Sunday, December 28, 2008

Another corporate governance event in India, and this time no body notices

Two weeks after Raju's family unsuccessful attempt to loot Satyam's shareholders, another promoter family has done something similar. This time, however, there is no noise in the media or amongst the institutional shareholders. It has gone quietly under the radar, like everything else in India. 

Promoters of Murugappa group are pumping 300 crore into their troubled NBFC - Cholamandalam DBS. According to Economic Times, "The NBFC will issue one crore zero coupon fully convertible preference (FCP) shares of Rs l00 each at a premium of Rs 200, aggregating to Rs 300 crores to the existing promoters of the company — The Murugappa group and DBS. The Murugappa group companies, which will be investing in these FCPs, include Tube Investment of India, EID Parry (India), Coromandel Fertilisers and Carborundum Universal." 

Carborundum Universal is an industrial company. When I buy a share of this company in the public market, I am really not interested in getting exposure to a financial NBFC through this company. I assume that the excess free cash of the company will either get reinvested in the business or be paid out as dividends. Aren't minority shareholders getting cheated out of their money by asking to invest in a troubled group company at a valuation that is not transparent?

The only difference between Satyam and this situation is simply this - Raju's own only 8% of Satyam while Murugappa's own 43% in Carborundum. So Raju's were much more brazen.  

The first criteria to evaluate any Indian stock should be simply this - do promoters have other companies into which the cash generated by the stock under consideration could be diverted? Because, in the next two years, more events like this will surely crop up.  

Saturday, December 27, 2008

Looking Back at 2008

To say the least, 2008 was a very satisfying year. While I also got some calls wrong and overall lost money, it wasn't much. And if I were to do a sleight of hand and calculate returns in rupees and not dollars (rupee is my currency of consumption these days), I would have almost ended flat on the year because of rupee depreciation vis-a-vis dollar.

Here is what I got wrong:

a) Municipal bond funds: I had chosen some better credit quality close ended municipal bond funds. I am still keen to buy the underlying assets of some of these funds, like the pre refunded bonds. What I missed was that these funds are like any other structured product that employs leverage. And when mark-to-market losses hit, such structured products are forced to delever, irrespective of underlying credit quality. Actually I didn't miss it - I advised almost all my friends not to invest in FMP's in India for these precise reasons. But I myself didn't exit these funds. Hope was not a good strategy last year. 

b) The second half rally in April-May-June: I got the timing of this wrong post Bear Sterns. I thought the "hope" rally would occur in May and June, and so invested at end of April. Actually the rally occured from the day Bear Sterns collapsed to end of April. 

c) SKF, SRS: It is only in the last month or so that I really understood the nature of these ultrashort ETFs. It was indeed very perplexing to me that while the underlying sectors have been cut in half over the past year, these ETF's are flat over the year. Now I know better - it is because they compound daily returns.

Suppose I start with 100 in SKF. Underlying benchmark goes down by 10% on day 1. Benchmark would be at 90. SKF will go to 120 (2x daily return). 

On day 2, if benchmark goes up by 10%, then the benchmark would be at 99. However, SKF would be at 96. So even though benchmark has fallen from my initial purchase price, I would end up losing money. 

The joys of structured products!! It is very important to make sure that I get exposure to what I really want to get exposure to.  

d) I also got several stocks wrong - like Aban etc. In almost all cases, I sold the stocks when they were down 20%-30% and went on to go down another 50%. So it wasn't an unqualified disaster. 

The most important lesson of the year - Selling right is more important than buying, at least in the environment that exist(ed/s). Just because something is down 80% doesn't mean it can't go down another 80%.  Almost everyone - media, newspaper, books, fund managers - is focused on the buying decision. Nobody talks of the selling decision. "Expertsin media write that - "Well the market is already down 50%, so it can't fall much more. So you should buy".  Even more funny is, "See everybody is down 50%. We told you its impossible to time the market. Our advice is correct. So remain invested in index funds."  Some people have lost their life savings following this. 

I have realized that there is one very important difference between economics and physics. Faced with facts don't match theory, physicists try to come up with alternative theories. Economists, on the other hand, try to change facts so that it matches their theory. So, today, economists on the left are arguing that defective regulation caused all the troubles. A year from now, I am sure conservative economists will come back and argue that government meddling post Lehman crises is what has caused the recession to be as long as it is going to turn out to be.  

And it is not just economists. Almost all fund managers that I meet have one particular lens through which they want to view everything in the world. All stocks in the world need to fit their theory of how stocks should behave. And if they do not, it is just a short term disruption that will be corrected duly in the course of time. "In the long run, everyone is dead", as Keynes said. It is very bizarre to say the least.

Of all the things I got right this year, the best one will remain the one on Jan 22, 2008. I got the Fed rate cut right down to the minute - and it was a "between the meeting" rate cut. Another one would be the assertion that all Indian real estate stocks are going down by 90% in April 2008 - what this meant was that some of them will go below cash. 

There is a difference between a stock and a business. Neither do stocks reflect business performance in the upcycle, nor do they reflect it in the down cycle.  It is only over long periods of time that one will observe correlations between surviving successful companies and their stock prices. But stocks will regularly deviate from their so called "fundamental" values.

Fundamentals, incidentally, is my nomination for the most abused word of our generation. "Fundametally, this stock is sound, or market is pricing the stock not on fundamentals but on irrational fears". These statements assume the price of a particular stock is not one of the factors that affects the business of the company. As events of last year show rather powerfully, the price of a stock is actually one of the most important factors that affects the business, and in turn the stock price. The operating and financing  decisions can be made separate in the excel sheet world of DCF models - in reality the financing decision impacts the operating decision. 

"Stabilizing an Unstable Economy" by Minsky should be made compulsory reading in all economics classes. It is a gem of a book. Different economics theories are true at different points of time in this world. At this point of time and in this cycle, it is Minsky's theory that is correct. 

Thursday, December 18, 2008

Bubble in Treasuries ..

Mish writes on the treasury bubble and why it might not burst soon. I agree with him - just because something gets beyond what we thought two months ago was reasonable doesn't mean it has to fall today. It can just exist for a long time.

Besides, shorting using TBT would be a bad idea - because of the structure of these ultrashort ETFs. They do double the daily returns - not annual returns. All these ultrashort ETFs are good only for day-trading, not for investing.  I want to find a way of shorting treasuries where I am happy to hold the position for 5 years. 

Satyam's board of directors should resign

Satyam has 9 directors. Of these, my guess is these 5 would be independent directors: 

a) Krishna Palepu - Harvard Prof

b) Vinod Dham 

c) Dr Rammohan Rao - ISB prof 

d) T R Prasad - IAS Officer 

e) V S Raju - former dean IIT Madras 

 If the board really had a unanimous decision, these directors should resign. If it did not, then CEO is lying and should be prosecuted. Remember Satyam is listed on NYSE, so Reg FD and Sarb-Ox will apply to it. Somewhere, there is a law that will get Mr. Raju.

P.S: In today's ET, the board of directors is defending the decision. They should definitely be taken to court to find out the truth. See Sandeep Parekh's post on their compensation. 

Wednesday, December 17, 2008

Mr. Raju backtracks - Maytas should implode

Mr. Raju has backtracked in 12 hours and will no longer steal $1.6 billion from Satyam. Is he that thin skinned? If he planned a robbery, then he should have been prepared to kill. We should soon have the first real estate blowup in India. It is Maytas Infra and Maytas Properties - if we ignore Unitech and Omaxe. 

Who will lend additional money to Maytas, and which lender will not try to recover money from these two companies? There is a really juicy story here for media to uncover.   

Fed cuts to 0

Anyone who was shorting US treasuries has been hammered, as I wrote 2 days ago ( Japanese bonds went all the way down to 1%. But yes, I agree that at 2.25% for 10 yr bonds, inflation risk is getting underpriced. I am getting tempted to buy TBT..

Tuesday, December 16, 2008

Raju steals $1.6 bn from Satyam - Why corporate fraud is an under estimated risk for Indian equities

Mr. Ramalinga Raju, hitherto esteemed Chairman and CEO of Satyam, today brazenly stole $1.6bn out of the company. Satyam, in which Mr. Raju owns a mere 8% (according to Bloomberg), decided to buy 100% stake in Maytas Properties for $1.3 billion, and $51% in Maytas Infra for $0.3billion, for a total outlay of $1.6 billion. Maytas Infra is a listed company in which Mr. Raju and family owns 36%. Maytas Properties, on the other hand is completely owned by Mr Raju. 

Satyam had about $1.2 billion cash as of Sep 30, 2008.  Effectively, that cash and a little more is being transferred to entities owned beneficially by Mr. Raju. This raises serious corporate governance issues for the following reasons:

a) Real estate has been in free fall in India since Jan 2008. Yet Satyam, which hitherto was doing IT outsourcing stuff, has suddenly decided to move into real estate and infrastructure. And to do this, it is not going through the organic route. It is taking the path of acquisitions. Specifically, acquisition of promoter controlled companies. 

b) The cash spent on acquiring promoter controlled companies is just a little bit higher than cash on books of Satyam. Is this a mere coincidence?

c) Satyam is listed on NYSE, publishes quarterly results that are filed with the SEC, and holds quarterly conference calls. Management meets regularly with investors. Yet, till last week, there was no indication from management that it is inclined to do its biggest acquisition and that too in a totally unrelated sector. Was there any discussion within the company or the board on this transaction? 

Or more likely, when Mr. Raju found his wholly owned company - Maytas Properties - in danger of defaulting of loans taken to purchase land at astronomically high prices in 2007, he unilaterally decided, as CEO and Chairman of Satyam, to use Satyam's cash balance to dig himself out of the hole? The board merely rubber stamped his decision. 

d) Is Satyam's board sleeping or what? Havent they looked at stocks of companies like DLF or Indiabulls Real Estate? The brazenness is shocking. 

One factor that investors in India have not paid adequate attention to is corporate governance. Promoters of almost 80% of Indian companies are corrupt. Historically, promoters used to steal money from companies by either making the companies fund their lavish lifestyles (like Vijay Mallaya) or simply have the company under-report numbers. Promoters kept the undeclared income - to enrich themselves as well to bribe all the beureaucrats, politicians and police officers. There is a big cash economy in India. 

In the past four years, as market multiples expanded and FII's and PE funds went crazy, India promoters found it more profitable to simply show this unaccounted for black income into the company's books. This resulted in a steep profit growth optically, high multiples on these suddenly high profit numbers and crazy valuations. Promoters got rich through the market route. Incidentally, this conversion of black income to white income and associated higher tax collection is what is behind the advance tax payments growth numbers that Indian media is so fond of tracking every pre-earnings season. 

A lot of promoters still leveraged themselves even more. Lending against stock was one of the most profitable business of brokerages till early this year. And now the promoters find themselves in trouble. Banks, brokerages and mutual funds are calling back their loans which the promoters cannot repay. Seems like a subsidiary of Maytas Properties has taken loans from HDFC mutual fund - we know HDFC has bailed out some of the FMPs (fixed maturity plans) of HDFC mutual fund because these FMP's had invested in suddenly illiquid commercial paper of certain real estate companies. The connection is complete. 

So what do you think the promoters will do? Will they honestly go bust and let someone else take their company away? Or, like Mr Raju, they are going to devise a scheme to use their company's money to bail themselves out? Will they again start stealing money out of their companies?  My belief is - an Indian promoter is unlikely to go bust in India because he/she is a crook of the highest order in 80% of the cases. Their role model - after all - is Mr. Mukesh Ambani.  Unitech's shareholders might go to 0, but its CEO wont go bust. He will simply sell Unitech's land to a 100% owned company at throw away valuations. 

Watch out for promoters with multiple companies and pressing funding needs: Zee-Dish, Reliance Power - RCOM etc. The list is long and the game is on. 

What is India's trendline GDP growth rate?

I am amazed by the number of Indian economists who keep proclaiming in the newspapers, RBI and Finance Ministry that what we are seeing is driven by fear and not reality. So once things turn to normal, India will revert to its trend GDP growth of 8%. 

First, sentiment is reality. Remember the animal spirits of Keynes. Greenspan also said that if he could figure out when greed turns to fear, he wouldn't need any other model. 

Second, the 8% growth rate of 2003-08 for India was during the years of the global credit bubble. I would not be wrong to simply lop off 2%-3% off that to come to a trend GDP growth of 5%-6%. 

And since in FY10 we will go below trendline growth, I would bet on a GDP growth rate of 3%-4%. Even agriculture growth can be negative depending on where agri commodities prices move. So far, I have seen only a few brokerages such as GS or Macquarie talk of 5.5%-6% growth in FY10. This to me is the top end of the trendline growth of 5%-6%, not the bottom end of trendline growth of 8%.  

Is there a way to short Ruble?

This is one of the easiest one-way bets out there. The way Russian Central Bank is devaluing the ruble - there is no two-way risk in shorting the ruble. The bank is implicitly admitting that the currency is overvalued. But instead of having one sharp depreciation, it is only letting it depreciate slowly.  

Now, is there a way for a retail investor to short the currency? I don't want to short the XRU - there is no volume. Besides, I am not really sure what is the structure of these ETFs themselves. 

Monday, December 15, 2008

Notes from Jim Grant's Video

Jim Grant writes the Interest Rate Observer biweekly, which is a very highly regarded publication of the buy side. This is a one-hour video in which he gives a 20 min speech on Ben Graham - his idol, and then spends the rest of time on Q&A. Worth a watch. He has also published a book recently - Mr. Market miscalculates - which I plan to buy soon.

  • Ben Graham lost 70% between 1929 and 1932. Still an outperformance as Dow lost 89%, so one can imagine the carnage. 
  • Graham's partnership went into 1929 crash in a levered position, so got hit. 
  • Recovered everything by 1936. 
  • Lost another 50% in 1938. 
  • So perseverance is key. Debilitating loss is no reason to quit investing. This is why Graham performed better than others - because he didnt leave the markets. 
  • Rule No 1: Dont lose money. Rule No 2: Dont forget rule no 1. 
  • Intrinsic value is a very dangerous concept. 
  • Market is equally disinterested in valuation at top or bottom. 
  • Graham was not interested in integrating macroeconomics in his security analysis, though he acknowledges that he should have paid attention to the backdrop of 1920's. 
  • By 1940, Graham advised institutions to invest in bonds yielding 2% and not in stocks - at the end of the second edition of his 750 page book that dealt with security analysis. Even he succumbed to fear. 

  • Mark-to-market accounting: Very self-serving the protestations of people who are now complaining on mark-to-market. They didnt complain during the upswing. Sachs (of GS fame) in his 1932 senate testimony had this view on mark-to-market accounting: Goldman Sachs Trading Corporation had blown up in 1932. One of its investments was in a company that was later to become General Mills. Mr Sachs and his accountants determined that they can carry the investment at cost price or any price right down to $1. So they took $1. Mr. Sachs, in his testimony, said that intellectually that is the correct price, whatever one believes in the future prospects of the company. (In the book 1929 - the Crash by Galbraith, there is a fascinating description of all the GS Trading Corporation) 
  • Real estate is almost always illiquid, but Wall Street has almost always made money off it. 
  • Wall Street is in a very dangerous position right now, political reprisal can be heavy. 
  • Bailout: Very troubling the way it is being implemented. Administration and treasury believe that there wont be second degree impact of the bailout, without having thought through what they are doing. They are scaring people by comparing it to 1929. Between 1929 and 1932, nominal GDP fell by 50%. Today, nominal GDP is still growing, so situation is vastly different. (This is a very important point. Real GDP growth is a concept based on some statistical calculation of inflation - and there can be hundreds of inflation numbers depending on the statistician. What we can see is nominal GDP, and stocks are priced in nominal terms, not real terms. When HDFC's CEO says that loan growth is 3x real GDP growth, he is wrong, because loan growth depends on nominal GDP growth, not real GDP growth. He is implicity assuming some constant inflation number that he doesn't specify). 
  • A big source of fear is Wahington saying "Not since 1930's." Cant they say "Not since 1974"? 
  • In 1974, hundreds of companies were selling below net cash. But there was no crash in credit, unlike today. Dow peaked in 1966, was going down till 1974, and didnt get back to old peak till 1982. 
  • Federal Reserve founded in 1914, and it took a century to reach $1 trillion balance sheet. In last 3 weeks it's balance sheet has balloneed from $1 trillion to $3 trillion. Inflation not possible today when credit is being destroyed. But who knows what happens tomorrow. Dollar is uncollateralized. Paper without any real value. 
  • Before WWI, gold standard. Then gold exchange standard. After WWII, Bretton Wodds. After 1971, dollar was free of gold. For past 37 years, dollar has been the reserve currency. Never before there has been so long a run of paper money without an inflation crash. So the system has actually worked for quite a long time. 
  • Paradox of dollar strength. Unpredictable consequence of dollar strength might be that people lose faith in all currencies - nothing is collateralized. Euro is a confederation of states. Ireland is having its difficulties. What if Spain, Portugal, France, Germany find the monetary regime too restrictive and decide to go on its own way. Since 1971, currencies haven't been collateralized, and the world doesn't mind. But the world didn't mind CDO for a long time, now it does. 
  • Private equity has devalued the "Your word is your bond" creed of Wall Street by walking out of so many deals. Hedge funds have been much better. 
  • One of the unintended consequences could be - a new wave of entreprenurial banking partneships, as the bigger banks become government departments. 

Inventory Writedowns

It will be very interesting to see how many companies take write-down on their inventories this quarter. Especially intermediate companies, such as oil refiners, should take big hits. Even if some companies don't take hits because of effective hedging programs, it will be difficult for companies to maintain margins in an environment where prices are falling. Besides, who cares about margins - companies can have higher margins but lower EPS if their product prices fall less than raw material prices. I think EPS for this quarter will be the first reality check as to how low earnings can be in times of distress.

Dollar is falling again. This sets up an interesting paradox for the US indices, especially Nasdaq, for whom a major chunk of the earnings is international.

Somehow there is a consensus that US treasuries are in bubble zone because yields have reached multi-decades low. It might be true, or it might not be true (look at Japan with 1% yields for multiple years). Besides, the mere existence of a bubble doesn't imply it is ready to pop. I think USD depreciation will precede a major treasury sell off. Now USD has started weakening since equity markets rallied. But is this the start of a full blown sell off? I don't know. Neither does anyone else. The way things evolve will determine what actually evolves.

Thursday, December 11, 2008

Udaipur-Haldighati- Mt. Abu vacation

Last weekend, I was in Udaipur to attend my colleague Sudhanshoo's wedding. Thereafter, I went to Haldighati - the site of Maharana Pratap and Akbar's fight, and proceeded to Mt Abu. Highly recommend the trip to anyone who has 4 days off.

Some thoughts:

a) Besides low cost tech outsourcing, there is one other industry in which India is globally competitive. That is hotels. And the USP is not limited to the royal palaces that have now been converted into hotels in Rajasthan. Even the smaller havelis and old houses that have been converted into hotels - whether in Jaipur, Pondicherry or Mt. Abu - have an ambience that no hotel in US can provide, all at a reasonable price. Now if we can just keep the terrorists at bay...

b) Some very good roads are under construction - the road between Udaipur and Mt. Abu was freshly built, and will rival European roads once the project is over. Apparently this road will go from Bhuj in the west to Assam in the east. Now we won't be driving 120kmph on average anytime soon, primarily because of the cows and goats, but an improvement from 40 to 65 kmph is a vast improvement in percentage terms.

c) There is a museum in Haldighati - apparently it is the private initiative of an individual. Seems like they are trying to make a historical theme park there. They are actually making the walls of a fort, to make it all seem very historical. Haldighati is where Rana Pratap fought Akbar's army and where his legendary horse, Chetak is buried.

d)In the battle of Haldighati, the general of Akbar's army was Sawai Jai Singh of Jaipur. So, essentially, it was a fight between Jaipur and Chittod. Now both these erstwhile kingdoms are part of Rajasthan. Is there a historic rivalry between different regions of Rajasthan, and indeed amongst different regions of the same states across the country that gets reflected in local, state and national politics? People are prisoners of history. Is this somewhere getting reflected within the internal dynamics of Congress and BJP? An interesting idea to explore further.

e) There is no agriculture to speak of around Udaipur. Apparently mining is where lots of people are employed. Road construction is another. Probably tourism. Tourism is a big industry in India. For all the beureaucratic indifference and official apathy, Incredible India is a relatively successful marketing campaign.

India-Pakistan Crises

Recently I came across Stratfor. It has recently published a couple of great articles on Indian-Pakistan crises.

Worth a read

Friday, December 05, 2008

Are some hedge fund strategies permanently damaged?

I am reading this article on Prime Brokerages in the Nov issue of EuroMoney. There is a very interesting point on the liquidity available in the shorting market. We know that many hedge funds are stuck in Lehman Brothers UK arm (LBIE) as LBIE lent out the securities further out, and now it is going to be impossible to figure out who owns those securities. There are many owners of the same security.

We have seen several fund companies (State Street etc) curtailing their stock lending programmes. One is the fear whether they ever get the securities back, due to heightened counterparty risks. Two is a stigma attached with helping the shorts. Regulators also keep changing the rules. People are more careful to locate the stock before it can be shorted.

If this is a permanent damage because of the counterparty risk issue, does it mean that several hedge fund strategies like long-short equity or convertible arbitrage become very difficult to implement even when markets stabilize? Because if one can't locate the stock as people are unwilling to lend it out, the shorts can't short it. Thats not good for the long-term market structure.

Thursday, December 04, 2008

Vendor Financing

I picked this up from FTAlphaville today, where Merrill Lynch is arguing that the global vendor financing model - where China finances its customer - is coming to an end. I had thought of it in the very exact terms in 2005 here (, so I feel happy that I wasn't wrong. It was one of my first posts. Though as I read that post again, I was certainly wrong on a lot of other things, like BSE being overvalued at 7000 and oil being overvalued at 55.

Merrill Lynch has published their 2009 economic outlook — the over-riding theme? Nothing less than the decline of the West’s financial supremacy.

From the report:

In the emerging world, particularly China, the vulnerability to the US financial crisis is likely to lead to a fundamental rethink of the development model. Expect long-run policies reducing ties to Anglo-Saxon consumption and a rebalancing in the global political power toward the emerging world.……

At its core, the global financial crisis brings an end to the vendor financing model, whereby excess consumption in the US was financed by a savings glut in the emerging world. The market will ensure this adjustment finally happens. This is coming from both directions…