HL 18 - Insights from the Options Pit: 'Vix'y 'Volcone'o

My posts seem to have a direct relationship with liquidity and credit availability in the markets...both have dried up!

In this post I draw insights from the beautiful, non-linear world of Options. The title is a grammatical mess but it captures the central idea behind this post. I make a case for increasing volatility over the next two months in the Indian markets and possible ways for investors to play this. I'm amazed at the near-term thinking manifesting even in the options world. The markets are so riveted on the near month expiry that they forget there's a next month...and a month after that. India will go to elections starting mid-April and the spectacle will be for everyone to see over a 1 month period.

As always, this time will most likely see tugs-of-word wars and plenty of ego-massages as one party tried to outdo the other in gaining the coveted majority number. Pre-election opinions point to a fractured mandate and there's a very high probability of frenetic post-poll activity. We are nearly in April but what are the markets saying?

...the markets seem to be pricing in a 'normal' situation. I define 'normal' as a period where the Nifty index volatility is around the long-run range (which roughly is the 25%-30% band). Volatility (or vols, for short) started picking up over last week and are currently in the 30%-35% band. Is there a possible opportunity?

Lets take a look at history for pointers on the possible way forward for the market over the next couple months.

Elections and Nifty behavior: Part I (Apr-May 1999)

The chart captures the Nifty index and the 30, 60 and 90-day volatility surrounding the election period in Apr-May 1999.

The period leading up to the election months witnessed quiet activity on the vols front and the Nifty was essentially flat...And then something beautiful happened...

Suddenly the markets took cognizance of the upcoming elections and uncertainty increased, manifesting in increased volatility. Vols shot up from the 25%-30% band to the 40%-50% range through the election months of April and May 1999. The Nifty rose 6% over this two-month period.

Vols settled back to the long-run range over the subsequent months and the Nifty continued its rise, along with the general euphoria surrounding global equities around the internet bubble.

So far so good...what happened in 2004?


Elections and Nifty behavior: Part II (Apr-May 2004)
Similar pattern?

Vols were chugging along unspectacularly in the months leading up to the elections while the Nifty was in a gradual downtrend. Interestingly, through much of April 2004 Vols were flat...and then they jumped...

Once again, increased uncertainty coupled with post-poll dash for forming alliances resulted in Vols jumping from around the 20%-25% band to the 40%+ region. The 30-day vol shot up to the 60% range...

The Nifty, however, dropped 18% over the two-month period...too bad for naked Call buyers.

Vols remained elevated for a while before reverting back to the long-run range.


Elections and Nifty behavior: Part III (Apr-May 2009)?
...hmm... probably there's something here. Nifty Vols over March were around the 30% mark. The past week saw the Nify mimicking the rise in global markets. And vols started rising, but there are still in the 30%-35% range. Elections begin in mid-April and run for a month leading me to make a case for increasing vols over the next couple months.


Comfort from the 'VolCone'
The VolCone is a chart of volatility over varying time periods (30/60/90/250 days) for the Nifty over the past one year. The chart captures the Maximum, Minimum, Median, the 25th and 75th percentile for the Nifty volatility over the past one year.

The solid Black line is the current volatility. We see that the 30 and 60-day current vols overlap the 25th percentile line. What does this mean? The way to interpret this is that one can reasonably expect 30-day Nifty volatility to be lower than 30% (current levels) about 25% of the time. Put another way, there's a 75% chance it will be higher than 30%. How high? I have no answer to that. This, combined with the closeness to elections, leads me to think that options are not being priced for this event. Increase in Vols generally lead to higher option prices.

Conclusion
The (confusing?) conclusion from the 'VolCone' chart combined with historical performance leads me to think that Vols could increase over the next couple months. Options are not pricing in the election event and once they do, there could be reasonable upside for an investor willing to bet on this occurance. Given the current conditions, I would be buying Volatility...(in option jargon, I would be 'Long Vega').

So would I do naked positions? I don't think so. I have never been able to predict market direction and find more comfort in playing my Volatility friend. I have no view on market direction but I have a reasonably strong view of increasing volatility. In this scenario, I would be inclined to putting on Strangles or Straddles, that allow me to play volatility without taking a view on market direction.

Why aren't the markets pricing it in then? I don't know. Vols have indeed starting moving up over the past week...so one of two things could happen. Either me or the markets are getting this wrong...

If new information compels me to alter my stance...I would do what John Maynard Keynes once said, "When facts change, I change my mind. What do you do Sir?"

Cautionary statement: There is immense risk of loss of capital in options trading. Readers are strongly encouraged to counter my views and base their decisions on independent due diligence.

HL 17 - A Tale of Two Companies

The frequency of my posts have dropped drastically. I am at a loss to decide whether this is attributable to market conditions, or me not having anything significantly intelligent to say...I am tempted to vote for the latter.

After months of contemplating what to write, I settled for an exposition on something that I term "beautiful". Capital structure is something that does not get as much importance as it should by investors, analysts and management in general. What is the optimal capital structure? I wish someone knew the answer. In this post, I take a look at how the markets treat two companies that are similar in most respects except for their capital structures. I then take a look at a case of possible mis-pricing and how often, even 'good' companies never seem to get their due.

Capital Structure irrelevant? Hmm...
I consider Chambal Fertilizers and GNFC (fertilizers again!) for this post.

Most finance experts and academics advocate having 'some' debt in a firm's capital structure. "You get a tax-deduction...debt is cheaper..." are some of the reasons cited. Not wrong in my opinion. What is the right mix? That's a question that doesn't really have one right answer. For the moment, even if we assume the company's management knows the 'right' mix, the broad market participants are mostly unaware of the 'right' mix. What do they do in such cases?

The example exemplifies the point beautifully.

Lets start with margins. Both companies generated about the same EBITDA margin for fiscal year ended Mar-08. However, GNFC topped at the net income margin level. It generated a good 3 percentage points more than Chambal.

Turning our attention to the capital side introduces a fresh perspective to these numbers. GNFC managed to generate 100% more profit for common shareholders, while employing 30% less capital and only 62% more equity compared to Chambal. Impressive? Very...in my opinion.

So what did the markets do? They rewarded GNFC's superior performance by ascribing a 50% less equity value, and 70% less enterprise valuation, compared to Chambal. In terms of multiples, Chambal is currently valued at ~4x more than GNFC on the EBITDA multiple and 3.5x more on the P/E multiple. What could possibly explain this wide discrepancy? Is it a sign of terrible mis-pricing or is there something else at play?

Traditionally, apart from the arguments put forward for assuming debt, common equity holders like debt as it bolsters Return on Equity. Taking on debt gives a firm leverage, which is a double edged sword. Take on too much and the management risks destroying enterprise value, take on too little and again there is a risk of firm value not being maximized. The optimal funding structure is, in my opinion, like a moving target. One cannot get it right all the time, but one can try and get as close as possible to the 'right' number.

When analyzing two companies within the same industry, the investor faces the tough prospect of forming an opinion on whether a company is over/under-priced compared to the other company.The statement seems innocuous, but is one of the most important factors for an investor to answer, in my opinion.

In the above case, assuming other things being more or less equal, it seems a bit intriguing to me that the markets are valuing GNFC only at 0.5x book value of equity and valuing Chambal at 1.5x book value of equity. Especially considering that GNFC scores on all other operational metrics. To some extent, the differences in capital structure could explain the difference in market values for the two firms. Firms with some debt in their capital structure get rewarded with a greater enterprise value, compared to an all-stock firm. The other explanation that comes close to rationalizing the huge discrepancy is that the markets are probably expecting far better growth rates in Chambal's case compared to GNFC. But in a lollipop business, most companies face similar growth prospects, give or take a couple points.

Maybe Chambal has a better history compared to GNFC?

Lessons from the past
A look at history reveals some very interesting insights into the two companies. The comparison is so striking that commentary is mostly unnecessary.
GNFC's growth rate over 4 years on almost every operational metric is better than Chambal's. Notably, GNFC has managed to grow Net Income at 34% CAGR with only 12% CAGR on Total Capital employed. This compares very favorably with Chambal's performance (13% Net Income CAGR, 10% Total Capital CAGR).

GNFC has also managed to grow dividends at 3x Chambal's rate. Dividends are important, as shareholders typically put a premium to companies that not only pay dividends but also manage to grow them at a good rate.

Turning to averages, its clear that GNFC beats Chambal hands down on every metric. It uses debt sparingly compared to Chambal and has turned in better return ratios.

However, the market and enterprise values, and valuation paint a very different and interesting story! The market value of both companies have grown at about the same rate over the past 4 years. Turning finally to valuations, one can see that GNFC has historically traded at a discount to Chambal.

Over/Under/Rational-pricing?
Why should a company that is larger in size (in terms of revenues), has demonstrated a history of better operating metrics, grown dividends at a much faster rate and is comparatively conservatively capitalized, trade at a big discount to its peer?

A look at 1H2009 results for both companies show that there has been a significant dip in operational performance. Since Mar-2008 Chambal's stock has corrected 20%, while GNFC's stock has fallen 58%. The latter had a production disruption for 3 weeks in July related to a plant shut-down, but how much will this matreially impact results 5-year out? Not too much in my opinion. GNFC will most likely post a pretty bad 2Q2009 result, however, a long-term investor shouldn't be too bothered with a on quarter dip.

The stock action reveals something striking about the markets. Yet again it demonstrates the short-term thinking that determines the actions of market players. The markets conveniently forget the long history of superior performance and beat down the stock only on the back of short-term negative news. Rational?

While the past, admittedly, cannot be used to linearly extrapolate into the future, it does reveal some important clues about companies. If I were to take a 5-year view - and was forced to buy a fertilizer stock - I would choose GNFC. The likelihood of management continuing to do the good things it did over the last 5 years is far more in GNFC's case than in Chambal's.

Conclusion
So is GNFC under-priced or is Chambal over-priced? Tough call to make. However, in my opinion, it's far easier to form an opinion on GNFC than Chambal. A company with a demonstrated history of superior performance trading at 1.5x last year's EBITDA and 2x last year's earnings merits a close look, even if it isn't a screaming buy.

The comparison reveals the market's implicit appraisal of difference in capital structures of two firms in the same industry. The markets, on balance, prefer firms which have some debt to no debt. What is the ideal 'some' is an open question.

More importantly, the comparison reveals a beautiful insight into the way the markets think and act. Sadly, holding on to a 'strong' company for around 4 years, did not guarantee proportional outperformance over an inferior peer in GNFC's case. It is an interesting lesson. While in lots of cases, the long term is a good judge of true value, the markets don't seem to get it right in some cases. The long term investor in this case loses out.

This, however, does not undermine the importance of numbers in the investing decision. While numbers are important, it is far more important to try and think far ahead. Thinking five years or more makes the investing decision that much more easier than predicting two quarters ahead. Most times, the key to a good investing decision lies outside the cosy world of multiples...

"I am in the business of, I guess, Guessing!"
- Yours truly

Every day its in the nature of this business to force people to take decisions on imperfect and incomplete information. However, over time, some get better at it as they develop a 'feel' for the numbers.

At the end of the day, the guy who keeps his head when everyone around him are busy losing theirs, is the one who takes home the biggest prize...

HL 16 - Delinquent Future?

My brain requested me to let it go on a vacation...So I listened and went on a sabbatical. I hope you missed me!

Much has changed - both in India and globally - since my last post. Markets around the globe seem to have caught a collective cold. I am probably feeling happy after quite a while in the markets, with so much pessimism going around. The markets have now tuned their radars to pick up the slightest of negative news flows to go on a free fall.

In this post, I take a look at some interesting developments in delinquency rates related to real estate and the response of the equity markets (S&P 500). Admittedly there are number of factors that have a bearing on the movement of the S&P 500 and one cannot see the causal effect of one on another in isolation. But as they say…sometimes the part is better than the whole…especially when trying to get a sense of how things fit together to form the larger picture!

Delinquency rates – to put it crudely – measures how many loans default as a proportion of total loans outstanding. The more people default higher is the delinquency rate. Why would people default? Simple, an economy goes into a tailspin --> people lose jobs --> low or no income --> can’t meet monthly loan payments --> increase in defaults --> higher delinquency rates.

What could be the relationship between delinquency rates and equity markets? One line of reasoning goes this way. Increase in delinquency rates --> people have less money to spend --> decrease in consumer spending --> liquidating of investments to meet important outflows --> collective negativity leads to slowdown in corporate earnings --> decreased stock prices.

Again, what is the cause and what is the effect is a debatable issue here. Here is a chart depicting the movement of the S&P 500 and movement in delinquency rates for real estate, residential and commercial properties.

Back in 2000, delinquency rates had just begun to rise and peaked in early 2001. What happened to equities? The S&P peaked just as delinquency rates started rising and then went into a free fall. The excessive froth that built up during the internet bubble took quite some time to settle down and the S&P continued its down trend till mid-2002.

Post 2001, delinquency rates started falling as the Fed intervened and cut interest rates. Interest rate cuts stimulate the economy, leading to a virtuous cycle of positive things resulting to a bull run in equities.

Looking at the low interest rates several players entered the real estate market with dollar signs in their eyes. They thought that the only way home prices could move was up and they leveraged themselves…well almost…to buy their dream home! But as they say all good things come to an end and this housing bubble too…

…The uptrend in the S&P which began in mid-2002 continued over the next five years. However interest rates were continuously rising during this time as the Fed worried about several things, not in the least among these being the build up of a possible housing bubble. Somebody had finally arrived to spoil the party. The continuously rising interest rates gradually led to a rise in defaults as people started feeling the pinch of costlier money. But somehow the equity markets were still oblivious to this development and continued rising…

Then suddenly – as always – the markets woke up and saw the above chart. Delinquency rates were at 8/9 year highs and everyone started wondering why on earth they were loading up on equities…

And the S&P started dropping...

2008 has been a forgettable year for most global markets. The fall in the S&P has triggered a fall in equity markets around the globe due to the coupling effect. What remains an unanswered question is whether the end 2007 peak will mark a repeat of the 2000 peak. Because if it does then those unfortunate people who correctly picked the top are in for a one way ride. Everyone says equities are one of the best asset classes in the long run. Ask a guy who picked the 2000 peak and see if you get the same answer. There is nothing that makes an asset class inherently good. Price paid is everything…

Delinquency rates have never been higher in the past 8/9 years but the S&P touched about the same level seen in 2000. The housing trouble seems far from over and a recession is almost the grim consensus currently. So till that time equity markets could be in for a choppy ride with an increased inclination to moving south rather than north. But there will be pockets of value waiting to be picked. One just needs to be patient and keep looking…

In the complex web of interconnected linkages, it is extremely tough to isolate one factor as the cause that leads to A, then B and then C. However, certain ‘indicators’ stick out like a sore thumb when overlapped with another. Delinquency rates and equities is one example. Credit spreads and equities are another. (For the curious: Check out this earlier post where I first played Dr. Doom. The S&P was at ~1520 then, its at 1380 now.)

I am fascinated and interested in unearthing these relationships. My other idol, the physicist Richard Feynman used to say this about physics – and something that is true in investing too –

“It’s all about asking the right questions and to keep looking. You do an experiment not with the intention of proving your prophecy but to learn about reality. This integrity will lead you to ask questions that you would have never thought of asking otherwise. In the process you unearth something about the way Nature works…it is fascinating!”

I totally agree.

I will never claim to ‘predicting’ market levels. I cannot do that. I don’t know how to do that. But by continuously looking at things that might have a bearing on each other I maximize my chances of staying out of big trouble.

As my guru, Warren Buffett says,

“I have made money by staying out of trouble.”

Pearls of wisdom from God himself.

HL 15 - Inefficiency and the Perils of Inaction

A lazy afternoon opened my eyes to the perils of inaction in the investments business. When going through some of my old files, I came across a company that I had identified about a year ago (October 06). I had done all the hard work, done the numbers, saw the opportunity…and did not do anything. I share some valuable lessons in this post with the company as the protagonist. This story is about Gujarat Narmada Valley Fertilizers Company (GNFC)

Inefficiency manifests itself
GNFC is engaged in the Fertilizers business. What was so special about a company operating in a regulated, commodity business where no one player seemed to enjoy a strong ‘moat’? There were better investment opportunities elsewhere in other industries. I don’t disagree. As a Buffett follower, I wouldn’t have touched this company, never mind the price…But as a part believer in Benjamin Graham’s ‘cigar butt’ type stocks, I couldn’t pass this company over after what I saw…

Cigar Butt stocks: A discarded cigar butt allows the smoker one last puff…but the last puff doesn’t cost much. Cigar butt stocks are those where there isn’t much steam left…but the prevailing price makes the proposition an ‘easy picking’.

The thing that drew me most to GNFC was its strong fundamentals. The operational performance stood out glaringly when juxtaposed with its similar sized peers. GNFC had seen 4 consecutive years of expanding margins and was steadily repaying debt. A very good sign. The glorious fallouts of this were gradually showing up in the numbers. A company was getting stronger…and nobody seemed to be looking…Table time..

Prices are as of October 20, 2006; the day I carried out my analysis.

In the table, I have compared GNFC with two of its similar sized peers in terms of revenue. Starting from the top, the difference in profit margins is self-evident. Strike 1. Moving on to the balance sheet, one can see that GNFC had the strongest balance sheet in the group. Its debt/capital ratio was very comfortable, while the other two had as much debt as equity. Strike 2.

GNFC had the best Return on Capital in the group. (ROC is my favorite metric. Personally, I spend more time on it than on any other metric when analyzing businesses. ROC tells you how much return a company is able to generate out of all the capital that it takes in (in the form of Debt and Equity. I look for companies that have enjoyed high returns on capital over long periods). What I saw warmed my heart. In an industry where most players were struggling to get into the early teens, here was a company that was achieving ROC in the high teens. Strike 3. GNFC came out tops on Return on Equity (too!). Strike 4.

While Chambal Fertilizers enjoyed a higher dividend yield, GNFC wasn’t too far behind. Now, I turn my attention to one of those beauties of the market. Mispricing.

To give a little background about the trend leading up to 2006, GNFC had expanded margins fron around 5% in 2002 to 14% in 2006. It was also consistently reducing debt and expanded its ROC. All positive signs. The other two in the meanwhile had increased debt and saw their margins either staying flat (Coromandel) or heading southward (Chambal). Both negative signs.

Given this background and GNFC’s current standing, one would have been rewarded for asserting that GNFC ought to trade at a premium to its lesser peers. Hmm…And one would have been wrong. The ‘efficient’ markets had apparently forgotten GNFC’s existence and shunned it to hell. And so an anomaly was born…waiting to be exploited.

Did the anomaly correct itself?
One year is a reasonable time frame to expect these glaring anomalies to correct themselves. Did it? Let’s take a look.


To give a 1-year perspective, prices for the above table are as of October 22, 2007. Prices in INR.

The markets had recognized their folly after all! Suddenly GNFC was in the limelight, and the other two were shunned. (Well not really, they did appreciate too!). But the Atlas had won…after all! The margin of return was more than twice the other competitors. A classic value pick.

BUT I HAD SOMEHOW MANAGED TO MISS IT…

Cut to 2007
Below I present figures for the same companies, for the same metrics…but for fiscal year 2007.

To give a 1-year perspective, prices for the above table are as of October 22, 2007.

Hmm, the industry seemed to have made life tough for all companies, GNFC included. All the companies witnessed a drop in margins from 2006. But the relative levels were unchanged. GNFC still Struck! Strike 1. After 4 years of debt reduction, the company increased debt in 2007. But so did the others. In Chambal’s case, debt had now become twice as much as equity. Strike 2 to GNFC.

Not surprisingly, the return ratios fell for the group as a whole, as most had to grapple with an increasingly alien business environment. While Chambal and Coromandel slipped into single digits, my friend GNFC still continued in the high teens. Strike 3.

This time around, one would have been rewarded even more handsomely for stating that GNFC now ought to trade at a premium to its brethren. Hmm…And one would have been wrong. Again. While the P/E and P/B for the group has expanded, GNFC still seems cheap relative to its peers. The other two seem overpriced considering their current operational health. So if somebody put a gun to my forehead and forced me to buy one company’s stock in the fertilizers business, I would pick my friend. But…

The line between ‘Relative’ and ‘Absolute’ valuation
This is where an investor needs to weigh carefully the approaches of relative valuation and absolute valuation. While a stock may look attractive relative to its peers within the industry, it may very well be expensive when compared to other businesses. Ultimately the underlying economics of the business ought to take precedence over standalone valuation. Faced with the prospect of choosing between two equally strong companies, I would choose the one which operates in the ‘stronger’ business. By ‘strong’ business, I mean a moat that keeps competition at bay. Where a new fellow coming in would find himself running into Atlases, not Lollipops.

GNFC is an example of an Atlas company operating in a mostly Lollipop business. So there may well be better opportunities elsewhere.

Conclusion
One question that may be linger in your minds is, “If this guy really saw all this, what did he do sitting on his...well..?” Answer: I take full responsibility for inaction. This brings me to the second part of the title of this article.

The losses from inaction far exceed the losses from wrong investment decisions.

It’s far easier to eat ones ego and reverse a bad decision than watch an identified easy pick go through the roof. In GNFC’s case, I was somehow not convinced of the then prevailing price. It still seemed a tad over-priced to me. I made a mental note of buying into it if it ever came to INR 90…and I kept waiting. (The price did come close to 90 once…but I was caught napping…)

In my experience, in the long run, I have seen stocks of Atlas-like businesses return far more than Lollipops. Very often though in a Bull Run, the Lollipops tend to trade at a premium to Atlases. The observant value investor has the world at his feet, literally, for there are Atlases for the picking…at a fair discount to their true worth!

I vow NEVER to ‘nap’ again!!!

Disclaimer:
I do not hold GNFC or the competitors mentioned above. The article should not be viewed as a solicitation to buy, sell or trade any of the stocks mentioned. There is immense risk of loss in blind-man-buff investing.

HL 14 - Blast from the Past

Two unrelated cases happened over the past week that compelled me to pen down my thoughts on them. Both are, of course related to the markets, but they aren't related to one another. The common tether that binds them is investor psychology. Read on...

Black Monday

October 19, 2007 marked the 20th anniversary of the demonic 'Black Monday' crash that shook the markets exactly 2 decades ago. On Monday, October 19, 1987, the Dow remarkably dropped over 20% in one day's trade. Most global equity markets suffered declines of over 20% by the end of that fateful October month.

Experts continue to argue about the possible causes behind the collapse. Program trading, bulk selling, overpricing, illiquidity were all put forth as reasons behind the event. In this section, I will write about human psychology 2 decades since. Maybe there was some pattern somewhere?

The table shows 1-day price change for selected major world indices on three specific dates, beginning with 'Black Monday' of October 19, 1987.

A very interesting pattern comes out of the table. One can see that major world indices dropped quite a bit, on October 19, 1997, exactly 10 years after 'Black Monday'. The 1997 fall, although not major in terms of magnitude strikes a chord when seen in relation to the general sentiment surrounding equities in the late 90s. The internet frenzy had begun and equity markets around the world were mostly moving in one direction...UP...But on the fateful 10th anniversary, most major global markets chose to fell together. The 20th anniversary did not bring with it any cheer either! Again equity markets dropped together and this time the percentage decline was bigger than in 1997.

Did the underlying economic fundamentals driving the respective countries change in a day? Were world markets suddenly gripped with a bout of collective enlightenment, which forced them to pay respect to their past?

This is where investor behavior comes into the picture. Nothing had changed in a day. In fact, over the 2 decade period, prosperity had only increased globally. GDP, GDP per capita, science, technology had all advanced rapidly. But investor thinking didn't change much.

In my opinion - and I am venturing into the esoteric sounding area called 'cognitive psychology' - human beings take decisions with their eyes stuck to the rear view mirror. An unlikely event as a 20% fall was enough to fill people hearts with fear and uncertainty. Every time the dreaded date came up, investors around the globe chose to let go of their rationalities for a day and sold off...Sold off till Black Monday became a self-fulfilling prophecy.

Go-Go CEO (during a Bull Run)...and Go-Go CEO (after the bubble bursts!)
The second event is a classic in many ways. It occurs so often that investors have forgotten to even acknowledge them.

CEO joins the firm during the onset of a prosperous bull run --> Investors push the CEO towards making investments that enhances their return (and conveniently forget the risk involved) --> CEO obliges and invests in areas that probably he himself doesn't fully comprehend --> For sometime the good times continue --> CEO is King.

--> Bubble bursts --> Pain begins --> Company takes a write-down --> People hunt for a scapegoat --> Get one in the CEO --> Kick him out -- Bye bye CEO!

This is what happened with the CEO of Merrill Lynch, Stan O'Neil. The brokerage took a hit of close to $8 billion related to subprime mortgages, resulting in its biggest quarterly loss since its beginnings 93 years ago. Although the CEO is no saint, I find it intriguing that nobody thought of ousting him when he was busy investing in these risky assets. (Maybe they didn't because nobody understood or wanted to accept the risks involved). The CEO is shown the door when he accepts and rectifies his mistake. Hmm...

The CEO was known as a guy with a stomach for 'risks' and was seen by many as the one who directed Merrill's entry into the subprime mortgages segment. So to that extent the axe had fallen rightfully...But the stock went up 10%, coinciding with this bit of news!!!

Maybe the good times will begin once again...

Conclusion
Every day of watching the markets, makes me embrace the theory that ultimately the winner is the one who is able to control his behavior better than anybody else in the markets. Greed, expectation, euphoria and fear are emotions that co-exist in investors, sometimes unfortunately leading them to their downfall.

A Buffet adage is in place here.

"We simply attempt to be fearful when others are greed, and greedy when others are fearful."

NOBODY could put it better...

HL 13 - Anatomy of a 'Structured' disaster

The financial world seems to be coming a full circle. While the global markets are busy trying to adjust to the problems triggered by the sub-prime meltdown in the US, data on the economic front threatened to spoil the recovery party. Suddenly, everyone is worried about 'risks', which they thought had been effectively 'diversified' away. The very financial innovation (Structured Products) that made investors happy till recently has suddenly turned their worst enemy.

And, as usual, turmoil in the markets leads to a round of scapegoating and finger pointing. The scapegoat ranged from rating agencies to the structured products themselves. In this post, I put investor behavior under the scanner. We will see the extent to which man - greedy as he already is - can stretch himself for that extra penny. I look at the whats-n-whys of 'Structured Products', the resulting collapse, and end with a commentary on investor thinking.

'Structured' to perfection?
Problem statement: Lets assume that you are a pension fund investment manager who has a mandate to invest ONLY in the highest quality debt products (AAA rated). You cannot invest in Equity. You find your returns being relegated to the back pages of newspapers and rankings. Not surprisingly, you aren't even taking home a decent bonus, whereas you find your neighbor (a hedge fund manager) going from middle class-to-wealthy-to-rich-to-filthy rich almost overnight. You come to me for a solution.

An ingenious solution to the problem props up in my mind. I think..."What if I invent a 'debt' product which will give an 'equity-like' return?" And lo! A product is born! I call it a CDO (Collateralized Debt Obligation). Before I present a chart, let me give you in two lines what it means...

People take mortgage loans. So? Simple, I club a slew of loans together ('securitize' them) and sell it to willing buyers. Okay, some borrowers will have ugly credit histories and hence the highest risks of default. So they carry higher risk, so an investor in these will have to be compensated with a higher return. But its still a debt product remember? So I look around for buyers and I find a willing buyer. In you. Higher risk implies higher return, so you are compensated for bearing the higher risk on these NINJA (No Income No Job or Assets) loans.

And so a product is born...

If these NINJA guys don't default, then there is a quite bit of money to be made. And this is what happened till recently. The CDO boom in some ways can be traced to the housing boom in the US and low interest rates. People took more and more mortgages and CDO demand followed. But as with all good things in life, this party too had to come to an end.

Interest rates started inching up in the US, gradually reducing demand for houses. Falling demand leads to falling prices. Falling prices meant that most people who bought at lofty levels were left with 'assets' that suddenly lost a big chunk of its value. The double whammy of rising rates on his mortgage loan and falling house price, resulted in Johnny feeling the heat. Result...Defaults started rising. Hmm...chart time.

Since defaults started rising, investors very quickly found themselves holding on to pieces of paper...Hell had broken loose...

Can I afford it?
Another factor probably went unnoticed for a long time. A metric named "Debt Service Ratio", which is the ratio of debt payments to disposable personal income. The little ratio was happily trending up since 1994 but nobody seemed to be bothering too much...till recently. When enlightenment dawned, the dream ended...and nightmares began...

As with any haphazard linkage, nobody knows whether the strain on finances led to slackening housing demand or vice versa. Or was it some other reason? And as with most bubble bursts, this was just one of the multitude of reasons behind the bust. But the blame went to something else.

Human Psychology
In the rather quick (and short) round-up of the mechanics of structured products, I turn to the last part of this post. Human thinking.

In order to appease eager bankers trying to sell these products to even more eager investors, rating agencies gave their stamp of approval with an AAA or AA rating. Bankers armed with this 'invincible' tag, didn't need to as much as lift a limb to sell the products. They opened shop and quickly found the products disappearing off their shelves.

The burst sent everyone running for cover. Investors blamed bankers, bankers blamed rating agencies...who conveniently washed their hands off the entire affair. The losers (and there will continue to be) were investors. Supposedly sophisticated investors, with the information world at their feet, were forced to revisit their assumption of invincibility. Big hedge funds suffered ignominious losses...but no one was ready to put it down to greed.

The entire structured finance business was branded a sham. A weapon that had backfired. Was this really the case?


I don't agree. Personally, I like the concept of innovating in the supposedly dreary area of investing. (Someday I might dedicate a post for this!). Products by themselves are never 'bad'. Its when 'investors' lap them up without understanding the risks that the dream run goes horribly wrong. The blame, finally, has to rest with the investor and his greed and his naivete. But in a competitive world, where human beings pressure one another to earn the extra return, these qualities are buried somewhere in the recesses of the brain.

Now I am sounding like a saint! Anything but. I believe that investors (whether amateurs or experts) would do really well to invest only in things that they understand and comprehend fully.

"A risk not understood is a risk that ain't diversified away." -- Yours truly

If that sounds like Warren Buffet talk, then it is! The concept of investing within ones 'circle of competence' makes immense sense to me.


But I am willing to wager a bet that human beings never learn from their mistakes, especially in the investing world...And I know, that this is one bet I will never lose!

HL 12 - Weather and Equities: A connection?

After venting my thoughts on the state of India, the country, I return to the world of equities – and sanity - with this post.

Seasons come and go, years go by…but to suggest some connection between the weather and the equity market would sound somewhat ludicrous, won’t it? I had this strange hypothesis of Summer being the worst ‘season’ to trade Indian equities, and Winter the best. Did the actual numbers support this theory? Apart from the intellectual exercise, I wanted to see if a trading strategy could be built around the Indian seasons. Here’s the outcome of my curiosity...

In this post, I take a look at the performance of the BSE Sensex since its birth. A ‘filter’ here is that I have split up the months of the calendar year based on the ‘Indian Seasons’. So, I have June to September representing the Monsoon season, October to January representing Winter, and February to May representing Summer.

Summer Effect

There are some sound reasons for Summer being the worst season to trade equities. First, there is the much awaited yearly budget, which brings with it an air of uncertainty and volatility, both before and after the announcement. In the world of equities – and indeed investing – uncertainty implies that market players are reluctant to commit to one particular view on the market. Result…money is taken out of equities and people play a wait-n-watch game. End result: Gains are muted, or, in some cases, markets exhibit negative return tendencies.

Second, the Indian market generally follows the April-March financial year. Money managers whose bonuses are hinged on their portfolio values as at financial year end are most wary about a sudden downturn. Why should I let go of my hard-earned bonus to a suddenly fickle market? Result…they book profits and take money out of the market. End result: Again…gains are muted, or…well...

Third – and this is my hypothesis – summers are psychologically the worst for human beings. The heat tends to make people highly susceptible to the slightest of provocations. A couple of avoidable incidents on the way to office…and the mind is inclined to succumb to impulse decisions. Psychologically, human beings are wired to lose their heads when the requirement is just the opposite. So, one bad decision generally precipitates to another...

“A bad head…is often a sad head…” – Yours truly.

A combination of the above (and some more that I haven’t mentioned for want of space) made me believe that summers ought to be the worst season to trade Indian equities. (Was I correct? Wait a while…)

Conclusion: Go away in Summer.

Not-so-rainy-days

After the unwanted uncertainty in summer, the monsoon brings with it an inflow of new investments. Now that there is ‘certainty’ regarding market direction, market players find it comfortable to initiate or scale up their exposures in equities. End result: Markets rise.

Another not-so-subtle reason for the rise in the markets in monsoon can be traced to brokerage houses. The beginning of the new financial year sees brokerage houses publishing their expected EPS figure for the market index over the next couple of years. The expected EPS culminates in next year-end targets for the indices (which invariably is higher than prevailing levels). End result: Money flows in…and markets rise.

Conclusion: Good season to go Long in Indian Equities.

Cool Winter
Probably the most significant development in the investing world over the past decade has been the mobility of capital. Money managers now have the entire globe as a playing field. The rise of the emerging markets –particularly India – has been a key driver of Indian equity markets. The high return is just too juicy for money managers to act blind and stay in the sidelines.

Global money managers generally follow the January-December year. With their variable pay linked to year end portfolio values, there is every incentive to inflate the values towards year end. What better way than to invest in emerging market equities? Portfolio rejigging happens at the beginning of the year and fresh allocations for emerging markets are set. Given the attractiveness of India as an investing destination, shouldn’t the Indian Winter be a good one for going or staying Long on India?

Conclusion: The best season to go, and stay, Long in Indian equities.

The Result
Here’s the table...

Looking at the long-run numbers (1979-2007), clearly Monsoon is the best season and Winter is the worst (albeit marginally) in terms of average return.

But the more recent – and probably more relevant – 2000-2007 period tells an interesting story. The Winter season emerges as the best with the highest average return. And the higher return has come at a significantly lower standard deviation, indicating the strength of this season from a trading perspective. The Summer season – as expected – has delivered an average negative return over the period. The Monsoon has delivered a reasonable return, albeit at a very high standard deviation.

I have also added the number of Up Moves (defined as >0% return) and Down Moves (defined as <0%>The Winter season has witnessed greater number of Up Moves (19) and lower number of Down Moves (9) compared to the other two seasons. Most significantly, the Winter season has not had a down season since 1997-98. The other seasons, sadly, cannot boast of this!

Conclusion
The above exercise – apart from massaging my ego – could form the basis of a trading strategy. Of course, there is no certainty of the trend continuing in the coming years, but (sorry to reiterate), markets have memories. Longer the time period, stronger is the memory (and inertia). Things continue the same way until some external force breaks the pattern! The trade is simple: Enter in Monsoon, increase ones position in Winter…and exit in Summer.

It would be naïve to discount fundamental factors at play in the markets. But this strategy, as with any technical trading strategy, will work only if the user sticks to the rules of the game. If the premise on which a trade was entered changes, its best to change ones opinion!

HL 11 - One Small Voice

Continuing in the spirit of Haphazard Linkages, I look at the consequences that a false sense of ‘progress’ has on an economy. Things may look ‘good’, but is it a true and justified reflection of the resources at a country’s disposal? Can things be made better? An economist aims for efficiency. A state where one individual cannot be made better off, without making another worse off in some way.

On the 60^th anniversary of India’s independence, patriotism and a sense of well-being abounds everywhere. People are mostly unanimous in their verdict that India had arrived and bask in glory…The Times of India headline, “60 and getting Sexier” couldn’t have captured it better. Every news channel and celebrity waxed eloquent about how much progress India had made during this time. Waxed eloquent about India’s stupendous GDP growth…about India Shining.

Did this appraisal reflect reality? Or was it just another day where patriotism oozed out of wherever anybody cared to look? As much as I want to believe the stuff expounded by the channels and newspapers, I am forced to objectively evaluate the opposite.

What follows reflects my personal opinion about the way I perceive India today. I will keep patriotism out and write from an economist’s point of view. From where I stand, I am forced to conclude that we as a nation need to drastically change the way we see reality. Or run the risk of being obliterated in the long run by smarter economies.

Firstly, there are lots of things that are right about this country. Standard of living has moved up, demographics are excellent; the Indian middle class has arrived and is shaping the way entrepreneurs do business. Of course India has progressed. But am I happy with the speed of progress? There seems a void. A void of incompetence and lax attitudes that seriously threatens our future if left untouched.

I begin by looking at our attitude towards education.

Education = Equality right?
Reservations are an old story now. Everybody knows the perils of it but it just keeps going on and on. So I won’t write about it. The thing I am worried about most is the prevalence of what I will call ‘Equality’ in education.

‘Equality’ which was supposed to imply equal opportunity to education, now seems to have taken a slightly different meaning. The word now implies ‘equalizing’ individuals so that there are no ‘outliers’. Here’s a true story. (I won’t take names).

A smart guy decimates his competition in class (Class of 50). He is the only one who manages to pass through a series of tough assignments and rightly expects his reward. What awaits him at the end of the tunnel? ‘Equality’!

The powers that be decide that it’s not a great idea to show-off to prospective recruiters that only one guy in the whole class had passed! So they decide to normalize the marks awarded to the class, resulting in 98% of the class ‘passing’ the assignment. Some find themselves happily vaulted to the Top-5 from nowhere. Not surprisingly, the smart guy is very upset. In a whiff of a wand, the institute takes away his USP…Superlative performance in a difficult situation.

The institute did what it thought was in the best interests of the students…and itself. Leaving morals out (evidently this is a case of unethical and immoral behavior), the economic consequences of this apparently harmless act are profound.

The ‘passers’ (pardon that term) find plush jobs with salaries that are disproportionate to their competence (the same is true for the smart guy). They start off and for quite some time their incompetence doesn’t show up. Once these sheep are left to tread on their own, disaster strikes.

Small errors get magnified into big ones very quickly, and most of these get laid off. In an expanding economy, most manage to find alternative jobs and so the disease stays hidden for some more time. When the economy turns for the worse…well, a quote borrowed from Warren Buffet is appropriate here…

‘Its only when the tide goes out, that we know who is swimming naked!’

Unemployment rises…the ‘incompetents’ start cribbing about what a raw deal they got from the business world…they find it easier to curse capitalism than to own up to their short comings…And if nothing changes, they go and beg to the government for a solution; which in most cases, obliges happily.

Where does this lead the country? A growing bunch of incompetent working class is the last thing that a growing economy needs. The costs of nurturing them in a growing economy are high, because in most cases their salaries are disproportionate to their skill level. The costs are also high when the economy turns for the worse, because the same level of wealth now needs to be divided over a larger proportion of unemployed people, who aren’t contributing to the GDP.

Result? The country stays a ‘developing’ one for longer than anybody desires. But nobody seems to bother…India shining?

What happened to the smart guy? Well…the guy, smart as he is, decides to leave the country. And makes a living elsewhere. I hear farcical pleas of Brain Drain somewhere.

The above example to me is a classic example of inefficient allocation of resources. The act of ‘equalizing’ led to the country losing out on one smart fellow to make room for 49 others. Admittedly, one guy cannot contribute as much as 49 others. But over a long period, the contribution made by a group of smart fellows far outweighs the ‘contribution’ made by a collection of 49s (if we can indeed call it a contribution). Contribution to the GDP and taxes (the smart guy’s income goes up, his taxes go up, assuming he pays taxes!). The 49s languish, and since they are out of sync with reality, most won’t be able to earn much…and by extension, their contribution to the country for once mirrors their skill level. And they become liabilities.

I am a firm believer in meritocracy. The not so competent guys need to make way for the better ones. There is every incentive for the former to get better in a world where meritocracy is awarded transparently. The disbursal may take an inefficient path, but it shows up in the end.

Bad Infrastructure = Political whim = Gargantuan loss of productivity = Encouraging mediocrity = Demand for subsidies = India shining?
Every day, I waste 15 minutes in traversing a 100 meter stretch of road due to traffic. I have a few 200 people for company. 200 men wasting 15 man-minutes equates to 3000 man-minutes of lost time. That’s 50 man-hours lost only in the morning. Add another 50 for the evening journey back home, and we are already staring at a loss of 100 man-hours every day. That is a conservative estimate. Extrapolate it to the whole country and what we see isn’t India shining. Talk about productivity?

A politico’s convoy zooms down the road, and traffic on both sides of the road is held up for ages. Most of the people on the roads aren’t aware that they will be held up for quite sometime and leave their engines running. Wastage of fuel? The convoy zooms down after ages, farting soot on the faces of the traffic cops.

Ask anybody who follows the Indian economy and he says that infrastructure is one area that demands attention. But is the attention there? Innumerable delays result in wasteful cost over runs and it’s the poor tax payer who foots the bill. The incentive system encourages the powers-that-be to keep delaying the projects. “What if some one else takes credit for this after my term?” Thinks the politico, whose time horizon is often not more than 5 ‘long’ years. “What will happen to my annuity?” Thinks the road company that is awarded the contract.

In a system, where the emphasis isn’t on accountability, there is every incentive to keep things inefficient. The powers-that-be find it easier to handle queries by irate masses rather than watch the ‘credit’ being snatched away from them.

China’s labor productivity has grown at twice India’s rate over the past decade and a half. While it’s simplistic to attribute the above as the only cause for this, the beauty of layered connections ensures that the above is one of the primary reasons behind this. Consequence?

Businesses demand more ‘sops’ and ‘subsidies’. The appreciation of the Indian Rupee causes a lot of pain to exporters, who line up with the government with pleas for more sops and subsidies to alleviate the ‘pain’. While I can understand small businesses asking for subsidies, I cannot digest thriving large IT/ITES companies demanding the same. Companies that enjoy consistent 30% net margins and loads of cash asking for subsidies, is tantamount to Bill Gates begging for a living.

Germany’s exports grew about 10% despite a strong appreciation of the Euro. How was this possible? Weren’t we taught that an appreciating local currency is supposed to hurt exports? Is Germany an ‘outlier’ that demands ‘equalizing’?

The answer lies in the huge difference in the competitiveness of the products exported by Germany and those exported by India. Instead of thinking up ways to enhance productivity and competitiveness, most find it easier to demand sops. Sops are like drugs; they ease the pain and provide temporary relief, but cannot cure the disease. Curing the disease demands the patient to bear short term pain for long term gain…but…

The other grouse that I have against the sops system is that it encourages mediocrity. When businesses know there is an easy (and profitable) way out of a problem, there isn’t a strong incentive to make things better.

Sports = Reflected Glory?
A country of 1 billion people struggles to produce a world class cricket team. We are nowhere in Soccer and Tennis. Cricket and Hockey is a classic case of reflected glory of the golden years gone by long ago. A few sporadic wins, like Halley’s Comet, engages media attention; which resurfaces after the next sporadic win.

While superiority in these can hardly qualify as a reason for a country shining, the attitude is what is paramount here. The way the players approach a game speaks a lot about their attitude. Can we see a hunger to win? More importantly, is there an incentive to pursue a game as a profession? Is there meritocracy?

But India continues to shine…

India Shining?
Every country has its short comings, but the moot point is, “Are we doing justice to the resources that are at our disposal today to the desired level?” I am tired of this attitude of being satisfied with mediocrity and reflected glory. L N Mittal acquires Arcelor to become a steel czar and India falls over to salute him. I am a huge admirer of Mittal’s business sense, but get furious at the media’s immediate act of basking in reflected glory of how an Indian is now at the forefront of the global steel industry. The media and the politicos who hail him to the heavens need to introspect and ask questions like, “Why did he leave the country? What made him successful in another country? Is there anything that we can change for the better to help grow over achievers? Are we creating an environment where entrepreneurs can build businesses profitably? Are we creating a meritocracy where each individual knows that if he gets better, the rewards are there for the taking? And if he chooses to sit on his backside and do nothing, he will be blown away?”

Mittal’s competence didn’t change dramatically when he left the country. But the external factors probably did…for the better. And maybe therein lies the answer. A Reliance and Infosys in a country of 1 billion cannot be forever used as shining examples of successful businesses.

As an Indian I wish I was happy at the progress that the country has seen over the years. But the realist in me poses difficult questions. Of course, nothing is perfect in other countries too. Some even contend that the Yuva needs to take to politics to change the country. I differ. I believe that each man should identify his strongest competence and work upwards from there on. As a tax payer, my focus on getting better at my craft makes its way to the country’s coffers by way of ever increasing taxes. What the country does with this money is now a prerogative of the politicos. Adam Smith’s concepts of Self Interest and the Invisible Hand will ensure that the country sees tangible progress over the long term. We have a choice of being happy with the way things are at the moment, or raise the bar and make things better.

Maybe then, I will have a lot of conviction in saying that India, is truly ‘Shining’.

HL 10 Update - Lessons from Credit Spreads

History...once again triumphed...The gloomy story painted by the behavior of Credit Spreads played out in the equity markets (again). The S&P 500 finally fell by over 7% from its high in response to the developments in the credit markets. Expectations of ever higher premiums in takeovers finally receded into the background.

The markets seem to be rational again...Or, is this just the proverbial tip of the iceberg? Another hedge fund, Sowood Capital, succumbed to the sub-prime disease. It seems there will be more casualties along the way. Evidently, private equity buy-out firms - for whom credit is equivalent to blood - are finding the going tough. But few seem to be openly accepting it.

In more ways than one, the tightening of credit is good for the markets, in terms of adjusting investor perception towards risk. This article from this week's Economist makes for good reading.

I am going to be watching the happenings in the credit markets with rapt attention in the coming days...

HL 10 - Lessons from Credit Spreads

What are Credit Spreads? Can they be used to predict equity market direction? How can one predict the behavior of one asset class by looking at signals from another asset class? This post looks at these questions…

An army of market watchers around the world spend a lot of time predicting market direction. Some follow the fundamental approach and base their views on things like earnings growth of corporates, P/E multiples etc; while some follow the technical approach. The latter express a view on market dirrection by reading charts. They talk support, resistances, head & shoulders, negative and positive divergences etc. While neither of the methods are per se ‘wrong’, it would be rather intuitive to learn about movements in one asset class by looking closely at what happens in another asset class. Credit Spreads is one such ‘indicator’.

Investors in ‘Junk’ bonds - bonds issued by companies that are teetering on the brink of disaster are classified as ‘junk’ - need to be compensated adequately for assuming higher risk by investing in the junk bond as compared to investing in a government backed Treasury Bond. So they demand a higher yield for investing in these bonds. The difference between the yield on a ‘Junk’ bond and a Treasury Bond can be termed as a ‘Credit Spread’.

Credit Spreads and Equities
High spreads indicate that risk-appetite among investors is very low. Low spreads indicate the opposite. When investor appetite for risk is low, they tend to invest most of their money in ‘low risk’ bonds. Less money flows into equities and hence, equity markets tend to stay depressed. When risk appetite increases, investors shift money out of debt and direct them towards higher risk asset classes like equities. Result? Equities start rallying. As a consequence, changes in conditions that lead to changes in investor risk appetite…lead to gyrations in equity markets!

Lessons from History
In 2003, something led to a contraction in Credit Spreads…and a rally in equities! (Chart helps! Data from Oct-03 to Jul-07)

Low interest rates led to a boom in lending. Corporates re-leveraged their balance sheets enhancing returns for equity holders. Something else also occurred during this period that led to a surge in lending. Private Equity. The LBO (Leveraged Buy-Outs) wave reared its head once again with returns that caught the attention of even conservative investors like pension funds. Demand picked up so much that lenders found it extremely lucrative to lend to the ‘sub-prime’ segment. For a while, returns from these investments far outweighed the inherent risks, as a sub-prime market collapse seemed unlikely. Attracted by the huge returns that these funds were generating, more money started moving out of low risk asset classes…

...Leading to a contraction in Credit Spreads (refer chart). The equity market reacted after a while and the rally began…taking the S&P 500 from 800 to over 1500 levels in the next four years.

The needle that burst the bubble eventually came in the form of higher interest rates and housing market slowdown. The string of interest rate hikes instituted by the Fed, gradually resulted in rising defaults on home mortgages. Rising defaults led to slowing household sales…leading to drop in house prices…leading to more defaults as people found the prices of their properties dropping and buyers hard to come by!

The sub-prime market blew up as a consequence of the housing market slowdown. As the risk of defaults increased, the effect was seen in the credit spreads…which started widening sharply since Jun-2007 (refer chart). Investors, burned by the meltdown, moved into low risk asset classes. Where was the equity market correction?

Current Scenario?
Credit spreads have widened sharply over the past few months after bottoming out at historic lows, but the equity markets, as usual, haven’t begun their reaction. I think the lure of higher premiums for equity by private equity firms is supporting the current rally in equities. On most occasions, equity markets have lagged the developments in Credit Spreads and this time seems no different. If history repeats itself (again!), it wouldn’t surprise me if the equity markets corrected in the short-to-medium term.

As usual, time is one’s best friend…or worst enemy!