Monday, 25 November 2013

Where Are The Fundamentals?

The following charts are useful in appreciating the previous bull market in India.


Improving interest coverage ratios and uptick in growth in the first half of the previous decade created a favourable environment for assuming a long equities posture. The acceleration in equities post 2005 coincided with a down tick in debt service capacity. This is in tune with behavioural characteristic of investor attention reacting belatedly to fundamentals. Cut to the present, coverage ratio is at 12-year lows and yet the equity index is at levels similar to 2007, when coverage ratios and economic growth were vastly better. 


Improving balance sheet health also reflected in a down tick in interest expenses relative to revenue until 2006. Post 2006, this metric has evolved on a deteriorating trend, and bank gross NPAs have grown at an accelerated pace. Both are at 12-year highs. The broad economic slowdown is partly to blame; however, blame ought to be apportioned to bull markets as well, as falling diligence levels incentivise easy access to capital, even to companies ill equipped to handle debt burdens. The gross NPA excludes recast loans, which form a good chunk of advances (10% of loans are NPA + restructured). What could lead to a reversal in this situation? Growth and a stable inflation environment would offer good starting points. How have these been panning out?  


Two other broad conditions created a supportive environment for equities post 2003. GDP growth picked up and stayed above long-term trend, while CPI ducked and stayed below trend until 2008/09. Since then, these lines have gone in the wrong directions. Achievement of GDP growth forecasts for 2014 & 2015 would still see growth running at 25% below trend, while inflation would be 30% above trend. Economic slowdown has also reflected in earnings. The RBI is focused on reining in inflation (the right thing to do), leaving the reins of economic growth in the hands of the government. As things stand today, stagflation is the path of least resistance over the medium term.

Given impending elections next year, reforms momentum has been waning, or being stalled completely. Political will to reform is low and unlikely to materialise until elections. In relative terms, China outlined a reform-oriented plan in its Third Plenum. China's pro-reform agenda contrasts sharply with the stalemated reforms process in India. With the former's economy expected to grow at a faster pace, capital is likely to prefer China to India in the medium term.

In sum, earnings and economic growth have slowed down inexorably, while inflation is stubbornly high. Things continue to deteriorate on the balance sheet front. Reversal catalysts are nowhere in sight. In such a scenario, it is hard to justify the equity market rally on the basis of either fundamentals or possible electoral outcomes; sentiment and hope - shaky foundations - are the pillars on which the rally (if sustained) is built.

Wednesday, 21 November 2012

'Can We Have Some (More) Obama Please?'

The US election is history. The dust has settled and life reverts to the dreariness of the usual. It is an appropriate time to pause awhile and look at some intriguing outcomes of the election.

Voting is perceived as an activity centred around individual voter self-interest. Well-balanced, informed voter base is an assumption that is considered unworthy of a re-examination. While the self-interest angle is quite palpable, the gamut of reasons put forth by voters on picking a certain candidate are often mired in vagueness

The following is an edited excerpt of an recent email exchange with a friend. HaLin wasn't eligible for voting, but under the garb of a market participant, had much practical interest in the outcome. This post is a summary of events as they happened.

Does individual rational behaviour lead to collective rational outcome? It is time to dive in to the world of individual definitions, nomenclature and qualitative perceptions.

--------------------------------------------------------------------------------------
Quote: 


...turning to the economy. 

Since Obama came to power in 2008, the running money spigots added about $2.6 trillion to the system through multiple Quantitative Easing (QE) programs. From the end of 2008 to end 2011, US GDP increased by $800 billion. c.$3.3 of fresh money printing corresponded to $1 increase in GDP. Some may argue, as indeed they do, that absent this QE, the danger of economic contraction was real, considering how much credit markets and confidence had frozen up. With the latest QE (Sep 13, 2012) the Fed is empowered to print money in unlimited amounts, dressed up in novel nomenclature, and they stand ready to do whatever it takes to revive the economy and until the labour market 'improves substantially'. This is essentially euphemism for more digging into the bottomless money pit to create new forms of debt. However, viewed against the grave counterfactual, one may put forward a case for Obama, supporting the money printing exercise. Benefit of doubt.

Employment picture  
Considering government numbers, the unemployment rate was essentially unchanged over Obama's term. It went up, then went down, quite coincidentally close to the election. Depending on how one looks at the numbers and who one peruses, figures vary but overall, it may be summed up that Obama's first stint wasn't a job-fuelling term. Again, one may argue that in the absence of QE, unemployment might have been worse. Benefit of doubt.
 
Debt situation, and the inertia of acceleration
All newly created money is essentially debt, which has balooned over Obama's term.

Household Debt as a % of disposable income peaked at 130% of income in 07/8, has reduced somewhat since; and now runs at 110-115% of income. Deleveraging? A chunk of this reduction has come thanks to bad debt written off by banks, many of whom were receipients of Obama's QE handouts. Never mind the circle. Benefit of doubt. 

A tidbit about US debt is insightful. It took the US 193 years to ratchet up the first $1 trillion to its sovereign debt. It then took 20 years to add the next $5 trillion, then just 10 years to add $10 trillion. Building inertia of acceleration. 

Obama administration opened the bottomless money pit in an attempt at reviving the economy/creating jobs, put money in the hands of those already sinking in debt, grappling with restructuring...so they could spend more. On the first two counts one may extend the benefit of doubt (Obama inherited a busted economy at the onset of the crisis), on the last, benefit of doubt may be sought under the refuge of 'time will tell'. Ask Japan.

New debt is being created (an expenditure), in order to kick start spending (another expenditure), while increases in revenue is mired in a haze. Piling on debt when overall debt is a fraction of GDP is different from piling on debt while sitting atop a debt mountain. 

Obama re-election, by voter group


Hispanics and African-Americans strongly preferred Obama. This followed a repeat in 2008.

Source: http://www.census.gov/people/wealth/

Low net worth + home repossession concerns + uncertain job scenario + pro-common man's presence + assumed familiarity + easy money policies, is a strong premise pointing to where this vote was most likely headed.
 
Financial market performance, under Obama I

Source: FT, Kitco, et al

This kind of extreme performance in financial markets in the backdrop of a flaccid economy may strike one as paradoxical. Much of it is thanks to the near costless, easy money programs that Obama administration championed.

If one turns next to the investor base that would benefit from this kind of performance, one would notice something interesting.

Source: http://www.census.gov/people/wealth/ 

The 1% figure prominently.

In summary, a Left-leaning President's pro-common man policies was the best thing to have happened to the pro-market, pro-wealthy 1% (Right leaners, mainly); while having a soft impact on reviving the economy/creating jobs. Even if Obama increased taxes, the 1% would breathe easy, thanks to the windfall gains they made in the financial market.

In the present world, the 'Left' is the new Right...
 
Much of the developed world's problems is thanks to spending more than their revenue and borrowing to fund the gap. The Republicans' plan, while vague (one cannot spell out everything), clunky, and with visible loose ends and gaps, would draw the curtains on QE, and easy money.

The 1% benefited under Obama (thanks to QE). Prospective Occupy Wall Street groups and haters of the wealthy might do well to pause awhile before re-training their guns on the 1%.
Romney would have been quite the party spoiler.

Unquote:
--------------------------------------------------------------------------------------  
The herd directs its ire on the 1%, while the strongest catalyst that helped the 1% (Obama) is loved and voted back in power. But it is fair to expect that the 1% will continue to be vilified, even as perceptions towards Obama rise concomitantly. 

The Right would rather sit well with the Left candidate. Kicking the can down the road is the in thing with no reversal in sight. 


Oddities are the order of the day.

Problem of the counterfactual
Would the Republican plan of deficit balancing work? Could a gaffe-ridden, politically gauche Romney have turned out a better candidate? Would Obama be able to translate oratorical elan and gallery-playing into addressing deep-rooted issues facing the economy? What of foreign policy? Climate change? Healthcare reform? 

Many have articulated views on some, or all, these topics without really knowing whose policies might really work. A mental anchor is sought and the first available anchor, howsoever a Chimaera, is embraced.

The Art of Voting, and Closing comments
Humans exhibit a ready tendency for optimism. The murkiness hierarchy typically runs from the present, past, to the future; in increasing order. When standing in the present, with a cursory picture of the past record, and little or no anchor to depend on for the future, humans innately lean towards a mix of preferring the status quo and optimism.

To expect an entire voter base to express an opinion considering all factors, and assigning appropriate weights to each, is a Holy Grail expectation. Individual self-interest frequently leads to sub-optimal collective outcomes.

The anti-Romney brigade tend to project their immediate self-interests and belief systems, frequently using these as a yardstick against which to judge the rest of the electorate. The anti-Obama camp reciprocate. 

Voting one's self-interest is an individually rational choice, aimed at leading to a workable outcome, even if far from ideal. However, the process of interaction of individual actions frequently leads to sub-optimal outcomes. As an ancillary consequence, the opposite emotions of ire and exuberance that follow, turn out to be frequently misplaced too. 

The prevalent dogma is feel-good, hear-good, and perennial can kicking. Voters get what they look for, not what is in the collective best interest. In a clash of propaganda, the camp with the strongest conviction prevails.

Long feel-good, short reality; continues to remain the flavour of the season.   

Thursday, 28 June 2012

Mind Of The Market II: All-Is-Well Syndrome, A Habit Of Misplaced Hope

In a chaotic world, a barrage of mirages can, sometimes, be confused for reality. In an environment of sustained negative developments and events, it seems somewhat paradoxical for misplaced hope to find an audience.

The second part in the Mind Of The Market series (Part I, here) will focus on recent elections in Greece and France, and the culture of all-is-well and misplaced hope that pervades market participant positioning. Paradoxically even as mainstream media resonates with negative undertones, participant actions paint another story.

-----------
Greeks came, voted a second time, and all seemed well. Again. For a disaster seemed averted. Greeks avoided Tspirageddon and offered the reins to a pro-bailout coalition led by New Democracy and PASOK, to steer them through the new phase in a never-ending saga.

The flight of deposits that had begun from Greek coffers into banks in stronger EU countries (run-rate approx. EUR 800 mm per day) seemed like a costly hedge to those that prudently went through the process. Money started trickling back into Greek banks, post elections and 'clarity'.

All is well.

Or, is it?

When The Mouse Garnered More Attention Than The Elephant
June 17, 2012 was a big day for voters. While global media and market participants were transfixed on developments in Greece, fretting about the possible victory of Tspiras' Left; a potentially far more important election transpired in France. Surprisingly, few seemed to notice, or care.

30-day search volume, a rough proxy for 'mindspace':


There was a collective sigh of relief when Left-centric Alexis Tspiras' Syriza lost to Right-leaning opponents in Greece. Over at France, the Socialists, under Francois Hollande, managed to achieve an absolute majority. Unlike Greece, where New Democracy had to jostle with PASOK to put together a government, France achieved a significant Socialist-dominated leadership, unlikely to face major opposition in implementation of policy.

In another queer development, a Party promising anti-austerity was voted to power (France), and a Party promising anti-austerity was shown the door (Greece). 

The Promise Of The Impossible...

A quick summary of Francois Hollande's election campaign agenda is insightfully oxymoronic.
  • Anti-austerity and growth-stimulating platform 
  • Reduce French budget deficit to 3% next year (current deficit: 4.5%) and eliminating it by 2017, although no clear road-map was enunciated. The Finance Minister insisted that targets would be met 'without austerity'
  • Reduce retirement age from 62 to 60 years
  • Creation of 60,000 new teaching jobs over the next 5 years 
  • Raise minimum wage by more than inflation and make it tougher for businesses to lay off workers
New jobs shall be created, working hours slashed, wages raised, lay-offs are tougher, pro-spending policies figure prominently; and yet, budget deficit is expected to be on the way down. Market participants seem to be placing an inordinate amount of faith in Hollande's ability in pulling off this Supermanesque feat of reconciling mutually exclusive objectives.

Hollande's pro-spending/stimulus stance is more likely to increase deficits than to decrease it. Especially, when the levers that would contribute to slashing the deficit are weakly understood. The whispering debt meter is likely to grow louder with time.    
  
...Yet Hope Runs High: France, A 'Safe' Haven

A look at market participant attitudes towards France over June is illuminating. Despite the slew of dark clouds on the horizon, largely thanks to the political impossibilities propounded by Hollande, market participants gleefully lapped up new bond issues by France. Reuters news runs:
 
French bond yields hit record low at auction - Jun 7, 2012

French yields fall at debt auction, demand firm - Jun 21, 2012

Yield on France's 50-year bond, due in 2060, fell to 3.27%. This was down from 3.34% in Nov '10, when the EU crisis was less intense than the present day. In the first bond auction after Hollande's Socialists assumed power, market participants accumulated new French bond issues. Bid-to-cover (a measure of participant demand) ran at close to 2.5x.

Yields began touching new lows (bond prices and yields move in opposite directions) and new issue appetite was healthy. When little had changed for the better and with the path of least resistance still pointing to more pain.

Hope floats eternal.

All is well.   

Greece: The Lair Of Liars & Wonders Of Short-Term Memory



While slightly dated, the chart captures the pre- and post- Euro situation in Greece. The (susiciously) reducing deficits leading up to Euro adoption reversed post-adoption. Much of this could be attributed to the benefits of cheaper sources of financing (common currency). Debt piled on and Cindrella had a ball. Until the party ended.  

Rumbles From The Past: Greece, 1990s
Barring a brief interlude in the early 1990s, PASOK - a Party associated with unbridled populism, a love for spending and tolerance for corruption - was at the helm of affairs throughout much of the 1990s and early 2000s, a critical time as Greece proceeded to adopt the common currency. In 2004, Greece admitted that it had fudged accounts to gain access to the Euro. Of course, that PASOK had presided over Greece when this activity was underway was deemed unworthy of mention. 

Voters exhibit an odd sense of history. Few remember, or question, the true reasons for their present quagmire but selectively remember the PASOK-promoted pay rises that they were beneficiaries of. Self-interested, rational beings indeed. Unsurprisingly, now, this same group is expected to lend support to their decades-old rivals - New Democracy - in forming a government and in steering Greece through trying times.

The Greece stock market roared its approval on pre-election rumours of pro-bailout faction assuming power.

Inertia Of Lying
Ahead of the critical EU Summit over the next few days, the Greek Prime Minister miraculously goes down with an eye problem, while nausea incapacitates the Finance Minister. Replacements shall make their way to the Summit, requesting renewed assistance from the EU powers-that-be.

The health 'issues' are likely to recur, at appropriate moments in this dynamic drama.

But, all is well.

A Habit Of Misplaced Hope

Time to gauge the pulse of the market. One would be forgiven for thinking all was indeed, hale and well. For a major disaster (Euro-imperilling government in Greece) was averted. All was/is, of course, well with France.

Cross-asset class behaviour leading up to Greece and France elections:




Risk-off sentiment prevailed generally, as market participants dived for cover in US Treasuries and bought protection to hedge against events in Europe (widening European CDS). Risk-off posturing continued with equity markets around the globe sauntering flat-to-down. Commodities reflected the sentiment, with dual-personality Gold being bid, even as Oil and Copper were shunned.

Post elections?




Built-in pessimism morphed into hope. The unwind began, as participants cycled out of US Treasuries, European CDS tightened and equities were bid. Oil and Copper continued to signal something amiss but few paused to ponder. The most significant change manifested in Volatility, which compressed materially post the weekend election events, a sign of return to 'normalcy'.

To sum up, little has changed for the better in the weeks post-elections. If anything, woes of varied character and intensity continue to confound Spain, Italy, Greece, France and Germany. This union is in disunion; on banking union, fiscal union, political union. The form of the Euro-wide bailout fund, European Stability Mechanism (ESM), remains shrouded in indecision and no clear path exists. Meanwhile, voices for Euro-defection and bailout requests (classic Game Theory responses) have picked up.

Market participants learnt all about tail-risks in the aftermath of the subprime crisis and Lehman Brothers. Few years since, tail-risks do not seem like tails anymore. The Black Swan event now would be a miraculous cure to the world's ills, or, the more likely outcome; the emergence of a new Order.

Until then, all is well.   ?

Monday, 11 June 2012

Mind Of The Market - I : Pavlovian Conditioning, Paradoxes & The Psychology Of Herding

In what should evolve into a multi-part series, Mind of the Market will endeavour to peer under the hood of the largest laboratory of human psychology in the world; the financial markets. Where frigid numbers and emotive participants spar enthusiastically in an elaborate and often bewildering drama-in-motion. Where apparitions and reality merge so finely as to be mostly indistinguishable. Where paradoxes and circular relationships reign supreme, frequently, and fervently, questioning the very essence of rationality and cause-and-effect.

Part I addresses the dynamics of Pavlovian Conditioning and market participant response to stimuli in investment decision-making. Intriguing paradoxes and the behaviour of asset prices - a cause (and consequence) of market participant response - is considered concomitantly. Finally, the psychology of herding closes Part I.

Pavlovian Conditioning and Asset Price Behaviour
When Ivan Pavlov discovered his lasting contribution to humanity - Classical Conditioning experiment on dogs - humankind was probably offering years of daily corroboration of the phenomena of Conditioning. An excerpt of the key theme of his study:
Conditioning is usually done by pairing the two stimuli, as in Pavlov’s classic experiments. Pavlov presented dogs with a ringing bell followed by food. The food elicited salivation, and after repeated bell-food pairings the bell also caused the dogs to salivate.
The table below broadly aggregates typical market participant response to event stimuli (information, emotional state and expectations):



Equities and commodities chime along lock-in-step, while sovereign credits adorn the character of a recession/bad news asset class ('safe' havens). Gold appears a near all-weather choice that is spurned during good times. The broad matrix, by no means sacrosanct, reasonably captures market participant psychology to macro stimuli.

Some Intriguing Paradoxes 

The Psychology Of Buying - Sovereign Credit

Mountain of Debt + New Debt = Increasing Debts-appeal
Amidst the ebb and flow of the financial crisis, new debt issued by USA, with a burden already as big as its GDP (and rising), has found enthusiastic buyers. Over the past two decades and change years, US’ debt grew 6-fold even as GDP grew 3-fold. Debt is now nearly 100% of GDP versus 50% in 1987. Back in 1987, US 10-year Treasury yielded 9.5% and inflation (CPI) was 4.5%, for a real return of +5%. Cut to the present, US 10-year Treasury yields were close to multi-century lows (c.1.5%) recently, while inflation (CPI) was c.2.5%, for a real return of -1.0%. 
Despite mounting debt burden and negative real yields, market participants gravitated towards US Treasuries. Negative real yields can be somewhat tolerated if there is a reasonable chance of greater depreciation in the currency of the marginal foreign buyer (if, say, a foreign investor makes (!) -1% by way of real yield and the US$ appreciates 6% relative to her currency, she would make 5%). 
Foreigners added ~$650 billion to their US Treasury holdings between Mar-11 and Mar-12 for negative real yields and since they hold close to half of US Public Debt ($11 trillion Public Debt, $15.7 trillion Total Debt, at last count), it is instructive to enter the mind of a foreign buyer, to discern their thinking.

Foreign holders of US Treasuries are exposed to risks on two fronts, (a) asset risk (risk of principal repayment and negative real yield) and (b) currency risk (US$ depreciation). The two largest foreign holders of US Treasuries - China and Japan - suffer from low/no real coupon and a gaping abyss if and when the US$ depreciates relative to their currencies (ignoring US insolveny risk, to keep things sane). The JPY is already feeling the heat thanks to JPY appreciation; while the Yuan, owing to the managed peg, has managed to stave off the eventuality, for now. But a gradual appreciation looks likely, for various reasons, and were it to materialise, these foreign buyers will be minus some big notes from their Treasury chests.

In the past, at the first signs of 'risk', the JPY, CHF, Gold and sovereign credits found many seeking shelter. In a vastly changed world today, similar protection is being sought. Ironically, in the shelter with the weakest foundation.

Classic Pavlovian Reaction overlaying rationality.

The Psychology Of Selling - Equities
Beneath the macro stimuli lie camouflaged several layers of micro stimuli that impinge on participant emotions and asset prices. Daily/Weekly/Monthly economic data releases, quarterly earnings reports and a host of other information trigger Pavlovian Responses in market participants; who, akin to Pavlov's mongrels that were befuddled by cause and effect; cause gyrations in asset prices bearing little relevance to actual intensity of the stimulus.

A quarterly earnings report below expectations often triggers selling in the company stock, even if the quarterly timescale bears little relevance, either to the longer timescale, or to the long-term dynamics of the underlying business. Among the higher order reactions to this earnings miss might be sympathy selling of companies in the same business (extrapolation of the reasons behind Company X's woes to Company Y), and a bump up in price gyrations.

Fed with data minutiae, often by the minute, market participants feel a compelling urge to act out (disseminate) incoming information. A quarterly GDP growth, or a quarterly earnings, print coming above/below market expectations gnaws at participants, and sightings of their emotional response can be found in the behaviour of prices. That these numbers, highly questionable in some markets, and subject to ex-post revisions, trigger multi-order reactions is intriguing. 

Instances of Pavlovian Reactions often trouncing rationality.

The Psychology Of Multiple Personality Disorder - Gold
For a wonderfully insightful example of rapidly altering human risk perceptions, it is illuminating to cast some light on the behaviour of Gold over 2011. Grave signs of multiple personality disorder was witnessed in Gold, which was one of the few asset classes that closed the year on a celebratory note.

1H 2011: Gold rose as sovereign debt worries escalated
2H 2011: Gold fell as sovereign debt worries escalated…further 

Even as fear escalated over August through December 2011 on resurgence of EU sovereign crisis, Gold suddenly seemed to have fallen out of favour. What was being hoarded on the premise of fear was now being sold, when the same reasons were available in greater supply.
 
It was roughly a year in two halves for the Yellow Metal. The first half, where it held allure to market participants as an inflation hedge/doomsday investment; while in the second half, this relationship broke down as Gold began tracking market expectations of Central Bank Quantitative Easing (a.k.a money printing).

At some point in the flowing continuum of emotional reactions, perceptions tipped; the stimuli had changed. Expectations of, or the absence of, quantitative easing began guiding market participant perceptions towards the yellow metal. As expectations for further rounds waned, so did interest in Gold. Recently, possible reopening of monetary spigots instilled some vigour in Gold.

The Psychology Of Herding
From being conditioned to dive into the seemingly soothing arms of sovereign bonds in time of duress, to selling earnings misses (and buying earnings beats) in equities, to flipping commodities on the near-term prospects of economies; herding represents one of the most innate characteristics in market participants inhabiting the financial landscape.

Being social animals, the evolutionary urge for tacit acceptance by the majority is a compellingly strong force. Apart from acceptance, the social fallout of being in the wrong while in minority further assists in the building of crowds. The prospect of quick profits while chugging along with the many instills a sense of comfort. Pavlovian Responses are, sometimes, a necessary appendage in this scheme of things.

Trend-followers, algorithms or otherwise, attuned to picking up these developments seek to exploit the power of the herd, before everybody else. Being alone, as a trend-follower, is a wondrously alluring prospect but, unfortunately, a mutually exclusive possibility. The trend follower, additionally, is an implicit Long on the persistence of the prevailing bias.

The enthusiastic herding into sovereign credit today, as a reaction to fear, has driven real yields in several geographies into negative territory. A few years down the line, when the world appears a little different from today, where interest rates would have likely ticked up from today's historically low levels; a host of market participants might awaken to the true meaning of the word 'safety'. 

Another typical Pavlovian Response in the face of catastrophe would be likely at this point - denial.

Thus, at the court, both great and small
Behave alike, for all ape all.
– Jonathan Swift, Excerpt from The Logicians Refuted

Sunday, 3 June 2012

The Correction (& Persistence) Of Anomalies

During dreary journeys across the market landscape scouring for interesting opportunities, the investor occasionally stumbles upon an oasis. Of extreme anomaly. The sighting is generally a mirage, a ray of false hope; but in some instances, the manifestation is very real and extremely intriguing, especially so when the anomaly manifests across companies operating in the same business.

The anomaly was first highlighted here ('Over-priced anomalies in bear markets'), when discussing One Life Capital Advisors (Bloomberg: OCAP IN). Extreme pricing is generally either an outcome of mass euphoria/fear, or a flock of informed market participant presence. OCAP IN seemed to be in the latter category. The post also highlighted the case of peer, Brescon Corporate Advisors (Bloomberg: BFS IN), as an example of under-appreciation. 

For brevity, the scheme of things as on the date of writing (Dec '11) is reproduced:


Such cases of extreme pricing always pique my interest. The situation seemed too far removed from reality. Diligence corroborated my hunch on OCAP IN's ridiculous pricing, and it corroborated my hunch of under-pricing in the case of BFS IN.

A mid-market focused investment banking, debt restructuring franchise with a reasonably long history of operations and respectable brand value seemed to be completely unloved. The company small size ($3.5 mm market value) and low liquidity were partly the reasons. Competition from investors scouring this market segment is limited and severe anomalies sometimes manifest, as a result.

BFS IN was available for far less than its cash and liquid investments (including equities), even after allowing for diminution in carrying value of these investments. Essentially, market participants were assigning no value to the business, a relatively reasonable operating history; a clear anomaly. 

As sentiment picked up in the first quarter of 2012 on the back of renewed FII inflows, stocks of under-appreciated companies come under the spotlight. BFS IN benefited from this surge in sentiment and currently trades at a market value of c.$7 mm, a 100% gain in a few months. The current market value is equal to its cash and liquid securities. Market participants continue to assign little value to either the business or its franchise, which is reasonably strong in its focus area. The margin-of-safety has since compressed but the example illustrates the minimal force that is sometimes required to effect a meaningful correction in anomalies.

On the other hand, the persistence of over-pricing is another intriguing aspect. OCAP IN continues to enjoy a market value of c.$70 mm - 10x BFS IN's market value - which, given its competitive standing, operational history, franchise value, business size, makes for an Alice in Wonderland situation. Shorting isn't the easiest in India but even if one could, the wait and weight of pain would be excruciating.
 
The principal risk in unloved companies is (1) questionable numbers/management, (2) the absence of a catalyst that could allow restorative forces to act with rigour. (1) is within the realm of known-unknowns and can be tackled to a reasonable degree. (2) is more sketchy. Sometimes, the catalyst takes so long materialising as to be virtually useless for value emergence. The catalyst in this case was an uptick in sentiment. But insisting on fat discounts to true worth allows leeway for unknown-unknowns that might afflict the company under consideration.

I'm watching this one closely, as I continue on my journey across the market landscape.



Saturday, 14 April 2012

Natural Gas Implied Volatility: Drift Back To Normalcy

Event-specific circumstances, sometimes, create interesting situations for deploying capital. The Indian Natural Gas sector presented one such instance; in Equities and Implied Volatility, this week. 

Background note here

IVs popped across the board, principally manifesting in Indraprastha Gas (Bloomberg: IGL IN, NSE: IGL), which was the chief victim in the melee. Reacting to the adverse regulatory pronouncement, other companies in the Natural Gas space too came under fire from investors, IVs spiked as stock prices swooned. IGL stock fell over 40% within minutes and other companies shed double digit percent. Petronet LNG (Bloomberg: PLNG IN, NSE: PETRONET), however, should have escaped relatively unscathed, as the ruling is expected to have little impact on its earnings power. But fear is a pervasive force, which divorces with rationality in time of duress. Time eventually acts as an arbiter in the estrangement but the process is gradual and fraught with roadblocks.

Panic-induced selling traces a typical cycle. An event acts as a stimulus, triggering ripple reactions (and over-reactions) in several directions. The magnitude and length of time of the selling is contingent on the gravity and expected persistence of the negative information. Once the initial wave of selling abates, traces of value can often be found in several pockets.    

The PNGRB ruling was directed towards gas transportation and compression operations. Regasified LNG, PETRONET's core business, did not fall under the purview of the regulator. To this extent, PETRONET's earnings power was insulated against the adverse regulatory development. The stock, however, shed about 12% minutes after the stimulus triggered widespread selling. The magnitude of correction was overdone, taking PETRONET's valuation to levels (sub-10x P/E, 5-year historical P/E = 14x), which offered an attractive value proposition for long-term oriented investors. PETRONET's per share earnings have grown at over 30% annually over 2006-Dec 2011. Turning to India's natural gas fundamentals, the favourable demand-supply gap is unlikely to reverse in the near future. The natural gas deficit situation is likely to persist over the medium-term and PETRONET is likely to realise above-average prospective growth in per share earnings. As market participants absorbed the impact of the regulatory development, Longs moved in to PETRONET and the stock recovered most of its losses by the close of the day. 

IVs had been hovering in the early 30s in late-march/early-April. The event stimulus resulted in PETRONET IVs popping across the board, with strong skew emergence as participants scrambled to buy downside protection. IVs increased to rich levels relative to history and Short Volatility postures offered attractive risk-reward.


The following chart captures the evolution of Implied Volatility and PETRONET Put Option Greeks, across strikes, in the few days post-event.


As normalcy returns gradually, IV and Vega (sensitivity of Option prices to changes in Volatility) are gradually drifting lower. For an option insurer, shorting Volatility at higher-than-normal levels improves risk-reward materially, offering a reasonable margin-of-safety. Subsequent IV compression leads to value realisation. The compression is most prominent in close-to-money strikes, with deep OTM strikes exhibiting lower sensitivity but working wonderfully, nonetheless.

Classic value emergence across the equity piece in the capital structure and in volatility, a less-widely viewed asset class. 

Disclosure: Expressed & unwound profitable Short Volatility positions. Continue to hold certain positions, as of this writing. 

Disclaimer: This is not a solicitation to buy/sell any instrument discussed here. Views are contingent on future circumstances and may change without notice. There is immense risk of loss in Options investing. Please consult your adviser, and more importantly your judgement, before making investment decisions.  

Tuesday, 10 April 2012

Ruckus, Volatility Skews & Gap Risk

It has been quite an eventful day for the Indian Natural Gas pack, which are quite effervescent as I write. 

The ruckus was triggered by a ruling by the Petroleum and Natural Gas Regulatory Board (PNGRB), fixing new tariffs for natural gas players. The PNGRB lowered gas network tariffs and compression charges by over 60% each. This prompted a free fall in stock prices of Natural Gas companies, with Indraprastha Gas (Bloomberg: IGL IN, NSE: IGL) caving in 40% within minutes of market open, on the back of rampant selling, as sell-side analysts rapidly scaled down forecasts. Other stocks shed between 5-15%.

A ruckus is generally kind to Volatility. Natural Gas Implied Volatility, which was quite tepid since mid-March '12, spiked reacting to the adverse newsflow. IV skews, which were flattish around the long weekend (April 4, 2012), have now turned into smirks as Puts have come into focus. The scramble for buying protection has pushed up Put prices. Spiking IVs offer attractive possibilities to deploying capital. Petronet LNG (Bloomberg: PLNG IN, NSE: PETRONET) & GAIL (Bloomberg: GAIL IN, NSE: GAIL) IV skews paint an insightful picture. 



Though IVs have picked up across the board, OTM Put IVs particularly, have bumped up neatly and now offer a reasonable risk-reward.  

Queerly, skew was inverted going into the long weekend. Generally, lower liquidity in OTM strikes should impel Option Writers to demand higher compensation for assuming Gap Risk. Writers, however, seemed happy to assume risk for low, flattish skews.

A long weekend brings its own advantages and disadvantages. The advantages gained through a Long Theta posture needs to be weighed against the possibility of Gap Risk, after the long weekend. As market participants process and assimilate developments materialising over the weekend, the chances of a Gap Open (up or down) becomes likely. One way of somewhat mitigating this risk while enjoying the benefits of time decay is to demand higher IVs. The other is to own cheap protection at low IV.

The Natural Gas pack is hounding the Longs today. The next few days will be interesting indeed.

Sunday, 8 April 2012

A Resurrection In Sentiment?

The Day of Resurrection is probably an opportune moment to pause and gauge the pulse of the market.

After the forgettable dalliance with 2011, risk assets seem to have found an amenable ally in 2012 so far. Tepid interest from FII towards India in 2011 has been replaced by renewed fervour ($9 billion net inflows in 1Q2012 v/s -c.$1 billion net outflow in 2011). 

Interestingly, very little has changed fundamentally. The March budget was a damn squib, with the Finance Minister hoping to walk the tight rope between taming inflation, curbing a burgeoning fiscal deficit, without fettering growth. The Budget was, however, low on major reforms and irksome issues continue to make their presence felt. Yet, FII continue to pile in. 

One of the intriguing things about human behaviour is its stickiness in altering the status quo prevailing bias. After a prolonged period of bull market, bearishness/pessimism is a rarity; likewise, after a bearish period, bullishness/optimism is a rarity. Bull markets are fuelled by optimism, which is confidence's child. The circular relationship seems to portend that confidence is a necessary prerequisite to bull markets. This needn't always be the case. 

When much bearishness is already imputed in prices, a minor dose of optimism is enough to take prices higher (converse is true around market tops). In temporal terms, optimism is a short-term phenomena, while confidence is more structural. Tangible on-the-ground improvement in business environment is a necessary catalyst to support sustained confidence.

Quick glimpse of the thermometers that I keep an eye on to gauge sentiment.


 
Is the bull market here? Or, is this a temporary oasis of optimism? 

Commodities, except Crude Oil, had a stellar January '12, as the risk-on trade gained backers on the possibility of QE3 favouring risk assets. February was quieter and March proved to be speed-breaker to budding optimism. 

The price performance of Healthy v/s Weak companies is a useful indicator of market participant focus of interest. 'Healthy' contains debt-free/net cash balance sheet companies, 'Weak' contains the most indebted ones. 

After a spell of negative price performance, a spell of optimism generally favours the indebted over the conservative. The debt-heavy tend to fall so greatly in a bearish environment that a temporary reversal in sentiment is enough to propel these pockets higher, as participants cycle out of defensives. As always, sustenance is key to gauge a structural shift.

January '12 was very favourable to the Weak companies in my index but follow through has been stolid. February saw the Healthy beating the Weak and March turned out to be inglorious for both, more so for the Weak. One of the companies in my Weak pack is Kingfisher Airlines (Bloomberg: KAIR IN, NSE: KFA), which is sparring with possible bankruptcy.

Gauging behaviour is one of the most challenging aspects in investing. Numbers convey a picture and they have their utility as communicators of market sentiment. But they cannot conquer uncertainty. Just as a good doctor, with experience, is able to ascertain much about a patient's health by inspection and smell (yes), a market practitioner does the same with the market. 

With the likelihood of QE3 remaining shrouded in speculation, commodities are likely to experience bouts of volatility, driven by the vicissitudes of QE3 banter. India, meanwhile, may track developments on the interest-rate front, with a rate cut fuelling optimism. For now, optimism needs a pair of strong legs, something that seems in short supply, to morph into confidence. 

Till then, Happy Easter! 

'Prediction is very difficult, especially about the future.'
- Neils Bohr, Physicist

Thursday, 29 December 2011

Dear SEBI. Can We Short Please?

The catalyst that turns fantasies into realities came in the form of this SEBI order for OneLife Capital Advisors (covered here). 


SEBI (Indian market watchdog) barred this company, several others and the merchant bankers to these initial public issues from accessing the securities markets. SEBI accused them of diverting IPO proceeds, performing shoddy due diligence and aiding promoters to prop up prices post-listing.


Unsurprisingly, in the beginning of the end scene, OCAP IN is down 15% as of this writing. A pummelling, rightly deserved. The end would be interesting. HaLin rued their inability to initiate Shorts on such cases, in the previous post.  


The Shorts are common whipping lads when markets and companies come under fire. The chorus against Shorts is inversely related to (1) market levels/stock prices, and (2) the acceleration of the fall from grace. Shorts are blamed for disrupting markets, for acting on misplaced rumours, for cornering poor and genteel companies looking to create employment in a socially responsible manner, and for generally being Evil. 


Few derive satisfaction from seeing others go bust and the Shorts aren't St. Good Guys at all times. But in certain instances, measured corrective forces in markets (provisions for single-stock shorts, for example) are a necessary counter-weight to the (sometimes questionable) actions of companies and issuers. A Long-only market character leads to a one-sided world, loaded in favour of companies. Frauds, historical and prospective, find a fertile setting to grow unabated in such an environment. 


Shorts impose a certain discipline on company managements, inducing them to contemplate the ill-effects of their actions, if exposed. Since the effect would directly be experienced by insiders through a drop in value of ESOPs/insider holdings, the Short-brigade bring some semblance of sanity to markets (its another matter that the Shorts themselves go insane occasionally!).  


The purging exercise brought about by the Shorts is a case of Darwinian survival of the fittest in business. By shorting dodgy companies into extinction, Shorts ensure that capital eventually finds its way to places where it is most welcome. (Social fallouts of capital re-allocation, a touchy subject, is left for another day)


The SEBI has a fine balancing act. If it raises minimum qualifying criteria, there's a risk of keeping public markets off-limits for fledgling companies reliant on capital for growth. This would impel them to seek capital from private sources, which come with their associated pros and cons. Relaxing qualifying criteria would attract shady companies. It is a tough problem which is, like so many things in life, without a black or white framework for a solution.


It is in such situations that Shorts serve a useful purpose. 


Is the SEBI listening?    





Wednesday, 21 December 2011

Over-priced Anomalies In Bear Markets

One of the alluring things about investing is the prospect of rare sightings of anomalies. In a torrid market, typically, the universe of value Longs tends to expand relative to bull times. The opposite - an anomalous over-pricing in certain pockets - is rarer.

One such example is OneLife Capital Advisors Ltd (Bloomberg: OCAP IN; "OCAL" or "Company"), a recently listed Indian company engaged in providing financial intermediary services, an aspiring equity broking franchise and portfolio management services company. 

'Aspiring' is the operative word, as OCAL was incorporated in 2007 and commenced business in September 2009. As the Company admitted, there is little to look at in their limited operating history. Nevertheless, market participants enthusiastically bought into the Company's prospective story. Overall IPO was subscribed 1.53x, with retail participation at 2.5x allotted portion and Institutional interest at 1.02x.  

Investment Banking franchise dynamics
People are an investment banking franchise's key source of competitive advantage. Superior deal sourcing, well-entrenched network of corporate relationships and deal history help differentiate one player from another in this competitive industry. Moat can also be derived by specialising in niche pockets (e.g., debt restructuring/resolution, mezzanine financing). A generalist investment banking franchise with limited history of operations, promoter pedigree and key employees (there were 11 employees as of the IPO filing) competes from a rather weak position. OCAL has all the ingredients of this eclectic combination.

Broking franchise dynamics
Broking is a fiercely competitive business, bearing a natural correlation with the capital markets. Except for instances where a broker serves an underpopulated segment in the market, pricing power is low and players compete fiercely in a race to the bottom of the price pyramid. Other means of building a moat is timely and best execution, low slippages, pre-trade investment research, post-trade execution services and attractive terms on margin funding. 

Revenues are primarily a function of volumes. As a result, waning volumes in a weak/sideways moving market has a negative impact on business. Well-entrenched incumbents tend to buy growth or rely on ancillary activities to drive revenues. A new, small-sized entrant would run into a gladiatorial arena full of competitors. OCAL is in such a position.

Portfolio Management Services dynamics   
This is a typical hedge fund structure, with respect to fees, that is. Performance-wise, there isn't much to be said about this group as a whole, in both absolute or relative terms. 

Revenues can form a good annuity stream (upfront yearly management fee) with optionality driven by Carry (a cut of profits). Recurring revenues are contingent on assets under management, which encourages management to embark on asset-gathering exhibitions to support revenue growth, sometimes to the detriment of investment performance.  
  
Differentiation is largely a function of investment performance than fee structures. Long history of superior performance under (hopefully) the same investment manager lends much credibility and strong competitive positioning. OCAL neither has the track record nor the personnel to guide this operation. A majority of its recent IPO proceeds (~35%) was earmarked for this venture, which hitherto contributed nothing to its topline. Attracting the right talent for this venture would not only prove difficult, given its history, it would also entail a large capital outlay; which will likely keep expenses on a rapid growth trajectory relative to revenues. It is difficult to envision OCAL achieving sustainable profitability, let alone cash flow, in the medium-term, given the scheme of affairs.

With this background, it is insightful to glance at a quick comparison, contrasting OCAL with a competitor, Brescon Corporate Advisors Ltd (Bloomberg: BFS IN). BFS IN is an investment banking franchise specialising in debt syndication, restructuring and resolution services. It is also involved in real estate and private equity financing.


OCAP IN has doubled since listing in mid-October.


An all-in bet on a perfect future
My interactions with the lead manager to the issue were illuminating. OCAL's current investment banking mandates = $95 mm (have to rely on the weight of words of the management). The revenue stream is a fraction of this value and payments are received based on achievement of milestones.

Working with a rather liberal 50% p.a. growth rate in mandates over the next 3 years and a 5% fee arrangement (typical, 1%-2%), the mandates would translate into revenues of ~$15 mm, which would accrue to OCAL over a period.  

Moving on to Portfolio Management Services. $2.5 mm is the initial funding received from IPO proceeds. Let's assume Management manages to grow assets under management (alliteration unintended) to $200 mm over the next few years and can charge 3% of AUM as fixed-management fee (typical, 1.5-2.5%). This would translate into revenues of $6 mm. 

Equity broking is a function of volumes. The largest company, Religare Enterprises managed volumes of $800 mm / day in 2010-11. Assuming OCAL manages 10% of this and using an average brokerage rate, this business would add ~$10 mm to OCAL's revenues. One of the ways of running a low-cost brokerage operation is to focus solely on execution, without adding ancillaries such as research (which add to costs). It was unclear, from my interactions, whether OCAL intended to take this route. 

Summing the three revenue streams up, one arrives at around $30 mm (cumulative, over a 3-year period). The largest integrated financial intermediaries currently trade at a Market value / revenue of ~2x, which is the multiple OCAL is discounting based on its prevailing market value. We haven't even touched upon profitability...

Parting thoughts
For a company with minuscule revenue, limited history and anything-but-upbeat business prospects, the stock enjoys good short-term momentum trading interests (daily traded value = $8 mm)The run enjoyed by companies like OCAL is a characteristic generally commonplace in bull markets. 

Market participants are expecting a stupendous show from OCAP IN over the next few years. With a drop in trading volumes and slowing investment banking mandates, the environment has been tough for players like BFS IN and indeed, for many players in the financial intermediation services industry. A situation that is likely to persist over the near-term. Another possibility behind the strong stock performance 2 months post-listing could be a take-over attempt by a larger rival, which appears remote.

These are the sort of occasions when one misses the ability to initiate a short.

Disclosure: No position

Disclaimer: This is not meant to be an invitation to indulge in speculative activity. Please consult your adviser, and more importantly, your judgement, before making investment decisions.