CIT

CIT emerged out of bankruptcy yesterday. There is no balance sheet yet out there. Heck, people don't even know what the share count is - for that you need to read the bankruptcy filing 8-K.

Total share count = 200 mn

Share Price = $28

WSJ is saying that $11bn of debt has been wiped out. That is on top of $5bn of pref and equity interests that have been wiped out. So in total $16bn has been wiped out - on a book of $64bn.

The books have to be restated at fair value. Even if there is a 15% write off of the book, so that $10bn of loans are written down, there should be tangible book value left. And after that, because there wont be any more provisions to take, CIT will report eye-popping earning numbers. This is like the Wells Fargo - Wachovia situation from a year ago.

Blue Dart

The company's operating margins are expanding again. As this is a very high operating leverage business model, and considering in 1H09 the company was hit badly due to operating leverage, next year might see a steep jump in EPS. I have purchased this stock.

So far, the Indian portfolio is up some 80%-90% odd this year.

IGK vs ING stock

A tale of two cities. ING announced 7.5bn Euro capital raise. The hybrid security is up 11%, while the stock is down 11%. Such a cool long-short.

Another good long short pair might be MO-RAI.

FAG Bearings

Very bad results. Margins have taken a massive hit. Stock is down 5%. Company doesn't talk to investors - so difficult to figure out what is really going on. Company is on track to do a Rs 40 EPS - 12x PE, which is not dirt cheap. I used to think this is trading at 8x-10x PE, assuming Rs 60 EPS for full year. Point to note with this company is - revenues go up sequentially. 3Q08 was a sharp jump over 2Q08, so yoy 3Q09 is down quite massively. This doesn't seem to be a seasonal business.

Considering 20% of my India portfolio is in this stock, I want to exit it. But considering it is so illiquid, I will need to figure out a better time to exit.

NRB Bearings is up 8%. It also reported numbers today. 1H profit is 8.5 crore. If we annualize it, we come to 17 crore. Market cap of FAG is 300 crore. So it is trading at 15x. FAG is still cheaper.

I hope this is the bottom of margins. Hopefully Schaffler group is not screwing us - the minority shareholders of FAG.

Mark Twain's quote

It ain't what you don't know that gets you into trouble. It's what you know for sure that just ain't so.

Selling out Godfrey

Selling out Godfrey Phillips. 1Q10 earnings had a excise benefit of 16 crore, as well as other income of 24 crore (vs 10 crore in 1Q09). Remove these two items, and core profits grew 20% instead of doubling. So 2Q10 profits should be down sequentially - quite massively. This is probably not what the market is looking for right now.

Excise Duty cuts continue to help

Exide Industries - the big battery manufacturer in India - reported Sep 09 earnings earlier this week. The crucial bit is this - gross sales went down by 5%, but because excise duty rate is lower this year, net sales were the same. Company reported a 50% jump in profits. But if one were to assume the same excise rate as last year, profits would have jumped by 25% - aided by lower commodity prices (lead).

It is possible that the reversal of excise duty cuts will be a big headwind for profit growth next year - especially in the manufacturing sector. Most analysts will probably take this year profit numbers and project growth on that. That might prove to be really wrong.

Disclosure: No position in Exide.

People not shaving as much!!

From Barron's article on Energizer past weekend:

Trouble is, consumers aren't trading in their razors and replacing their blades as often as they used to. "A lot of people you see around aren't shaving as much as they used to," P&G CEO Bob McDonald said recently.

That is very strange indeed.

Verisk Analytics

Verisk Analytics had its IPO last week. Barron's mentioned over the weekend: "The company's business bears resemblance to the likes of Visa and the Chicago Mercantile Exchange - once-cooperatively owned, low-capital-intensity, high-margin growth businesses. There are also similarities to current market darling MSCI, a data and risk-modeling leader." What that implies is a biz growing topline in low-double digits and expanding EBITDA margins leading to a high teens EPS growth rate - what Visa and MSCI promise.

Verisk has two segments - Risk Assessment (52% of revs) and Decision Analytics (48% of revs). Decision Analytics is growing much faster. Risk Assessment has grown its topline at 4% over last four years (from $450mn in 2005 to $525mn in 2009E by annualizing 1H09). Decision Analytics, on the other hand, has become 2.5x between 2005 and 2009 (from $197mn in 2005 to $481mn in 2009E by annualizing 1H09). Some part of that growth has come through acquisitions - between Jan 2006 and June 2009, Verisk acquired 10 companies, 9 of which were in Decision Analytics segment.

Now one can focus on the low teen growth rate, high (and expanding) EBITDA margins in the low 40's, and low capex (low single-digit capex-sales) and get excited. But the most crucial element in this story is probably acquisitions.

a) Six month ended June 30, 2009 revs - $503.7mn. Six month ended June 30, 2008 revs - $437.7mn. Increase of 15.1%. Ex acquisitions, rev grew $50mn, or 11.5%. Positive.

b) FY2008 revs - $893.6mn. FY07 revs - $802.2mn. Increase of 11.4%. Ex acquisitions, rev grew $52.8mn, or 6.6%. That's not encouraging.

c) FY2007 revs - $802.2mn. FY06 revs - $730.1mn. Increase of 9.9%. Ex acquisitions, rev grew $24.6mn, or 3.4%. That's definitely not encouraging.

The problem with acquisition led growth is - acquisitions don't come cheap. Verisk acquired a company XactWare in 2006 for $188mn. Additional contingent payments of $98.1mn and $62.9mn were paid in April 2008 and May 2009 as XactWare achieved certain financial results. XactWare had $63mn in revs in 2007 - now its revenue run rate should be $90-100 mn. to have triggered the contingent payments. Clearly, XactWare's performance has been much beyond whatever the initial expectations were - so it is a success. But equally clearly, Verisk has till date been sharing that success. And if an acquisition doesn't succeed, then Verisk shareholders carry the bag.

Can this company grow revs in low double digits on an organic basis? Because if the organic revenue growth is mid-single digits, and the company pays up for acquisitions to get to double digit revenue growth, then that is quite different from what Visa and MSCI are all about. 2009 has so far been a great year on organic revenue growth. But is there something one-off - like a major contract or pricing increase, which will slow down pricing growth in future years?

It is entire possible that under the old structure, the company didn't pass regular price increases to its owner customers. As an independent company, the company will be more focused on profits. So we might see much higher organic revenue and profit growth going forward.

Verisk has around 200mn shares outstanding - 113mn Class A, 67mn class B, and 24mn stock options at strike price of $9.38. At $26, the company is valued at $5.2bn. We don't know the consensus EPS estimates right now. 1H09 PAT was $90mn. This number includes some one-time expenses like IPO expenses and pension costs. Still, it seems like the stock is already valued in the mid 20's multiple on FY09E EPS and low 20's on FY10E EPS.

I doubt that bullish broker reports once the silent period is over will be enough to catapult the stock into the low 30's anytime soon - assuming markets don't rocket another 20% by that time. But it will definitely be a very interesting stock to follow.

Disclosure: No positions in Verisk, but might change at anytime.

Converting paper profits into real money

Over the last few months, I have cut out and then got back in a few times. It might have been better to buy and hold since April - the profits would have been more - but the periodic profit taking has enormous benefits psychologically.

But now, I am cutting out on all the positions I have even a little doubt on. The ones left in US portfolio are Berkshire, Philip Morris (best play on dollar weakness), Cinemark, Long CTSH - Short Infy, and a few odd here and there. The ones in India are Jagran, FAG, and GSK Consumer, and a few others here and there.

After this, I am close to 40% into equities.

Deflation and Commodity prices

Sometimes I really wonder why bulls on everything else are perma-bears on commodities and commodity stocks. That such high return ratios for commodity stocks cannot be justified. I don't think they realize that if commodity prices were to collapse, we will get outright deflation. The only thing holding the world up right now are high commodity prices.

That makes me wonder - all this recession and not even one scare of CPI deflation (not asset price deflation)!! Or is that a 2010 story?

The simple reason to invest in EM's is - there is structural inflation here. Somewhere like Brazil, where we get 7% inflation and an appreciating currency - if one can time the currency swings right - is the best. Economic theory would suggest currency depreciation in an inflation heavy country. What we see is currency depreciation in potentially -ve inflation countries and appreciation in +ve inflation currencies due to capital flows. This is such a better way to generate returns.

Jagran Prakashan

I recently purchased Jagran Prakshan. Publisher of Dainik Jagran newspaper in North India. Reasons:

a) My hunch is - ad biz in India is going to rebound much more strongly than anybody anticipates. Last year, media companies reduced ad rates as ad buyers stepped back fearing a recession. So media companies faced a volume AND price decline. Advertising is like real estate and commodities in that respect - volume and price both go up and down at the same time.

Now, the thing is - India continued to grow at 6%. This year, ad buyers are back - real estate, IPO, financial services are getting back on their feet. Media companies are now seeing more volumes, but they haven't pressed the button on prices. Sooner or later, they will.

b) Analysts are modelling just volume growth and not pricing growth - at least for Jagran. That will prove a bit conservative - maybe a bit too much.

c) The biggest swing factor for newspaper EPS is the newsprint prices. Currently they are rock bottom. This has benefited Jagran. If they go up substantially, this will be -ve. What I am hoping is that they don't go on a rocket fire here.

d) It can easily do Rs 5.5 EPS this year, if newsprint prices remain within bounds. So the stock is trading at 19x. While it might look high, remember that Indian consumer staples are trading at 25x. They are unlikely to beat consensus estimates - while a consumer discretionary (media) can.

e) Will Indian newspapers go the way of their US counterparts? There are a couple of analysts who argue that they do not structurally like the newspaper industry, considering what is happening to newspapers in the West. What they forget is that newspaper circulation peaked in US in 1984. Till 2000, newspapers remained in fine shape. There is zero threat of Internet to the local language newspaper industry in India - till the time Internet content is predominantly English.

Disclosure - Own Jagran.

So here is how it is now. Consumer - Jagran, Godfrey Phillips, a little bit of GSK Consumer. Financials - Shriram Transport, Crisil. Manufaturing - FAG Bearings. A little bit of this and that. Biggest risk is in Crisil - Moody's (MCO) chart gets scarier by the day.

Excise duty cuts - what happens when they reverse?

I looked at Godfrey Philips numbers in a bit more detail, considering I have mentioned it a few times now. The profits of the company almost doubled yoy in 1Q, which is very unusual. I thought there might have been some dealer inventory movements, and only after looking at 2Q will a clearer picture emerge.

In 1Q10 (June qtr), there is an excise duty reduction of close to 16 crore. Considering PBT is 82cr, this is almost a 20% boost to profits. Now this is a non-recurring item. My guess is that company had already paid excise duty on some goods on which it was able to claim the benefit when government reduced excise duties some time back - I might be wrong here.

So one can knock off 20% of 1Q earnings. Also, like other Indian companies, 1Q has higher "other income" as (fixed maturity plans) FMP's mature. If we exclude both of these, 1Q EPS is higher by 25% yoy. Full year EPS should be somewhere between Rs 120-130 excluding the excise tax benefit - Rs 140-150 including it.

The relevant question is - what happens when government again increases excise taxes? Like a lot of other Indian companies, GP hasn't passed on excise duty cuts to consumers, thus capturing incremental margins. Would companies be able to increase prices to offset any excise duty increase by govt to retain 1Q profitability? I doubt that they can do that in one quarter - such price increases will be spread out over a longer term. This is a big risk for some Indian companies. Surprisingly, no one is talking about this. Something to keep an eye on.

Disclosure: Own GP. Positions might change at any time.

Godfrey Philips starts producing Marlboro

This article came out in Economic Times on 9th Sep. I don't think in any other country Philip Morris has let a partner take control of the manufacturing and distribution of Marlboro. This might not make a huge difference to GP's bottom line today, as Marlboro's share in India is really small. But nonetheless, it is a positive.

The stock is trading at less than 9x EPS - if we were to annualize 1Q10 EPS. Now, it is possible that there were some dealer inventory movements etc. in the first quarter, which boosted 1Q earnings. So we will need to wait till 2Q earnings to really figure out the pattern here. Still, the company has gone into new markets (West Bengal and Tamil Nadu) and launched Marlboro. The second largest tobacco company in India is available at less than 10x, when all other FMCG stocks are trading at 25x. Stock might go down if equity markets swing around, but to me this one is for keeps.

Disclosure: Own GP

The Step Function and the Punchbowl

Markets have the ability to create the reality they believe in. Asset prices go up - for whatever reason - and problems get solved. Since March, this is what is happening.

The world moves in step functions. When asset prices are in a x to y range, the impact on sentiment and consumption is completely different from when asset prices go into y to z range. Just maybe, we are now taking another big step and moving into a completely different zone - where the blue sky is indeed the limit. Interest rates are 0, inflation is low and growth is accelerating. Will central banks take the punchbowl away now that the party has started?

Shriram Transport Finance

LIC Housing Finance is on a tear. I had sold it late July - my rationale was that the stock wont do anything till 2Q earnings unless company does a QIP around 650. Seems like thats what they did today - selling stock at 658.

So now, here we have a company trading at 10x PE and around 2x PB. 3 years back, the company was a basket case on account of souring loans. Has the culture of the company changed that much that it will not be making bad loans today in its hyper charged growth environment? Don't know, but I will not bet on the culture change thing in LIC. Maybe the stock goes up 50% to close the valuation gap with HDFC. But this stock will give me sleepness nights. It is in 2011-2012 that we will really come to know how smart LICHF was in 2009.

My preference is with Shriram Transport Finance. Trading at 12x PE, 3x P/B, quasi monopoly in commercial vehicle lending. The company survived the CV downturn of last 18 months without too many scratches => they know how to lend to this segment profitably. Having seen the downturn, they will be managing risks carefully. The stock is expensive compared to LICHF, but the lending biz is probably much better quality. In banking, numbers can be very deceptive, so it is better to pay up for a good quality lender.

Disclosure: Own Shriram Transport Finance

Some nice one-liners

Hanlon’s Razor: Never attribute to malice what can be adequately explained by stupidity

At times of crises, sacred cows turn into hamburgers.

Apollo Hospitals

Barrons had over the weekend a story on medical tourism (subscription required). It had mentioned Apollo Hospitals in that context, besides a host of Singapore and Thai providers. Now this is a theory that has been around for a decade, and indeed the Indian hospital companies might have benefited in the past few years because of this. And they might benefit more if US insurance companies start reimbursing patients for more procedures carried out in India. But this is just the sideshow story.

The real story is the shabby public health infra in India, and the opportunity for private players. If we look at what Fortis is paying for Wockhardt, Apollo would look a no-brainer. But then, we know that Sardarji screwed the Japs with Ranbaxy, and the money is burning a hole in his pocket. So we shouldn't take it as an indication of what a hospital is really worth.

What I like about Apollo is that the stock is not very volatile. Its correlation with the market is non-existent. So it is a relatively good stock to rotate into out of the more risky stuff. One can also think about it as a long-term investment - if one believes in the Indian hospital story. It is a capital intensive biz. And with Apollo, numbers are always an issue, like for a lot of other Indian companies. The saving grace is that the hospitals are there for everyone to see.

Disclosure: Own Apollo

India car exports beat China

Very interesting article on Bloomberg. Auto stocks have run up, but some auto comp stocks are still ok. It seems like not a lot of Indian brokerages are covering them now - they gave up on these companies post the meltdown last year. There might be interesting plays here. I own FAG Bearings.

WSJ: Weak Back-to-school sales spell trouble for holidays

WSJ is out with an article today on weak back-to-school sales (subs reqd). Now who knows what it means for holiday sales - but people will extrapolate. And one can expect more noise, more articles, and more confusion around holiday sales as Sep grows into Oct. This is probably going to be one big factor which keeps global markets on its toes - which is why I took money off some of the riskiest names I had last week.

Unfortunately, these stocks - Nilkamal etc - are up 10% since then. Indian mid-caps/small-caps are still running strong even though the bigger indices have turned. Probably these are the best stocks to long-short. They don't rise until the large caps are well and truly up (see May 2009), and they don't fall till the large caps have been taken to the cleaners.

Whats up with Berger Paints?

This chart is very strange. At 1:30 pm yesterday, the stock popped up, and has since being going up straight on volumes that are much higher than it usually trades. Is there some insider info out there? Is this company getting sold or something? If some fund house has suddenly become interested in this stock and is buying it at whatever price, the traders at that fund should be fired. Running up a stock 25% is no way to buy the stock. If I find out who the fund house is that is buying the stock, I will never ever buy a fund from that company.

Berger Paints

Exiting Berger Paints. Stock is now 17x-18x EPS. While cheaper than Asian Paints, it is no longer a no brainer. I have moved some of this money into Godfrey Philips - at 10x PE, it is a very cheap tobacco stock.

Taking Risk Off

Sep is here. The way Chinese markets are moving - it seems like bad news is going to come somewhere from there. And late Sep, early Oct - we will get concerns on holiday shopping sales in US. It is time to take risk off the table. If there is +10% move in the next 2 months, I don't mind not being a part of it.

I sold Nilkamal and Phoenix Mills last week after the stocks jumped 20%-30% within a couple of days I purchased them. Now it might turn out not to be the smartest thing that I have done if I am unable to re-enter at a lower price. But what is the harm in experimenting?

Disclosure: Positions might change at any time.

ET: Biscuit prices to rise by 10%

ET has an article today on biscuits. Note that Parle - the industry leader - is still not increasing prices. It is the second tier players that are increasing prices. This seems to be a replay of 2007 - when sugar and wheat prices spiraled up - and Britannia's margins halved in a year. You are in a bad industry if the industry leader is not driven by the profit motive. I wouldn't be surprised if Britannia stock takes a heavy knock after next qtr numbers.

Lightning impact on economy

This is very interesting from today's WSJ (sub reqd):

New research even suggests that lightning's effect on technology can shape the course of regional economies. After analyzing lightning data for the lower 48 states, four economists from the University of Copenhagen found that those states more prone to lightning strikes tended to see worker productivity grow more slowly than in states with very little lightning.

This held true when the economists controlled for a range of other factors, including hurricane frequency, urban density and the education, age and racial characteristics of local populations.

The economists concluded that the use of computers and the Internet spread more quickly in areas less prone to lightning strikes, boosting worker output there. This lightning effect didn't exist prior to the 1990s, say researchers Thomas Andersen, Jeanet Bentzen, Carl-Johan Dalgaard and Pablo Selaya, when the advent of the Internet led to the rapid adoption of information technology in the U.S. and an accompanying surge in productivity.

Adani Power

Adani Power traded flat on listing. Good that I did not invest in it, and got the 10% return instead by playing Torrent Power as a tangential bet on Adani Power.

We need a few successful IPO's to get people really excited. Adani Power unfortunately was not it. And NHPC is also not going to be it. The IPO market might take a back seat for a few months if NHPC doesn't do well. At that time, broking stocks like Kotak might crack up a bit. And then there might be a flood of IPO's. If things play out that way, there might be an entry point into brokerage stocks sometime around Oct-Nov.

ET reports that IPO financing is picking up again. NBFC's have raised almost 10K crore for it. Good for Crisil and ICRA. They need NBFC's.

Also, by the way, it has started raining again - at least in Mumbai. A couple of days it rains more like this, an article here and there that monsoons have picked up, and agri commodities (sugar) cool down a bit. I might get to re-enter Dhampur at lower levels. Nothing ever goes up in a straight line forever - though the stock markets are doing that right now.

Nilkamal Limited

Recently bought some of this stock. This company has 3 key businesses, from the company website here,

• Material handling crates, containers and bins. One will find Nilkamal plastic crates in vegetable markets, dustbins in cities etc
  
• Plastic Moulded furniture - chairs, tables etc. This is where the company started from. At a lot of weddings in India, one will notice that plastic chairs are Nilkamal.
  
• @Home - Home Store retail chain.

The company was initially into moulded plastic items. About 2-3 years back, it started this furniture retail chain called @Home. I have been to a couple of its stores, and my perception is that is amongst the better ones in India. They have put some thought in how the store is laid out. That doesn't mean it will succeed - furniture retailing is a very difficult biz. But there is an option value.

The retail chain is making losses. The moulded plastic items business is very profitable, and the company has done very well over the past decade to become a market leader. On a consolidated basis, the company is trading in mid single-digit PEs. If one does a SOTP and values the plastic biz and @Home separately, then the plastic biz is trading at low single digit PE. It is a levered company - market cap of 130 crore, debt of around 300 crore. Levered companies benefit when interest rates go low - as is the situation today - due to lower interest expense. The potential appreciation in a leveraged company's stock is higher than in an unleveraged one (so are the losses). On an asset value basis, the stock can easily be a double.

Risk with this stock is - it is a small cap. If markets start falling, these stocks just do not find any buyers.

Disclosure: Own Nilkamal. Positions might change at any time.

Phoenix Mills

I recently bought Phoenix Mills - a real estate company. Phoenix mill mall in Lower Parel is the biggest mall in Mumbai south of Bandra, and is becoming even bigger as new commercial space gets ready for occupancy over next 2 years. The value of just this mall is probably more than the market value of the entire company today - depending on the cap rate used. About 250 crore annual rent from the mall when completely developed in FY11, while the current market cap of the entire company is 1900 crore. Company has very little debt - though one can always doubt the veracity of a real estate management team in India. Considering the way the population of Mumbai is growing, and the time it takes to develop a mall here, I think it is a very long time before any serious competition to this mall emerges in the location where it operates.

So the other malls and hotels that Phoenix mill is developing and has already sunk capital into (including the other one in Kurla in Mumbai) are not being ascribed much value right now.

I like this statement by Atul Ruia (director of Phoenix Mills) in this interview with Mint earlier this year: "You raise capital in good times and build in the bad". Phoenix mills raised 980 crore through a QIP in Aug 2007. It is one of the few developers that hasn't yet diluted shareholders this year after stock fell 80% from their peak - unlike a DLF or Unitech.

The risk with this stock is - it is a real estate stock. In any market correction, real estate will fall the hardest, and this stock will fall accordingly. I have bought it with an intention of not looking at it till 2011.

Disclosure: Long Phoenix Mills

Dhampur Sugar

Sold out Dhampur today when it siked up. Last week I thought I will keep it. But it has already done so well compared to its peers as well as the broader market (it was up today when its peers were down 5% !!) that it makes sense to take money out. Shanghai is down 6% right now - that makes it down 15% in last 2 weeks.

Sugar stocks are favourites of the speculative crowd. So even if earnings are quadrupling next year, it wouldn't matter if people decide to rush to the exits en masse. But still, I think Dhampur hits 150 next year. So hopefully it falls some and a bit more.

Dhampur: Mkt Cap = 450 crore. Debt = 900 crore. EV= 1350 crore. Sep 09 EBITDA = 200 crore. EV/EBITDA = 7x. Debt/Mkt Cap = 2x

Shree Renuka Sugars: Mkt Cap = 4700 crore. Debt = 800 crore. EV= 5500 crore. Sep 09 EBITDA = 500 crore. EV/EBITDA = 11x. Debt/Mkt Cap < 0.2x

Balrampur Chini: Mkt Cap = 2900 crore. Debt = 800 crore. EV= 3700 crore. Sep 09 EBITDA = 375 crore. EV/EBITDA = 10x. Debt/Mkt Cap < 0.3x.

The EBITDA numbers are all approx. Still, the broad argument is - sugar is in a bull market. Dhampur is the most levered. So if these stocks go up - Dhampur will benefit the most. If one makes the argument that Dhampur is cheaper on EV/EBITDA and the gap should narrow, then we get a multi-bagger.

Disclosure: No position, positions might change at any time

Sugar, Inflation

WSJ has an article on spiralling sugar prices today - seems like there is a production drop expected in US too next year.

There is an inflation conundrum in the world today. Pessimists are wondering - how long is it before all the money printing causes prices to explode exponentially. Optimists point out to the excess production capacity in the world and are more worried about deflation. It seems for now that the optimists have the upper hand.

However, the argument of excess capacity is not true across all sectors, industries and countries. Right now in sugar, expected demand is exceeding excess supply. And it is probably in sectors like these that we will see significant price spikes caused by low interest rates and excess liquidity - much more beyond the 94% that sugar has gone up YTD. In other words, we will see very high inflation in areas where demand exceeds supply, and low inflation/deflation in sectors where supply exceeds demand - which is true for the majority of global economy. For commodities like sugar which are traded on exchanges, it is that much more easier for speculators to pile on.

This argument can be presented in another way too. If in commodities where there is a shortage don't see 2x-4x price spikes in record low interest rate environment, then the optimists on inflation are probably right - how will we get price increase in other areas with excess capacity? So more than anything else, I think sugar is a very important case study.

Disclosure: Long Dhampur Sugar

GSK Consumer, FMCG, Sugar, Tech

Got out of GSK Consumer, got some more into sugar (Dhampur). GSK at 20x can go to a Colgate at 25x, but 25x can also come down to 20x. Arguing that a stock at 20x becomes 25x is basically a play on momentum, and right now FMCG stocks in India have lost that momentum.

Monsoons are a big issue. Between 2002 and 2004, FMCG growth flattened out as monsoons failed successively. While we are far away from that possibility this time, markets will no longer price these stocks to perfection as it has been doing of late. For food companies (esp. Britannia, whose biggest competitor Parle hasn't raised prices in years) it is a double whammy - growth might slow while raw material costs (esp sugar) go up.

I have traded in and out of sugar over the past few months, this time I will let this one run. My thesis is - all sugar stocks are going to get priced at peak multiples on peak earnings in the next 6-9 months. I did some work on the Indian sugar companies two years back, and from what I recall Dhampur is the most levered on debt/market cap basis. Right now, Dhampur is not more than 8x '10EPS - some will argue it is at 4x-5x '10 EPS. So, there is a potential double here after the double that has already happened.

What I am not sure of is - is it Indian sugar companies or Brazilian sugar companies (Cosan) that benefit the most. The deficit is in India - so the exporters to India (Brazil) should benefit more. That is something we will figure out only as time passes.

If Indian FMCG stocks lose their safe haven status, where will the long-only funds park their money if markets tank? Last year, FMCG stocks had negative beta for a time with the Sensex. My suspicion is - this time it might be tech (Infosys). Again that is something we will figure out only as time passes.

Also got out of Torrent Power when it spiked today. This was an indirect play on Adani Power IPO. This company doesn't talk to investors at all, and its financials look suspiciously clean for a power company that is on a capex spree. Maybe it runs up another 20% if Adani Power opens up with a bang. But the way Adani Enterprises has traded in past 2 weeks, I am not that sure.

NHPC IPO

I am unable to understand the logic of the pricing of NHPC. It is planning to raise close to $1bn from the markets soon. 30x PE, 2x P/B for a govt run 6% ROE company is crazy - one might be better off in 2018 putting money in RPower at Jan 2008 valuations rather than putting money in NHPC at Aug 09 valuations.

I had first looked at this company in May 2007 - the last time it filed its DRHP in anticipation of an IPO. At that time, I thought this company would be a great short if it ever got listed, and I continue to believe so. Shorting this and going long NTPC (govt owned thermal power company) will likely make a lot of money if held over a long period of time.

The company's ROI is close to 5%, and it appears to have always been below 5%. The company survives on generous equity infusions by the government each year. What it means is that over the long run, the company will repeatedly dilute its equity holders to fund future mega-projects. The government of India has really sent taxpayer's money down the drain with this company.

Now the bulls might argue that the company has always been on a capex spree as it was developing new projects, so its important to ex Capital work in progress (CWIP) from the asset base to calculate ROI, as the CWIP doesn't generate earnings. But we can argue the same for NTPC. Like for like ROI for NHPC is substantially lower.

Developing a hydro project takes more time than thermal, so NTPC's capacity growth should be higher than NHPC. So not only will NTPC grow faster, but because of its higher ROI, it will need to dilute lesser to fund its growth. If the market gives NHPC a nice pop on the opening day so that its P/B discount to NTPC narrows, it might be a great time to put on the trade.

What I am not sure is of the funding cost of this trade. And whether one can really put on this trade considering the only way to short in India is through futures.

US markets rally, and so does dollar

Something different happened on Friday - dollar turned up even as markets rallied. For a long time now, markets and dollar were moving in the opposite direction. Last year, dollar went through the roof as the financial crises intensified. So this is probably significant if it is a break in a pattern, and is worth keeping a close eye on. Somewhere in the interest rate market (10Y approaches 4% - it is at 3.85% now) or the currency market will emerge the first signs of trouble. Dollar strength could signal US markets outperform emerging markets in dollar terms, especially commodity driven emerging markets as commodities are inversely related to dollar.

GSK Consumer

There was a good article on GSK Consumer two weeks back in Business Standard. 70% share in milk beverages market (50% Horlicks and 20% Boost) makes it a more dominant player in its category than even Colgate is in its category.

June qtr results were quite good for GSK, like for all other FMCG companies. GSK is at 20x and I have been thinking whether it is time to exit. The only reason not to sell is - Nestle, Colgate, HUVR are all trading in high 20x - low 30x. Even the mid-cap Indian FMCG companies like Godrej are now trading at 23x. GSK is one of the cheaper FMCG stocks around!!

Colgate has had the best growth numbers over last 3 years. GSK and Nestle growth has not been dramatically different over the past 3 years. Nestle has been trading at 25x levels for past 3 years. Is it very unreasonable to bet that GSK moves higher from here?

I am getting tempted to take money out of FMCG stocks and move into media stocks. I doubt there are positive earnings surprises left in FMCG, but it is possible that ad inflation pick up in India again later this year. India is a consumption growth story.

Cognizant vs Infy

Cognizant's reported very good results today. Seq revenue growth rate of 4%. Guidance of $800 mn rev for 3Q, implying a 3% seq rev growth rate. Infy on the other hand, had flat seq rev growth in June-09 qtr, and is guiding to flat rev growth seq for the Sep qtr.

This is why I went long CTSH, short Infy in early June - CTSH has a better growth profile than Infy. CTSH used to trade at a wide premium to Infy till a year ago - right now Infy trades at a premium to CTSH. Since I initiated the long-short, Infy's premium has grown a bit. As I had mentioned then, we will need at least two quarterly reports out of CTSH for markets to realize its superior growth profile. We got one today.

Shriram Transport Finance NCD Issue

This is a good issue. At 11% yield, spread is quite high over bank fixed deposits (7%-7.5% today) or G-secs for the premier commercial vehicle finance company in India. These NCD's will be listed on NSE, so it is possible to exit them at any time - no need to hold them till maturity.

There are 5 kind of NCD's. Option III is effectively a zero coupon bond, which would have the max capital appreciation if yields were to compress. I have applied for this one. Issue is open till 15th August.

Godfrey Phillips

The second largest cigarette company in India reported a great 1Q10, like VST. Cigarette's biz operating profit went up by 45% as the company took price increases. It recently got the Indian distribution for Marlboro, and has launched in new territories (West Bengal and Tamil Nadu). Even after the run this week, it is trading at 10x (and possibly below).

A trivia: Lalit Modi, the IPL head honcho, is the son of K.K.Modi (GP promoter)

Disclosure: Own Godfrey Phillips, VST and Philip Morris International, though position might change at any time

GSK Consumer Healthcare

Like other FMCG companies, GSK Consumer reported very strong results. There are four big MNC owned FMCG companies that are investible in India - Hindustan Unilever, Nestle, Colgate and GSK Consumer. Others like P&G are not good long term buys, because the parent companies have 100% owned subsidiaries through which they are launching new products. These four are launching all the new products through these listed companies.

Unilever is barely growing its volumes - growth there is being led by pricing. The other three are growing very well on volume and pricing. Unilever, Nestle and Colgate are all trading in 25x-30x PE band. GSK is trading at 18x-20x. If GSK keeps up the growth momentum it has shown in the last several quarters, I wouldn't be surprised if the valuation gap closes. This is what has happened with Colgate over last 2 years vs Nestle.

Disclosure: Own GSK, positions might change at any time.

Edelweiss, Motilal, IndiaInfoline

Edelweiss Capital didn't really have the same kind of qtr like Motilal Oswal or IndiaInfoline. For the other two, PAT and rev jumped almost doubled qoq. For Edelweiss, qoq growth was 50%. YTD, Edelweiss stock has underperformed Motilal and IndiaInfoline - does this qtr have a clue as to why?

It appears that Edelweiss had lower broking rev growth than others, which would imply company lost market share. Part of it might have to do with the nature of clients. Edelweiss had probably more hedge fund clients (it is the largest derivative broker) than the other two, and they got wiped out last year.

The question is - is there something structurally different about Edelweiss that it might not grow as fast as the other two? Edelweiss has a huge prop trading book (40% of its revs are from arbitrage trading), while the other two are pure brokers. Is this book as scalable as broking revs? Besides, Motilal and India Infoline also have a huge retail broking network, while Edelweiss is primarily institutional, so this might reduce the long-term acquisition potential of Edelweiss. Why will any foreign broker acquire an arbitrage trading group?

One thing is sure - valuing Edelweiss on PE is strictly not correct, as its arbitrage business requires capital and is more appropriately valued on PB. The ROE's on this book are in low teens - so that warrants a discount to pure brokers.

I had bought Edelweiss couple of weeks back on the theory that if Edelweiss delivered the same kind of growth as other two, it is the cheapest amongst the lot on PE basis (10x PE vs 15x for Motilal and 20x for IIFL). That has turned out to be incorrect - Edelweiss didn't have the same growth. So I sold Edelweiss today. It is unlikely to outperform the other two from here. Market will need better 2Q results - better relative to competitors - to do that.

Next time - I will pick up one of IIFL or Motilal. Brokers are the best way to play beta. IIFL is a very good company but also very expensive and loved by everyone. Motilal might be a more intriguing play.

Regal

Regal's attendance growth again lagged the market, and by a wider margin this time. Company keeps driving ticket prices higher, which has an adverse impact on concession revenues (which is where theatres make their money). This implies Cinemark should once again have better attendance growth than industry. Lets see. At least I picked the right one here.

Not in case of Mastercard vs Visa. I picked Visa, and Mastercard has outperformed Visa by close to 20%.

I bought a share of Berkshire Class B. It is underperforming the market this year, which is strange considering the bear case on Berkshire is around the index put options that Buffet sold at market peak in 2007. I would have expected higher beta here.

Now I own both Microsoft and Berkshire :) WSJ had a pretty positive article on Microsoft today.

Some Nice Quotes

From Howard Marks letter to be found here:

Einstein: Not everything that can be counted counts, and not everything that counts can be counted

Keynes: A speculator is one who runs risks of which he is aware and an investor is one who runs risks of which he is unaware

Investors face two risks: a) The risk of losing money, and b) the risk of missing opportunity. Investors can eliminate one or another, but not both

The words of late Amos Tversky aptly represent my view: It's frightening to think that you might not know something, but more frightening to think that, by and large, the world is run by people who have faith that they know exactly what's going on

Torrent Power and Adani Power

I bought some Torrent Power as a speculative play on the potential success of Adani Power IPO, which has opened today. Torrent Power will have more active generational capacity soon as Sugen comes online than Adani Power will have by 2012, with plans to add as much as Adani in the future. Besides it controls distribution in Ahmedabad and Surat - so I am assuming both Adani and Torrent are close to the Gujarat govt. If Adani Power gets valued at 20K crore post listing, Torrent Power will look so cheap in comparison at only half the market cap :) That is the level of my detailed analysis.

Of course I am willing to overlook here the small fact that one needs to view Torrent Power's numbers with suspicion. But then, is Adani any different?

Another way to play Adani Power IPO is to subscribe to it. But then, by the time listing happens in 3-4 weeks, the world might have changed. Investors in Reliance Power IPO in Jan 2008 didn't really enjoy the ride as the stock listed in Feb and the Sensex was on its way to 10K instead of its way to 40K. This way, if things were to turn suddenly, I can exit.

FMCG Margin Expansion

Certainly I got it all wrong in April on FMCG margins - margins have been the biggest surprise of this recession. Volume growth has been so strong that companies haven't had to cut prices. Commodity and media deflation has reduced costs. As a result margin expansion has been very strong, much beyond even the most bullish expectations. So profits have zoomed up 60%-70%.

1Q11 (June 10) would certainly be a very tough qtr for FMCG companies. 2Q10 (Sep 09) might continue the trends of 1Q10 (June 09). Volume growth is unlikely to suddenly break down barring a shock.

Verizon-Verizon Wireless and ABI-Inbev

The situation at Verizon and Anheuser-Busch Inbev is remarkably similar. Verizon's cash cow is Verizon Wireless, where it owns only 55%. However, it fully consolidates VZW. Similarly ABI owns only 61% of Ambev, which is the real cash cow. ABI too consolidates ABV.

The fully consolidated businesses at both companies - wireline in case of VZ, and ex-Ambev biz in ABI, is where the disproportionate amount of consolidated debt is. So looking at consolidated debt/EBITDA for both these companies is wrong, unless one adds the market value of the minority stake in subsidiaries to debt.

Similarly, the FCF yield for both these companies is vastly over-estimated. Analysts estimate ABI is trading at 10% FCF yield. That's incorrect. ABV doesn't pay off its entire FCF as dividends. So, the consolidated FCF looks much better than the real economic benefit to ABI. The real FCF yield is closer to 8% than 10%.

In Verizon's case, the FCF yield is even more exaggerated. Wireline biz doesn't generate any FCF today due to FiOS capex. The reported FCF is all from wireless, so it needs to be multiplied by 55% (VZ stake in VZW) to come to VZ's real FCF yield today.

Both VZ and ABI have to figure out ways to tap into the cash flow of their subsidiaries - VZ to fund its dividend (its wireline biz can't fund the dividend on its own today), and ABI to reduce its leverage. The best solution is if it happens in a way other than a dividend from the subsidiaries. If VZW or ABV pay a high dividend, the consolidated debt picture at VZ and ABI will look much worse, as there will be cash leakage to minority shareholders in the subsidiaries.

Asian Paints and ICI

Asian Paints - the largest paint company in India, has reported pretty staggering 1Q10 results. EBIT is up 66%!! While paint sales are up 17%, EBIT margins expanded from 15.7% in 1Q09 to 22.0% in 1Q10 in paints.

ICI India - the third largest paint company in India - also had a similar qtr - EBIT jumped 45% as sales grew 7% while paint EBIT margins expanded from 6.9% to 9.4%.

There are quarterly fluctuations in paints industry depending on dealer inventory and timing of festivals (particularly Diwali), so yoy rev growth on a quarterly basis can fluctuate. Like other FMCG categories, paints industry also probably benefitted as commodity costs fell (oil is their biggest raw material item) and media costs deflated.

Asian Paints has cut prices recently. It is unlikely margins remain this high in the industry. On that matter, I think it is very unlikely margins remain this high for FMCG companies on a substainable basis going forward - company after company has benefitted from media deflation. Stocks like HLL and Colgate are now priced at 25x-30x on all-time high margins.

Now it is true that Indian media has created a lot of inventory in the past couple of years. So some of its woes are justified. But before competing on price, FMCG companies (like HLL) will step up advertising and promotion expenses.

On ICI, company's market cap is around 2000 crore, and cash is 950 crores. Unfortunately, company has now started lending cash to Akzo Nobel India's subsidiaries. Even if it is at arm length's basis and company earns 10%, I am not investing in the stock as 50% of the company earns 10%. This is the biggest risk of investing in MNC subsidiaries in India which hold excess cash (case in point was Novartis).

On Asian Paints, the company has voluntary decided to take prices down by 2% odd. Historically, it seems that company wants to operate at a high teens margins - if margins expand beyond that, it cuts prices. As the industry is consolidated (AP, Berger, ICI and Nerolac control 70%) and everybody else follows AP price points, there is no danger of anybody else initiating a big price war. The volatility of the profit pool in this industry is lesser than in others like soaps, where Godrej Consumer is very happy at having a massive qtr, but won't do anything on price till a price war breaks out. So if Godrej Consumer is trading in line with Asian Paints (both at 25x PE - isn't it amazing!!!), there is a relative valuation mismatch.

Crisil and ICRA Earnings

Crisil reported CY2Q09 on expected lines. Ratings biz continues to grow driven by bank loan ratings requirement of Basel-II. Research is not growing, as Irevna's outsourcing biz has stalled. EPS growth from cont ops at 12% is in-line.

ICRA continues to grow faster than Crisil as it is a pure play on Indian ratings. In FY1Q10, its EPS jumped 72%.

However, the sequential picture is much different. Crisil's rating revenues went up from Rs597mn in CY1Q09 qtr to Rs 607mn in CY2Q09 qtr. ICRA's rating revenues, on the other hand, declined from Rs 288mn in FY4Q09 to Rs 201mn in FY1Q10 - that's a seq decline of 30%. Thats very strange.

Both companies are at 18-19x, but it is quite irrelevant. The relevant issue is what SEC does with these companies. Seems like RBI in India is very happy with the way these companies are.

Also note, Berskhire sold some Moody's last week.

Disclosure: Long Crisil

Disclosure: Sold LICHF as NIMs compressed drastically. Stock is not going anywhere till 2Q earnings now, unless they do a QIP at Rs650. 2Q earnings will be in Oct, which is a long time away.

FAG Bearings and SKF

FAG Bearings (505790.BO) is the subsidiary of the german Schaeffler group (the group that got into trouble last year for buying Continental). It is also a bearings company, like SKF India. Like SKF, they don't talk - so there is not enough information out there.

FAG and SKF had quite contrasting qtrs. FAG's rev is now growing yoy at low double digits, while SKF is declining at low double digit. This might be because FAG is largely automotive bearings, which might have seen a revival with the revival of domestic auto industry. SKF, on the other hand, is also heavily in industrial bearings, which are still to revive. QoQ, SKF is seeing growth, but still not yoy.

However, the story at margins is completely different. SKF's margins have bounced back - this qtr EBITDA margins are at 13%, up from 8% in CY1Q09. FAG margins, on the other hand, have declined from 19% in CY1Q09 to 15% in 2Q. FAG's margins have always been much higher than SKF historically - FAG has been in high teens, while SKF has been in low teens.

Considering both these companies import a lot of what they sell in India, one could have expected margin expansion in 2Q as rupee has appreciated from 1Q to 2Q. That has happened for SKF, not FAG.

FAG is trading at 10x PE on 2Q margins of 15%. If the margins bounce back to high teens (Maruti, Bajaj and Hero Honda are all now making tons of money, so their suppliers should also benefit), it is trading at 8x PE. That doesn't mean that stock will go up - it can easily trade at 5x PE too, like it was not that long ago.

From a little bit of what I have read, it seems like bearings is not a commodity industry. Auto manafucturing is an intensely competitive industry - anybody can make a car. But there are only a few big companies in the world that can make bearings.

The big question with SKF and FAG India is not about their long-term top-line growth prospects. It is about margins, and specifically this - how much money will their parent companies let their Indian subsidiaries make? The Indian subsidiaries import from 100% owned subsidiaries of the parent companies, so there is a transfer pricing issue. As a minority shareholder in the Indian subsidiary, we can get beaten over.

Still, I have gone ahead and purchased FAG. So far, the parent company has played fair. Now the parent company has a huge debt load and might play unfair. But FAG India makes only $20mn of profit every year. Playing unfair here won't make any dent in Schaeffler's billions of debt. I plan to hold this for some time, but it is a risky bet.

Disclosure: Own FAG

Philip Morris International

Raises guidance to $3.10-$3.20. 2Q EPS is 0.83. Unless EM currencies appreciate even more from here, it is unlikely 2009's guidance gets raised much more beyond here. 1H EPS is $1.56, so if we assume similar performance as 2Q for rest of year - i.e. 2H EPS of $1.69, we come to $3.19.

Both PM and BAT have mentioned Korea as a growth market. PM mentions in its press release:

"In Korea, the total cigarette market was up by 2.8%. PMI’s shipment volume surged 17.9%, driven by market share increases. PMI’s market share reached 13.7%, up 1.9 points, driven by strong performances fromMarlboro, up 0.8 share points, Parliament, up 0.7 share points, and Virginia Slims, up 0.2 share points."

Must be bad for KT&G. It might be one of the companies that one of the big 4 (PM, BAT, IMT or JTI) acquire next.

LIC Housing Finance

From a cursory glance of LIC Housing Finance, Gruh and HDFC, it seems that spreads have compressed sequentially. Is it a 1Q phenomenon or something else? Or is it that all these companies as well as banks are aggressively competing with each other right now, reducing the spreads.

Because HFC's can lever up their entire equity (they dont need to keep and SLR), they have an attractive biz model in India. Question is the spreads and the NPLs. And of course, what multiple the market decides to give these biz on a particular day.

Disclosure: Own LIC Housing Finance.

Coca cola earnings

From Coca-Cola earnings.

• Russia’s unit case volume declined 9 percent in the quarter, reflecting the impact of a continued challenging macroeconomic environment. Russia is struggling - this might impact PM and BAT due to downtrading.
• Unit case volume growth in Northwest Europe was partially offset by weakness in Spain and Eastern Europe due to significant macroeconomic challenges in those regions.
• Strong unit case volume growth of 6 percent in the quarter was led by a 6 percent increase in Mexico, a 5 percent increase in Brazil and a 6 percent increase in Argentina. Latam is up 6% on volumes in 1H - thats good news for the other beverage companies.

Mexicans are just behind Americans in per capita consumption of carbonated drinks and obesity rate is ahead of US - amazing for a developing country.

Ron Paul singles

This is funny (from today's WSJ):

Mr. Paul, an obstetrician and two-time presidential candidate, considers the Fed to be unconstitutional. He sells "Audit the Fed" T-shirts on his Web site, and his movement has a small but deeply committed following: Supporters even have a dating Web site in his name, "Ron Paul Singles," where users seek others displeased with the Fed.

Comment in Barrons

This is a good statement in this week's Barrons.

In coming months, Kass says the fear of being out will overcome fear of being in. Kass believes the March low of 666 on the S&P 500 might mark a generational low, but please don't mistake Kass -- or us -- for bulls. Huge bull rallies inside bear markets are hardly unusual. The long-term market headwinds haven't gone away, he notes. In addition to the macro concerns Roque cited, Kass lists an elevated savings rate, which lowers consumption; spreading wage deflation; the devastation of the construction and real-estate industries, once big job creators; and a reduced securitization market, a former growth engine, as factors that will weigh on stocks for years. "These issues raise the specter of a fragile recovery and a double-dip both in the economy and stock market next year," he says. Kass sees a "lumpy and inconsistent" market for the next few years, with substandard to negative returns.

Hindustan Unilever struggles

ET has an article today on how HUL is struggling in all its business lines, whether it is soap or toothpaste. In its previous conf call, HUL clearly mentioned that without market share, profitability is impossible in the long run. Colgate is reporting blockbuster results by having sales growth while at the same time cutting ad expenses. Ad expenses are down as ad rates have taken a big hit in the last year - both because of excess media inventory as well as reduced ad expenses by other industries which are struggling (financial services etc).

HUL doesn't seem to be suceeding so far in whatever they are doing to stem their share loss. Is a more aggressive HUL here? They can either cut prices or increase ad and promotion expenses aggressively, or both. Or they might not do anything despite what they say - which would be good news for Godrej Consumer and Colgate.

Zee reported results two days back. Their subscription revenues are now more than ad revenues - that is something I didn't realize would happen so soon. Ad revs are down massively yoy, and that is probably the case for a lot of media companies right now in India. Can there be a sudden ad upsurge in India?

What is a good media play in India? Problem with Zee is that it is not what it seems - it will be investing in DishTV and WWIL whenever they run into problems.

Indian Company Earnings

I will start writing down my one-line thoughts on earnings of various companies to help me later on 1-3-5 years down the line if I happen to look at them again.

1. Colgate: EPS jump of 40%!! From Rs 5.3 in 1Q09 to Rs 7.5 in 1Q10. Ad and other expenses have come down, while Colgate hasn't cut prices (I recall reading they actually increased them during the qtr). If investors annualize this, it is Rs 30 EPS for FY10 vs consensus at Rs 25. Stock at Rs 645 is 21x. Suddenly it ain't so expensive anymore (this is India)!! Nestle is at 28x, and right now Colgate has the highest EPS growth amongst all.

Question is - how long can margins expand?

2. SKF India - Sales down 15% yoy while EBIT is down close to 50%. Even when commodity prices have cooled off. Is it mainly because of the trading biz - importing heavy bearings into India and selling it here - which might have been hurt very badly by rupee depreciation. After all auto has recovered. Or is it that while auto is important, overall industrial growth is more important for this company. Company doesn't talk and analysts dont cover it - so this is all guess work.

3. VST: EPS has gone up 250% yoy - but a better way to look at it is probably sequentially this time around. What has happened to this company in the last year is actually quite amazing. This is the 3rd largest cigarette company in India. In 1Q09, its biz collapsed as Indian govt increased the excise duty on non-filter cigarettes by 2x-5x. VST had a high share of volume from non-filter segment. Suddenly the company found itself without a biz. So it did a very smart thing. It launched the same cigarettes in filter category - at a higher price. I guess its customers came back. So suddenly, its profits have zoomed up and have been going up every qtr for the past 4 qtrs - much much higher than under the old tax regime. At least that is my guess - no analyst covers this stock, and the company doesn't talk.

Right now, it is trading at 6x-7x PE. The company pays out most of its earnings as dividends. Disclosure: Bought stock today. This is high risk as the stock has always been cheap. I am betting some people will get attracted by a 10-15% dividend yield next yr.

4. India Infoline: Brokerages are minting money - no surprise there. QoQ profits have doubled. But stock is at Rs 132. Annualizing 1st qtr, we get Rs 6 EPS. 22x PE for a broker is a bit too much - even if they dont have any balance sheet risk and they exist in this great country with a wonderful future called India.

Calpers vs Rating Agencies

Calpers is targeting the free speech defense.

The text of the suit is here.

Calpers sues rating agencies

Article in NYT. Basically Calpers investment managers outsourced their decision making to somebody else. When they got ripped off, they are suing. The question to ask is - is Calpers relying on its own brains today in its fixed income investment process, or are they still relying on rating agencies.

Something to watch out for. I am basically betting that nothing will change.

SEC's Schapiro Eyes Credit-Rating Firms

WSJ (sub reqd) has an article today on what the SEC is doing with credit rating agencies: "Securities and Exchange Commission Chairman Mary Schapiro is set to tell Congress she has directed her staff to look into ways of preventing debt issuers from shopping around for the best credit ratings".

What that means is - the credit rating system as it exists today will continue to exist, with a few tinkers here and there. Rating agencies are govt created monopolies with unregulated pricing power.

Ratings are a way for investors to outsource the blame of their stupidity on others (the rating agencies). HSH Nordbank investment managers would have told their superiors - "But I invested in AAA" - and they wouldn't have been fired. Such a cool way to protect the downside and get the bonus on the upside.

This is worse than tobacco - in tobacco everyone now knows the harm caused by the product.

Disclosure: Long Crisil.

Russia - the world's third largest beer market

After China and US, Russia is the world's third largest beer market. Russia and Ukraine are also in the top 5 for smoking. Seems like the former USSR's population made a virtue of vice.

Is 2009 a rerun of 2008?

The indices have behaved strangely similar so far. Fall in Feb, rally starts in March (Bear Stearns in 2008), topping out in June. Further out - struggle till Aug end, and rollover in Sep and Oct?

Except that Shanghai keeps marching higher. That is very different between 2008 and 2009. In 2008, Shanghai kept going lower and lower.

Crisil and Rating agencies

Crisil is 51% owned by S&P, and is S&P's subsidiary in India. It is the biggest player in Indian domestic ratings business, but is not a pureplay on it. Only 20% of its biz is domestic ratings, another 20% is outsourcing revenue from S&P global, almost 40% is financial research outsourcing (Irevna), while the rest is consulting and advisory revenue. As ratings has a higher margin than other revenue streams, the contribution at the EBIT line is different: domestic ratings - 35%, S&P outsourcing - 25%, research oursourcing - 40%. Stock is currently at 15x CY09 earnings, so depending on one's view of Irevna, it is either cheap or expensive. It is one of the stocks in India that I have continued to hold since 2007. If one is bullish on India and infra spending, then either Crisil or Icra (Moody's sub, and this is purely domestic ratings) are probably a good bet.

One of the most surprising things since the financial crises exploded in August 2007 is that while various parts of the financial industry - banks, brokers, insurance companies - have seen their business models and ownership structure change irreversibly, the rating agencies continue to exist and do what they have been doing for the past 100 years. There are some half-hearted proposals here and there to change the way rating agencies work, and there are some shorts now (Einhorn) targeting rating agencies. But there doesn't seem yet to be a regulatory or legislative urgency to change anything the way ratings system work. The question is: if equity markets can work without ratings, why can't debt markets?

Recently, BIS published a report titled "Stocktaking on the use of credit ratings" (hat tip: Prof Verma). What is clear is that ratings are used more pervasively in the US than in any other country. If Fed was to decide that it will stop using credit ratings in its decision making process and instead recruit a team of inhouse credit specialists (for e.g. to figure out eligible collateral for TALF), that would be a death sentence for the rating agencies.

If this team of inhouse credit specialists were to make their ratings public, it would become an FDA style agency for the credit markets. This is what rating agency bears say should anyway be the case, because today we have govt. designated monopolies earning non-regulated returns.

There is however, a very big risk with a govt owned rating agency. If the ratings of the govt agency turned out to be bullish or faulty - and they will at least once in the next 100 years - then investors will go the US govt to be reimbursed. So, if Fed decides to set up a team of inhouse credit specialists, its recommendations would likely remain private.

What is the benefit of rating agencies to investors? Maybe rating agency help reduce costs - in the sense that not all bond funds, banks etc have to hire smart credit analysts to buy bonds. However, that is extremely undesirable as we can see. Ratings create a false sense of security.

Net net, till the regulators decide to do the hard work of analysing bonds and loans to calculate the capital cushions of various financial institutions, I don't think rating agencies go away. Having more NRSRO's won't reduce S&P and Moody's dominance in the next 2-3 years. What can certainly change is the way these companies are compensated. That is something that doesn't seem to be happening today, but it can change anytime.

Telefonica and DT should swap O2 Germany for TMobile UK

Everybody is speculating how TMobile UK might be paired with one of Vod, O2 or Orange to consolidate the market. One analyst speculated Vod acquiring T-Mobile UK and giving DT its underperforming Turkey biz (Telsim) + cash. DT has a stake in OTE - a Greek mobile provider. So this will give DT a way to expand its Balkan footprint.

There is another attractive combination for DT. That is with Telefonica. It can sell TMobile UK to Telefonica (O2), and acquire O2 Germany from Telefonica. O2 Germany is ranked fourth in Germany where EPlus is executing very well. Telefonica will be better off consolidating the UK mobile market, and DT will be better off consolidating the German market. The synergies in such a transaction will be far higher than in any other combo, and for all the players - including the ones not participating in the deals. Vodafone will benefit because not one but two of its main European markets (UK and Germany) would get consolidated.

Egyptian Pound conundrum

I am going country by country to understand Vodafone better. Vodafone is the second largest mobile operator in Egypt. Egyptian pound is pegged to USD. The country also seems to have an independent monetary policy - overnight lending rate is 10.5%. Foreigners can invest in Egypt stocks. How is that possible? A country is pegging its currency, following an independent monetary policy, and allowing capital flows? If investors get confidence the peg will be maintained, the easiest way to make money is go long Egpyt and benefit from the 10% inflation. Currency carry traders must really love Egypt. Something is not right in the way I understand the situation.

HKD is pegged, but then HK doesnt have a independent monetary policy - HK follows Federal Reserve. Yuan is pegged and China has an independent monetary policy, but it doesn't allow capital flows. INR is virtually floating freely, so India has capital flows as well as an independent monetary policy.

Why is this important? Well, if Egyptian pound were to devalue, Vodafone's estimates will get cut. There is a similar risk with Telefonica, which has benefitted a lot because of the Venezuelan peg.

The New Paradigm for Financial Markets, by George Soros

I am currently in the middle of this short fantastic book by George Soros. I haven't read any of his other books except the first few pages of Alchemy of Finance in 2003, from where I picked up the concept of reflexivity (i.e. prices can impact fundamentals and earnings). This is Soros's paradigm for financial markets:

"Instead of being always right, financial markets are always wrong. They have the ability, however, both to correct themselves and occasionally to make their mistakes come true by a reflexive process of self-validation. That is how they can appear to be always right."

Some other key points are:

a) While the methods of scientific enquiry have proven successful in physical sciences, it is incorrect to use them to the same extent in social sciences - because of inherent uncertainty and indeterminacy.

I recently read an article arguing that financial markets collapsed because economics doesn't use some superior mathematical techniques that have been used elsewhere for sometime. Many people argue that better risk management techniques will make sure a crisis like this doesn't recur. That is incorrect - because risk is also a function of leverage, and not merely the volatility of the underlying cashflows. An inherently more risky financial product is less risky when bought with no leverage. Conversely, if people believe in "a great moderation in the volatility of inflation" (Greenspan and Bernanke) - and by implication cashflows, they will lever everything up more - so the system ends up with more risk. Uncertainty in participants actions makes the future indeterminate in social sciences. Light, on the other hand, doesn't change its speed.

b) The Enlightment tradition focuses solely on the cognitive function and not on the manipulative function. "The philosphers of Enlightment put their faith in reason, they saw reality as something seperate and independent of reason, and they expected reason to provide a full and accurate picture of reality". This philosophy has served physical sciences well for centuries. In security analysis, this is equivalent to constructing a DCF and a WACC to figure out the price.

"The postmodern approach goes the other extreme - by focusing on the manipulative function and treating reality as collection of often conflicting narratives, it fails to give sufficient weight to the objective weight of reality". In security analysis, this is the equivalent of saying all DCF is non-sensical. Or something similar to what the world leaders are attempting right now - "lets talk our way out of this recession."

The truth lies somewhere in between. Sometimes, financial theories work - and sometimes they do not. The trick lies in identifying the turns. Because "the behavior of markets is best regarded as a historical process". A long-term investor might not get the same prices when theories start reworking as when they stopped working. The movement of prices during the chaotic period might have irreversibly changed the fundamentals - like US regulators panicking on seeing financial stocks falling and seizing WaMu etc.

Where I disagree with Soros is when he extends this theory to politics. Soros gives the example of the Bush administration as following the dangerous post-modern philospohy, and how it not merely recognized that truth can be manipulated, but promoted the manipulation of truth as a superior approach. But haven't politicans done this throughout history and in all countries. Goebbels did it in WWII. Even De Gaulle was manipulating when he kept insisting "I am France (Je suis la France)" - when France was under German occupation and De Gaulle was living in UK.

The difference between politics and economics is - while it well accepted that politicians manipulate, it is not recognized that markets can be manipulated as well. Because the manipulators are we ourselves. The manipulation might be passive and not active because no one person controls it. But to the extent that the biases of thousands are able to turn imagination into reality through the market mechanism, it indeed is manipulation.