been very difficult..But in CFA, there is no portion in the syllabus which you can classify as very difficult. The success or failure in CFA exam depends upon the amount of time you’ll be able to dedicate for this exam..Here is an approximate amount of time that you need to spend to prepare completely for the exam.

If you will complete term 4 and 5 at MBA/you are already a MBA degree holder and a major in fin before you take up the exam – 150-200 hours of preparation
If you have completed your year 1 of MBA – 250 hours of preparation is required
If you have not done the year 1 of MBA – At least 500 hours

Hence I would advise you to start early, so that you can adjust for unavoidable circumstances like the college exams or a critical deadline at office etc.
Every topic is important: You cant crack the exam by being a master in a particular area .. I have heard stories about people who had more than 5 years of experience in finance (say in corporate finance) and hence was overconfident that their scores in their area of strength can compensate for the other areas ..But that particular strategy has badly misfired.I would recommend you to concentrate on each and every topic.

Financial Statement and Analysis , Ethics : The two topics that could create the difference …FSA carries a lot of weightage(approximately 22%) and Ethics carries a weightage of 15% ..Now FSA is very important because it is difficult. If I can take the liberty to calling myself a veteran in this subject(my moment of stardom during my first year was because of this course) then even ‘I’ felt the area to be difficult and it needs immense amount of preparation..And regarding Ethics, you need to make sure you practice the situational questions a lot..Mere reading of the theory will not help..Make sure you have practiced at least 500 questions in ethics before you have reached the exam hall..The choices will be very close and differentiating them will be possible only if you have practiced.

Stick to Schewser : My personal take would be to stick completely to schewser notes . But make sure you understand every word of Schewser notes . Try to jot down your conceptual understanding/implications of concepts in your schewser material itself , so that it’ll help while revision . Some of my friends have completely read the 3000 page scary book sent by CFA institute . But you don’t have to read the books..But I would revoke my advise in case you think of doing a shallow reading of Schewser..I never touched the books but I would have been more thorough with the schewser material concepts than Schewser himself!!

Revision: The syllabus is heavy and it contains a lot of stuff. Hence you can tend to forget a lot of things..So keep at least a month for revision..And start practicing model papers which turned out to be very crucial for my preparation. Don’t skip derivatives, as the topic is very important for CFA Level 2...Also I would recommend you to maintain a formula sheet/concept sheet which you note down after you complete every study session. This will be very important before the day of the exam…

Devil's Advocate - An interview with Sam

This is a hypothetical situation wherein Sam , India’s best financial analyst and a firm believer in fundamental analysis(DCF valuation) is being interviewed in the Devil’s Advocate show by our own Karan Thapar..

After all the formal introduction about the guest is done , CNN IBN cameras now focus on the two persons in the closed room : Karan and Sam…

Karan : Sam …Do you think discounted cash flow valuations can work?

Sam : Why not?...(Usual stuff for about 15 seconds before Karan interrupts)

Karan : Then what is the reason you valued ‘Adani and Co’ at 2500 crore about an year ago and today you are valuing it at 600 crore..Are you factoring in the public sentiments..

Sam:(Like a typical guest who faces Karan thapar) : My valuation was not 2500 crore..Media had interpreted it wrongly.

Karan:(Takes out the report prepared by Sam an year ago and reads it for him)..So what does the last statement mean? Why have you reduced the value by 75% today

Sam:(Some usual stuff..not very convincing though)

Karan: Ok , Sam ..the critics of DCF point out that it is not possible to find a reasonable estimate beyond three-four years..But you seemed to have predicted a high growth cash flows till 15 years before assuming a stable period(terminal value)..How on earth can you predict the absolute cash flow for 15th year from today

Sam:Karan..But we had sufficient assumptions which justify the growth and the cash flows(Very unsatisfactory answer indeed…But that’s the way it happens when you are caught offguard)…

Karan : What do you think about the market? Are they driven by sentiments or are they driven by fundamentals…

Sam(Like a batsman who has been long waiting long for that one loose delivery …pounces upon this)………..So I would say its completely driven by fundamentals…Markets are efficient Karan!!

Karan(He never asks a question without a follow up..and here it comes precisely)..So how on earth will you justify the 2000 point rise of the market when the election results were announced and UPA was elected back to power…Were they sentiments or did the cash flows of the Indian companies as a whole change all of a sudden…Are you not making a strong statement when you say that markets can’t be driven by sentiments…

Sam(tries to save his face…justifies for about 30 seconds before karan interrupts again)

Karan: I want to interrupt you here Sam…But if you can’t justify everything through fundamentals then relative valuation seems to be a better choice for investors..Compare two companies based on their multiple ratios…That seems to be efficient, time saving and also easily interpretable…

Sam: But it can’t justify the real value of a company…If a sector is completely overvalued then you can’t really identify it…

Karan throws a couple more questions before shaking hands with Sam towards the end of the show…

Sam, I Can’t take any more of it….One more word, you are fired!!

Caution: Read till the end…

Scene 1: @IIML
Wow…..I’m amazed, Thrilled ...” I have got the best corp. fin role on the campus”...Placements this year has been fantastic and it parallels…parallels…No , I can’t remember a year where IIML had such an amazing placement with 575 offers on slot 0!!....

Scene 2: @ my firm
Thomas: Hey Vivek, This is Jagadeesh Balu and he is the new management trainee under you , he is a IIML pass out
Vivek: Hey Balu!! Welcome to the firm (“God, The culture of calling with the last name has again started….I’m not Balu…I’m Jagadeesh :)”)


Scene 3: @ My desk
Vivek: Here’s the model which you are going to work on …Estimate all the values and come up with an NPV for the project
Me: (After working with the model diligently for about couple of days ) : But Vivek…This model seems to contain some basic flaw..This is not apt to value a technology firm…This has been created for manufacturing firms..Lot of tinkering work needs to be done in order to work on this!!
Vivek : We know our model ..This model has been working perfectly all this time…Do as directed
Me : ???


Scene 4: Five years latter: @IIML campus, as a recruiter for finals
Me: So why do you want to join our firm??
Ravi: (Blah blah blh…)
(Some Q and A does not change over years and this was one such standard ‘q’..I got a standard answer)
Me : Good!!


Scene 5: At the corporate headquarters(A grp level meeting abt an acquisition) : My first meeting with CFO of the firm
Pete Sampras (CFO): The competition has intensified and unless we diversify ,our bottom lines are going to be under serious threat…Hence this decision of acquisition...ML has given us a acquisition price of $25 billion (By this year, the value of M and A deals by Indian firms has become very much comparable to the developed world)………………………………………………(He keeps on speaking for about 2 hours , half of which goes above my head and remaining 25% through my ears and the rest 25 somehow reaches my brain!!)….Any views gentleman
Me (I rephrased whatever the CFO said , jargonized whatever the CFO told ,took in some numbers to my help)…….and hence we are in for a great run after we acquire this firm…
Pete : (He would have definitely understood that I was beating around the bush) : Excellent!!


Scene 6 : Ten more years later , A grp level meeting abt an acquisition : My first meeting with a group head….(didn’t I mention??…I’m the CFO)
Me (CFO): Sam..I would love this company and would be ready to pay any price for this…
Sam: But Sir…Paying a premium of $2billion for such a stock might not make too much of a sense..(He starts quoting a lot of facts , numbers and his argument was more than convincing I would say)
Me: But I love this firm…Acquiring this firm will make us the topmost in the industry..(As a CFO , obviously I had much more data and numbers to justify my stance….Another half an hour of elaborate discussion)
Sam: This is not fair Sir…This is going to erode shareholder value..This seems to be a decision purely driven by ego
(Partially he was right….But his last response was so blunt and it hurt me a lot!!)
Me: Sam, I Can’t take any more of it….One more word , you are fired!!
Sam: (Keeps on continuing)
Me:Sam..Sam (My tempo starts rising)

Jaga…Jaga…Jaga….
Sam…Sam….Sam..
I was shouting at the top of my voice but I could hear somewhere somebody yelling my name and this voice also seems to be increasing all the time…
There was also some music playing around me…
God Gosh…..MY ALARM!! How long has it been ringing…What is the time….I opened my room door …


Arun: Dei, How long will I be banging at your door …Its already 9.30 in the morning and you have Prof Vipul’s class at 9.45…You were telling you might be having a surprise quiz
WAS I IN A DREAM ALL ALONG!! WHAT IS THE DATE TODAY?? 13-7-2009……

Me : Coming back to my senses ……..Realizing that I’m in my room , I started to rush to the class not to miss the lecture of one of the best professors in the campus!!
The sad story of classes, quizzes, exams continue!!

Cash in hand –The double edged Sword

Fifteen years back
Me: Mummy, I need ten Rupees to buy Cadbury Diary Milk…
Mom :( After series of questions and negotiations): Ok, I’ll give you five Rupees dear…

Today...
Me: Mom, I need five hundred Rupees (I haven’t mentioned why do I need it)
Mom :( Without any further questioning brings the money from the safe): Is five hundred enough or do you need more??
Me:!!!

This analogy can be interpreted in different ways from a market perspective. This can be seen in the light of a startup company asking for funds and even though the business idea may be genuine the funds may be rejected and in the case of a big matured company investors fear to question the management. But in this article I would wish to see this from the perspective of the market perception of ‘cash in hand’ with some of the companies.

Before that I would wish to give you some technical background on this front. A company, out of its earnings every year, retains some of the amount for its reinvestment needs and gives out some of them as dividend. But company need not use the entire undistributed dividend for its reinvestment purpose. It can have some free cash in the balance sheet. We have a terminology in Valuation called as FCFE – Free cash flows to equity. Free cash flows to equity is the free cash available with the company after meeting every conceivable reinvestment needs .This is the potential dividend which can be given to the shareholders .(If you are so technically inclined , the formula for FCFE is Net Income – (Capex-Dep) – (Change in Non cash working capital) )*..
But companies don’t distribute the potential dividends every time. They distribute only 50-60% of this amount as dividends...What happens to the remaining amount...They get into the balance sheet of the companies as (excess) cash...This cash gets on piling up year after year...If you go and ask the CFO of a firm which is piling up such huge cash his response would be “We have strategic growth plans…We are looking for potential acquisitions.In a couple of years we may be needing this cash for that acquisition” or “(Assuming a non recessionary environment) – You never know, when will the economy be hit by recession..So we are basically saving it for the rainy day!!” – To certain extent the arguments could be justified and they are reasonable.

Now let us come to the main point of contention.When some firms have such a huge cash balance in their balance sheet, how do you value them...”Hey wait.Whats the big deal in valuing cash – Ten Rupees in cash is going to be valued as ten Rupees..What big deal about it”...Nope…, Assume that your company was giving you a returns of 15% in the past (In technical parlance ROE=15%)..You were also happy that you are earning good returns. But the company was piling up huge cash on its balance sheet by not giving dividends to the investors...After a few years, analysts start questioning the reason for pile up of such huge cash...Now the company to save its ego, acquires a totally unrelated business and the Strategy head gives a justification in terms of diversification of the business…Five years later, the company finds itself In a difficult position..The return of 15% has now reduced to 13% as the new business has started to erode shareholder value. The company finally realizes its mistake and divests that particular business…
Now the same company, if it starts piling up cash in the balance sheet, how is it going to be viewed by the investor..?Is he going to value that cash in the balance sheet at par value? He will not do..Right??.His reason for worry would be that ‘What If the company gets into another stupid diversification activity and loses that cash”...So in that case the cash in the hand will be viewed with skepticism and will be assigned a lower value in the market than its actual value …
Similarly if an investor observes a CISCO or Microsoft building up cash then it is going to have a positive effect as they know the cash will be utilized effectively…

Like the analogy of the son and mother that I started with, whether the investors attach a par value or above par or below par value to your cash in the balance sheet depends on the companies past credentials…”Markets are efficient dear!!”

*-Assuming completely equity funded company.

“This one is for you Prof”

Assume that you enter into a highly competitive environment, not sure of whether you belong to that place. Assume that there is a credible person, who takes pain to boost your morale in such a situation…Can you forget that person in life…My accounting professor ,the late Mr.Amanullah , is one such person who made me believe that i belong to that tough environment. He died a couple of days ago in a car accident, when he travelled from Delhi to Lucknow for a conference…


He managed to dedicate a majority of time for us in the first trimester..He handled quite a lot of additional sessions when students found accounting a hard nut to crack.And he was open to any doubts regarding the subject/personal counseling during any time…


This article is my humble dedication to you Prof…


When doing a Valuation, you need to do a lot of tinkering work in the Balance sheet before you can start using it. Here are some of them which are very crucial.Please bear in mind that Accounting was an area which was created for old age manufacturing companies. Though lot of accounting flexibility has been brought in for the new world companies, there are certainly some loopholes which can make the valuation totally different from the actual.Here are few of them.


R and D expense: When you deal with technology companies this is going to be a huge number.Technology companies classify Research and development activity as an expense. As per accounting norms expense should be matched with the benefit/revenue in the particular period. But the benefit of the R and D activity is going to accrue over a period through a breakthrough technology or a patent (in case of a pharma) or a new product in the market (FMCG).Hence this particular investment need not be expensed but has to be amortised over a period of time..The amortization period has to be in sync with the period over which the benefit is going to accrue. Same goes for advertising expense in the case of a marketing company whose spending is directed towards creating a brand.


Inventories /Depreciation policy: Be careful with the inventory/depreciation policy that the company follows..Companies could swing between different policies to make them look better under different situations .Basically a particular policy should economically justify the activity which they do. Delta Airlines extended its useful life in order to reduce its depreciation expense.As an analyst one should be sharp enough to observe this aberration (the industry was using a much lower useful life)..


Leases: Most of the FMCG/Airlines operate on leased assets .It makes a huge difference in terms of valuation whether you classify a lease as a financial lease or a operating lease..Most companies tend to classify their lease as a operating lease.This makes the impact of the lease item only to the income statement..But when we classify it as an financial lease then the there will be an asset/liability in the balance sheet and more often than not some of the crucial ratios like ROE, ROC are pulled down…


Underfunding of Pensions: Companies park a lot of their excess cash in pension accounts for the employees. Now the key thing to be noted is the interest rate earning assumption that the company has made for the Pensions. There could be an optimistic assumption regarding the interest rates .An analyst should observe the Pension interest rate assumption vis-à-vis other companies and need to adjust the balance sheet factor in a liability.


Onetime expenses/Divestures/restructuring expense: This item does not require any changes in the balance sheet/income statement as such.But while doing a valuation one needs to understand that this is not a recurring expense and need not be considered while valuation. Let me put in simple terms..Assume you bought a 10.Rs lottery and gained a crore out of it. Can you project this income over your life time.That is can you assume that you are going to invest 10.Rs year after year and you are going to earn 1 crore out of it.Distant possibility right…So in valuation we try to project only those items which are recurring in nature..Agreed that the above mentioned expense will be in tens of crores.But they are generally not considered because the value of a company will be in thousands of crores and one time activity of this magnitude will not affect the valuation of a company.

These are few of the accounting adjustments that need to be made before doing a valuation.If I could think of more, I’ll come up with another article on the same…


PS:
Me: Sir, I’m finding it hard to crack all other subjects except accounting
Mr.Amanullah: If you have cracked accounting, then certainly you have to be bright…You’ll definitely perform better in the other subjects as well.
True Prof, I was certainly bright…And you made me realize it!! I will not forget you in my life time…..

Greed , for the lack of better word , is good

If you are one among those who are very serious about trading, or fascinated by the concept of corporate takeovers then the movie ‘Wall Street’ which released couple of decades ago would be a perfect recipe...

This article is about some of the interesting aspects of finance that I learnt through the movie. The movie revolves around two characters: One, a trader who wants to desperately succeed in life and other a shrewd corporate raider.

‘Gordon Gekko’, the screen name of the corporate raider, was an immediate sensation, and as quoted by the directed it drew inspiration from lot of real life corporate raiders like Carl Ivanch, Porson (who coined the term Leveraged Buyout), and Goldsmith etc. This character won lot of critical acclaims for Michael Douglas and he also won an academy award for the best actor.

Corporate Raider:
It was a term introduced in the 70’s and it was used to describe investors who used to observe some opportunities in a particular company and hence take over that company by becoming the single biggest shareholder.

Once they take over the company they restructure the company – improve its operations, throw away the existing management and bring about a change in the company, thereby sowing the seeds for better profitability in the future years. If this is one form, the other form is to strip off the assets. This is little unfair from the company point of view. They take over the company through huge debt and start paying off the debt by selling off the assets. One variant of this is LBO where the companies with huge cash on their balance sheet are taken over and then the debts are paid off through the cash from the company’s balance sheet itself!!

Mostly such takeovers happen when the market value of the share does not properly reflect the economic value of the assets that the business own. Mostly the inefficiency will be with the top management and their attitude towards running the business. Hence in most of the hostile takeover the first thing that happens after the takeover will be to replace the current management team.


There is one particular scene where Gordon Gekko addresses the shareholders of the Teldar paper which he takes over , sums up the entire essence of management inefficiency, difference between managements interests and shareholders interest, exploitable business opportunities, golden parachutes etc...Here Gordon Gekko delivers the most famous dialogue of the 1980’s ‘Greed, for the lack of better word, is good’. This was a very powerful scene in the movie and I would request you to have a look at it.
http://www.youtube.com/watch?v=7upG01-XWbY

Insider Trading:
We speak about market efficiency, rapid information updates etc...But the insider trading that happens big time in the market screws up the entire market efficiency. This has been beautifully portrayed in the movie. The way traders base their trading on insider information, how they artificially increase the price , and after a particular price level how they sell it off(after which the stock price would spiral downwards) are brought out .A real trading floor is brought before our eyes , the way the traders handle client calls , the way they write out slips …,( That’s a million dollar learning that I had today!!)

Life of a Trader:
‘Money will make you do things which you normally don’t do’ …….Life of a trader has been portrayed to be very risky and seems to consist of volatile fortunes. In the movie a trader who would have worked for more than about 25 years with the firm would make a big loss and immediately he would be fired (Mercy does not find a place in the dictionary of the trading house) …”One big loss and you are gone”
At the same time our protagonist who would be doing a lot of insider trading and hence earning surplus profit would be amply rewarded (Our protagonist would be arrested latter for his involvement in the insider trading)...

Big Bosses:
The way Gordon Gekkos character was portrayed was simply awesome.
When our protagonist keeps on telling a lot of info on companies , Gordon Gekko would simply respond “Tell me something that I don’t know” ..The arrogance about his talent would be clearly visible in the characterization. The shrewdness in completing the deals, the very remembrance of hell a lot of info on his head, the quick response to changing situations made me really awestruck at the capabilities of the Big bosses.
Overall I loved watching the movie and 2 hours of my time could not have been better utilized…

My dear, do you know how much I ‘value’ you

This intro article on valuation was long due from me. Every time I wanted to write the article, I had something or the other coming up my way and could not take this up..Anyways here it comes finally..

Valuation is like a torch in the dark: Assume you ought to purchase a house …You obviously need to have some base price in mind for that house. How do you derive the price for the house? You tend to think in terms of how much of a rental income this house can garner. You will also add in factors like whether the house is centrally located, whether there are any legal risks associated with the house, do we have water facilities associated with the house etc. So using these factors you might be able to roughly quantify the value of the house. So similar to quantifying the value of the house, the concept of Valuation in finance believes that every single asset can be ‘valued’. But take it with a tinge of caution …It is ‘roughly’.Hence if a Harvard MBA claims that he could value an asset precisely, may be ask him to repeat his course at Harvard!! Valuation involves a lot of uncertainties. In order to value a company, you have to be very comfortable with a particular company, the sector in which it operates, the key risks associated with the business. Hence more often than not it is not the person with significant hold on finance concepts emerges victorious on valuation but rather a person who is very comfortable with the business and the industry succeeds the most.

Keep your egos in check before a Valuation: Valuations are done based on discounted cash flow basis. Discounted cash flow is valuing the future cash flows of the company at the present value. This involves cash flow figure which is going to happen in the future, estimated growth rate for that cash flows, and the risk associated with receiving that cash flows...Man, Every data which has to be used is a future value. I always have the peculiar habit of trying to predict my CGPA half way through my semester. This is an activity which I have done right from my UG days...You know what…I have never come close to what my actual CG finally..There were a lot of factors which was leading to the difference. Either I would have gone terribly wrong in estimating my peers (The concept of Relative Grading) or my Professor would have set a unexpectedly difficult ‘Greek and Latin paper’ to me...Anything could have happened .But I confess I at least deviated 5-10% from my actual CG.But the good thing was I never stopped the habit of calculating it. It always gives me a sense of satisfaction to calculate it and come up with a number and it helped me in altering my preparation strategy for the rest of the semester. Valuation is also something similar …Microsoft beat the expectations of the analyst in 51 out of the 52 quarters during its high growth periods. They came up with a EPS of at least couple of cents above what the analysts predicted …But this did not stop the analysts from predicting the value next time …Valuation is a tool which would help you not to make some irrational decision...Assume CISCO wanted to acquire one of the growing technology companies...For sure the CISCO cannot come up with a 4th decimal digit accuracy of the target. But it helps CISCO in not paying a price way too much beyond the actual price. Hence don’t get upset or get too egoistic when you value a company as you are bound to go wrong.

Markets aren’t the best judge: If you are a believer in market efficiency, come out of the wrong notion that the markets predict the value of the equity of the firm correctly every time new information arrives. In fact market efficiency theory states that ‘New information comes into the market at random fashion and the markets adjust themselves to the information very rapidly” (not correctly).....Hence markets are also not correct every time and you have to be careful about the inefficiency in the market. And this existence of inefficiency in the market is what drives you and me to value the company and find its real worth and to earn abnormal profits out of that equity.

Hope the article threw some bit of insight about Valuations…..

PS: *Some of my critiques claim that my blog has less of technical content but has more of stories and other stuff embedded(like Bollywood , cricket etc) …My reasoning would be simple a) This blog is not to prove my technical prowess in finance . But rather it exists with the purpose of sharing the knowledge of corporate finance to as much people as I could...Currently my readers have been as diverse as my younger sister who has a little knowledge on corporate finance to some Profs, whose lectures have been the inspiration for my blog..Hence I have to take a balanced approach in my articles.

CFA Level 1 - All that begins well ends well

A flash back of my preparation during the last three and a half months
June 7, 5 pm: “Stop writing, keep your pens down ...Any further writing will lead to violation of CFA code” …By this time I was quite convinced that my performance in CFA level-1 was couple of notches above what CFA would consider as a par to clear this level.

June 6, 10 pm: With my hands heavily clutched over my head, I was seriously looking into the notes of formulae’s and review material that I had prepared for myself.These notes came in really handy for the last minute preparations. It helped me concentrate on my weak areas. Thanks to Lokesh for providing me with a separate room for my preparation..Amazing hospitality!!

May 25, 10 pm: (After Chennai losing the semifinals).”Fuck...The IPL system is not fair…It should have been an all-league system and damn I have wasted 36 hours watching this bloody IPL …” …Came back to room and took my FSA material….”God….I don’t remember what is an Asset Retirement Obligation”…”55000 at stake…Long way to go…Come on…Scale up”..

May 15, 11 pm: Saikot to me “ whats happening to you??....So serious..You have 25 more days and you have already read the syllabus once completely”..Chill yaar..”You have been very consistent in your study schedule and you will easily crack the paper!!”
May 8 , 3 pm : In the tea shop , having my 5th tea of the day(after bunking the office for the third day in the last 20 days) and breaking my head over the spot rate and forward rate concept...Damn , Kill the mathematicians!!

May 4, 5 pm: Double checking my mail box to make sure that I’m not in the dream world ..”A mail from Prof Aswath Damodaran” wishing me on my birthday and also giving some valuable comments about my blog artcile which compared CSK players and finance…Wow...What better birthday gift I could have asked from my friends..Thanks to Arun,Arvind,Sangeetha and Suren..”On cloud nine …So no CFA preparation for the day”

Apr 25, 3 pm: Reading a blog article by a guy on his CFA December 2008 exam experience..As his blog puts it “CFA level 1 was much more difficult than I thought ... Serious and consistent preparation is the key to success “..Me: God, what’s this idiot telling..I called up my friend who took CFA Level 1 last June and is appearing for Level 2 this time. “You have to read the books…Scheweser materials might not be sufficient..At least I read the whole CFA materials twice”..To myself :Jesus….I’m gone…I’m reading just the Scheweser , that too still left with more than 30% of the portion..”I’m in the middle of nowhere”

April 17, 8pm: (In Gurgoan) Mahendiran to me(First day of IPL): “Mumbai Indians are going to be the champions this time..It’s a very strong and balanced team..See the big names in the lineup..Nobody could match them”…For me it was the battle between CFA and CSK...Battle between brain and heart..Brain had to take the back seat..I cannot compromise on CSK matches for any reason!!

Apr 7, 8 pm: God…What are these people telling? …Market research on education sector..Presentation, Excel.And I also have to make the sales pitch…Damn ,This is too much…It’s already 8pm and I’m yet to be done for the day…When will I study for CFA?.
Feb 16th , 5pm : After all the placement debacles of seniors ,to myself “ My dear ..Now that you had a trailer for what could be your final placements scenario, its better you start doing something serious..CFA Level 1 might be a pretty decent value add to your CV ..If not anything, your level 1 experience will help you in gaining good knowledge about the subject…Go ahead”

All in all its been a great experience in the last three and a half months of preparation for the exam.. I know for sure I crossed the line well before the ball hit the stumps. Just that the third umpire has to press the green button… which will happen on July 28th!!..Will keep you posted on the updates.

PS: The purpose of this article was two fold a)For my level 2 preparatiobn this will serve as an inspiration to me b) For all those who face difficulty while preparing for level 1 can breath easy after reading this blog because....The syllabus is meant to be tough and will test our nerves

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 IPL..lol..Just 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).

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.