The slow beginning of deflation - the case for bonds

Commodity prices are cracking up left, right and centre. Ospraie - one of the stars of the commodity hedge funds - has blown up. The speed at which things unravel is sometimes startling.

Slowly but surely, the global real estate asset price deflation is moving to other asset classes. Is there any link between asset price inflation/deflation and consumer price inflation/deflation? Considering that we had a period of 2002-2007 (and many more periods before that), when asset prices (esp real estate) moved up sharply while CPI remained contained, one would argue that these are two different categories of inflation. So one should be careful in extrapolating asset price deflation to CPI deflation.

At the same time, I would be really surprised if we continue to have asset price deflation and CPI inflation. I haven't read any paper which has looked at the historic correlation between these two, so this is more of a hunch than anything else.

If this assumption indeed is true, it has profound implications. The wrong thing to do in a CPI deflationary environment is to buy equities. When prices that companies charge for their goods fall, they might pull down absolute profits left for shareholders, because it is not necessary that price declines lead to volumes picking up in a depressingly deflationary environment. The best time to buy stocks are when interest rates are rising from low levels to moderate levels (in response to accelerating growth), than when they are being cut from high levels to moderate levels (in response to decelerating growth).

So one needs to be higher up in the capital structure. Considering that spreads on bonds are also quite high these days when everyone is still worried about inflation, one can end up making a killing in bonds on a risk-adjusted basis. Over the next 5 years, inflation might come down and spreads might compress, so there is money to be made.

My biggest bet of the last year - being long on USD and short on Rupee - has wiped out all losses from 1H08. But, if things in US are as bad as I think they still are, Fed will cut more. The recent commodity price deflation and the USD strength has given them enormous wiggle room. So we might see another period of USD weakness in the next 9 months. But that again is bullish for bonds. The interesting thing to watch would be whether it leads to another commodity spike.

There was one more trade I had tried to do earlier this year - shorting the pound when it was at 1pound = $2USD. I couldnt figure out how to execute it economically. Now it is $1.80. It is amazing to see how currencies move around to transmit the positives/negatives across countries and continents.

Verizon will make a bid for Vodafone in 2012 - the depreciation of the pound has not ended by any stretch of imagination.

Om Shanti Om in Beijing Olympics

In the women rhythmic gymnastics event, the Israeli team choreographed the last 60 second or so of their last routine on "Dhoom Taana" from Om Shanti Om. They finished 6th. Very strange indeed!!

In 2004 Olympics, China won 73 medals and India won 1. In 2008 Olympics, China won 100 and India 3. Indian Olympics is a much higher growth story (growth of 200%) compared to a maturing Chinese story (growth of only 40%). Giving a 200x multiple to India's 3 medal count (there is a huge runway of growth left) and a 6x multiple to low growth China medal count story (this is a cyclical peak due to home country advantage, besides how much more can they go to), we come to a valuation of 600 for both. India has finally caught up with China!!!!

Freddie Mac

It seems Freddie Mac is going out of existence soon. For a $2bn market company (as of now, when stock has fallen another 20% after being massacred throughout the week), how does it raise $10 bn? Bush administration is going to be forced to do something dramatic just before it bows out of the White House.

I just saw the fight that really launched HBO (and the cable TV industry) in 1975 on ESPN. Thriller in Manila - the fight between Ali and Frasier - was the first live telecast using satellite. Gerald Levin was the brain behind this. He was also the CEO of Time Warner 25 years later when it merged with AOL - the largest M&A deal ever.

A Verizon takeover of Vodafone

A speculation here. The biggest M&A deal in the world of the next 4 years is going to be a Verizon takeover of Vodafone. Verizon might then divest its landline business and become a global wireless operator - somewhat on the lines of what Vodafone did to Mannesmann at the beginning of the century.

It all boils down to Verizon Wireless - in which Verizon owns 55% and Vodafone owns 45%. It is probably the best wireless operator in the world with a churn of sub 1.2% and is a crown jewel. Because of the way Verizon has manipulated the situation, Vodafone's stock has become relatively undervalued, while Verizon has become relatively overvalued.

Here is why. A lot of telecom investors are focussed on dividend yield and free cash flow yield. Verizon controls the board of Verizon wireless and it has argued against Verizon Wireless paying a dividend to its parents to reduce its leverage for years. This works fine with Verizon. It consolidates Verizon Wireless, so the consolidated cash flow statement includes all of Verizon Wireless's cash flow (including Vodafone's piece of it). So the free cash flow calculated using cash flow statement overstates Verizon's free cash flow power. Besides, as debt reduces at Verizon Wireless, it makes consolidated leverage at Verizon look better (if one forgets to count minority interest as debt).

Vodafone has no such luck. It carries Verizon Wireless as an investment on its balance sheet. Because it doesn't receive any dividend from VZW, its cash flow statement doesnt include any benefit from VZW, and so its free cash flow is understated. Whatever free cash flow Vodafone generates today, it is from its properties other than VZW, and it is from this that it is paying out its dividend.

So on a free cash flow yield basis, Vodafone is cheap. A big cause of it is VZW. Verizon can capture this discount. Pound has started weakening, and if it continues to weaken further as UK falls off, UK takeover targets will become attractive in the next 3-4 years. Someday, Sprint will get its act back in US and it will become difficult for VZW to grow by churning Sprint subs. Growth in US wireless through domestic M&A will be difficult - after Alltel, there is hardly anyone of scale left to acquire. VZW will spend 2-3 years integrating Alltel. That is when Verizon will pounce on Vodafone.

Oil, dollar and interest rates

I had thought in April that commodities will weaken as Fed ends its interest rate cut campaign, because that will support dollar. http://gaurav1.blogspot.com/2008/04/time-to-short-commodities.html. That didn't happen. Then I thought that probably Fed needs to hike interest rates to make dollar strong to kill commodities.

What has happened is different. Expectations on Europe have changed from rate increases to rate cuts. So the expected interest rate differential between dollar and Euro has narrowed, strengthening the dollar and weakening commodities. A valuable lesson. Relative interest rates are more important than absolute interest rates in the forex market, and by extension commodities.

There is a clear linkage between credit crunch and commodities through interest rates and forex moves. A lot of people think these are two seperate problems. They are not. All these demand-supply theories on commodities are BS in the short run, and not enought to explain oil prices going up from 100 to 145 in 3 months.

This is another evidence of the point made by Charles Kinderberger in "Manias, Panics and Crashes" - asset deflation moves from asset class to asset class and country to country - often through capital market linkages. Oil price spike caused by credit crunch has made sure that emerging markets weaken significantly.

Commodity crack-up..

Commodities are cracking - finally. If it becomes a deeper slump over the next 24 months, there are going to be lots of issues with industrial companies and banks that are heavily exposed to steel, cement and other commodity companies. The swing factor for a lot of these commodities is China, and I have no clue about what is happening there.

In the immediate term, commodity stocks might fall a lot and start pricing in a very pessimistic scenario. One of the key learnings of the last 9 months is - nothing goes down forever. So there might be a quick trade here. But there is a global slowdown/recession, it is spreading, and high commodity prices dont fit in well with a theory of global slowdown. I think inflation is going to turn into deflation over 24 months. So need to be careful with commodities.

Sold out Aban at a loss of 30% - there are much better oil drillers available cheaply now with lower leverage, higher exposure to deepwater drilling, and better corporate governance. This stock didn't rally when oil was moving up in May June because Indian markets fell, and hasn't rallied since when Indian markets have gone up in July-August, because well oil has been falling. Now when Indian markets fall again, and their fall this time will have nothing to do with oil, this stock can crack up further. For a highly leveraged company, its stock price is paramount to its survival.

Why will India markets fall again? They have been rallying since RBI apparently surprised the markets with more tigheting than the markets bargained for - because oil is falling. Interest rates and inflation are high and they are not coming down for the next 5 months, and all you need is 5 months to turn the cycle decisively. Earnings estimates are way out of whack for all Indian companies.

Catching the bottom

Barrons has this excellent reason for why no one can catch the bottom...

"THERE'S A REASON THAT STOCK PRICES ALWAYS BOTTOM BEFORE the economic news turns for the better -- and it isn't all about the "wisdom of crowds" working its information-processing magic in the crucible of the market.

It happens partly because a struggling market, in its impatience, tries to anticipate the turn so often, with bottle-rocket rallies, that eventually it turns out to be right.

It's easy to tell the false dawns from the real ones, of course. Just wait a year or two, and it'll be clear in retrospect. Divining it in real time and anticipating the anticipatory is a good deal tougher."

The risk is volatility

In financial theory, volatility of an asset class is considered as a proxy for its investment riskiness. The risk is captured in the discount rate. So, to value on asset, the formula is

V = Sum of {C(i)/(1+r)^i}, i = 1 to infinity, where

V is the value of the asset,
i is the year,
C(i) is the cash flow in year i,
and r is the discount rate, calculated as

r = r(f) + Beta * {r(m) - r(f)}, where
r(f) is risk-free rate,
Beta is associated with volatility,
and r(m) is the market return

This way, rising volatility increases discount rate, reducing the value of asset.

However, it ignores the impact volatility has on cash flows - the numerator of the equation above. The incidents of the last few months makes me believe that volatility impacts not only the denominator by increasing discount rate, but also the numerator by impacting cash flows.

Take the instance of Indian IT companies. Last year they were hit because rupee appreciated suddenly. They took on derivative positions, in some cases excessively. So, this year, they are getting jacked when rupee is depreciating. Last year, Indian importers didn't take forward cover, thinking rupee will appreciate forever. This year, they are getting hit.

The point is - volatility makes decision making difficult. If oil price rises to $145, should an airline hedge or not? Should a steel maker plan to massively expand capacity today or not - when there are some tentative signs that China is slowing? If people say that they will not make a decision till volatility subsides, that itself hurts overall growth. One man's savings is other man's income.

So, more than oil prices etc, I think it is volatility itself that will restrain global growth. The animal spirits are sagging - India and China had their share in the last few months and now it is Brazil's and Russia's turn - and they are essential for any boom to continue.

The bull and bear dilemma

Alan Greenspan starts his article in FT today with the following sentence - "The surprise of recent months is not that global economic growth is slowing, but that there is any growth at all". That is precisely the reason why bulls and bears alike are being challenged.

For, when one puts on the bear hat, one can argue that credit destruction should have caused things to fall apart. Unfortunately for bears, that hasn't happened. Amongst all the doom and gloom, US is still growing at a snail pace. China still continues to grow - and it was the reason given behind the commodity price spike.

So, should one then become a bull? If the once in a century credit crunch results in just a 20% decline in equity markets, why should one ever not be in equities? To that, the bears will argue - just wait and watch. The real destruction will start now as China and India slow, and capital to western financial institutions becomes scarce.

There are various dilemmas in investing right now:

a) Should one invest for quarters? Suppose a stock like Bharti falls to 14x PE today when it is growing at 20%+. I can say with reasonable confidence that the next 12 months are going to be fairly good, and the next earnings report will be solid. I dont know what happens after that -competition heats up, inflation hits rural India causing subscriber addition to slow down etc. Should I buy for the next qtr? The risk is that the stock doesnt recover in the next 12 months. Or for that matter PSU banks. Chances that they report good numbers over the next 9 months is good, after that who knows. How should one think about investing when next qtr might be good but 2 year out might be bad?

b) Should one buy stocks that would be the last to fall? Stocks like Colgate, P&G etc? If things dont fall apart, one will end up making money in these - their multiples have also compressed, although not that much. And if things become really bad, one wouldnt lose much (hopefully)

c) Should one invest on reversion to the mean? The amazing thing of last few months is - whatever has fallen has come back, and whatever has risen has fallen back. Banks fall, then rise, then fall again, then rise. Commodites were going one way, now are going the other way. India was going down, Brazil was going up - in the last month Brazil is down 20% and India is up the same. The risk with this is - one never knows when the mean reversion happens. People were shorting oil at $120 in May, they would be only even now. Besides, what is the mean? Still, this is worth exploring.

Growth and commodity prices

What has helped US avoid a recession so far? Exports - to the fast growing emerging markets, read China, India etc.

What has caused commodity prices to go up? a) Loose monetary policy, b) China's growth - it is still growing at 10%+. I was looking at the presentations of various commodity companies - Mittal, Rio, BHP etc - and they all start with China and end with China.

In the previous commodity cycles, did prices fall because excess supply came up, or did they fall because demand didn't materialize? I dont know - my guess is demand growth was much lower than expected, so excess supply got created because suppliers were betting on a higher growth rate in demand.

Is it possible that China slows down just enough for commodity prices to fall, but still grows at a good enough rate to keep US out of recession? For this, Chinese growth will need to shift from investment led growth to consumption led growth. Whether it can happen at all, or if the pass can happen smoothly is a million dollar question.

Have Olympics distorted investment demand patterns in China in a big way this year? We will soon find out.

Fooling some of the people all the time

I have been reading this book by David Einhorn - the most outspoken of the Lehman shorts - and it is terrific. I would highly recommend it to anyone who wants to spend a lot of time investing, for the following reasons.

1. This is probably the only book out there on how to build and research the short case on a stock. 99% of the investing books out there devote their attention on buying rather than selling.

2. This is a very good read for any bank analyst as to how financial companies can fudge numbers if they dont do mark-to-market (MTM). By avoiding timely writedowns and pushing NPAs out in the future, financial companies can engineer their stocks to remain high and raise additional capital at these inflated prices, so that problem loans become a small part of the overall capital base.

3. It is important to understand the true economics rather than the last quarterly financials - whether on the short side or the long side. I have not read a better account of financial forensics.

4. A short idea can also take a long time to play out. The investing philosophy is thus short and hold, rather than buy and hold. As the natural tendency of stocks is to go up, it is risky. So, one needs to be absolutely convinced of the investment thesis to do short and hold, much more than one is convinced on a long idea.

An exchange traded debt sell off?

According to Quantomonline, there are 119 debt securities that are listed on the stock exchanges. I have put their ticker symbols below.

It seems as if there was a sell-off in the exchange traded debt of various securities yesterday, starting sometime around 10 am. AIG, Comcast, CBS, ING, AT&T - financial/non-financial debt all sold off. Someone must be liquidiating.

Now I know inflation is heating up and all these long duration bonds are most sensitive to interest rate changes. But how can one explain that AFE - AIG's senior unsecured debentures maturing in 2034 - are yielding 12%, while its 6-1/4 senior unsecured bonds maturing in 2036 are yielding 7.2%. Even its 2067 bonds are yielding 8.7%. Or for that matter - CCS, CCT and CCW - all Comcast unsecured bonds maturing somewhere around 2055 have different yields. CCS is yielding 8.7% and CCT and CCW are yielding 8.3%, while its 2038 bonds are yielding 7%.

Here is the list to make the portfolio on yahoo or google finance.

AAR ABA AEP-A AFC AFE AFF AKF AKT ALF ALQ ALZ ATT AVF AZM BGM CCS CCT CCW CEG-A CPV CRP CSB DFP DFY EHA EHB EHL EMO EMQ F-A FCJ FCY FCZ FGC FGE FSB FSE GAH GAJ GAR GBM GEA GEC GED GEG GEJ GEP GER GFW GFZ GJM GKM GMA GMS GMW GOM GPD GPJ GPM GPU GPW GRM GUL GUQ GXM HGM HTB HTN IJD IKJ IKL IKM IKR IND INZ ISG ISP LNC-G MLG MPJ NRC NRN NRU NXY-B OUI PFK PFX PHA PLV PMK POH PRD RBV RGM SBCKP SVJ XGM SGZ JSM ISM OSM TDI TDA TVE TVC UDM UZV UZG VNV WRS XCJ

Loading up on CCS

Comcast is the largest cable company in US. Its leverage is 2.5x Net Debt/EBITDA ($30bn debt and $13bn EBITDA in CY08). Interest coverage is quite high at 6x (EBITDA/Interest). As it is a subscription based business model, it is quite recession proof. People might cut their video service as they are thrown out of their homes, or they will stop taking premium services. But the chances that this company goes into bankruptcy is close to 0, if their is anything close to 0 these days.

The company has various series of debt. One of the debt series - CCS - trades on stock exchanges like a stock. The company pays its interest like a dividend. The face value of this is $25. This is a 6.625% note due in 2056, but it is callable anytime after May 15, 2012.

Today, this has fallen a lot, for no obvious reason. Comcast stock and other debt of Comcast are trading just fine. At its current price of $19, the yield to call is 15%. The yield to call on other debt securities - depending on maturity and seniority - is not above 8%. The yield to call (rather than yield to maturity) is the right thing to look at, because if on May 2012, this debt is trading at today's price, Comcast will have every incentive to refinance the debt at the lower rates and pocket the difference.

I think this is one of the best investments out there. On a BBB corporate, one is getting a yield of a corporate in distress. I have bought some today at $19. Lets see how it works out.

Dollar crosses 1.60 against Euro

The effect of Fannie and Freddie intervention on the dollar is here - dollar crosses 1.60 for the first time. But it is not that Euro should be strong against dollar - Eurozone is also struggling now. There is going to be competitive devaluation between dollar and Euro starting later this year.

If there is a way to get a fixed deposit in Chinese Yuan, that is probably the best investment right now. Even better would be middle eastern currencies that are pegged to USD. In an year where there are historic macroeconomic events occuring, the pegs could also be broken.

The debate right now isn't between a bull and a bear - it is between a bear and an ultra-bear.

Bharti- RCOM - MTN

The Bharti - MTN, RCOM - MTN saga has been going on-off for the last 3 months. Today ET is reporting that MTN is again sounding out Bharti after its failed talks with MTN. This is now smelling desperation rather than opportunity on the part of the various suitors, and might indicates one of these things:

a) Analysts and stocks are way too optimistic on the growth prospects of the Indian mobile companies. So Bharti and RCom are trying to use their stock to buy out other companies before the tide turns south.

b) Something similar could be said for MTN. It probably is looking to use its expensive stock as currency.

c) Is their really a strategic rationale to have an pan emerging markets mobile service player? There are hardly any revenue synergies in having a Indian subscriber as well as a South African subscriber. Cost synergies will be there - one can better negotiate with equipment vendors - but Bharti is big enough on its own to squeeze 90% of the cost savings out. There will still be different country headquarters etc, so how does one get SG&A synergies?

The stock chart of Vodafone says it all - stock is today where it was in May 98. Bharti would be better served by buying Idea or Vodafone India out if they really want to do a deal - reduce competitor, gain market share etc.

Fannie and Freddie continued...

It is a very confusing situation. If Paulson wants to avoid moral hazard, he has to extinguish current shareholders. He has done that once to Bear Sterns shareholders. Will he do the same with Fannie and Freddie shareholders? If these stocks stay where they are, there is no way these companies can raise the requisite equity. So treasury will step in, which will involve wiping out existing shareholders. Now logic might not work and Paulson might change tracks. But I will go with logic.

The survival of existing shareholders is contingent on stock going up. Stock price is driving the fundamentals. Interesting stuff. Don't think I will, can or should punt.

Fannie and Freddie worth punting?

Should I buy or sell Fannie or Freddie stock today? It is an interesting puzzle. On the positive side, US govt is now backing the debt of these companies. On the negative side, Paulson's track record with Bear Sterns shareholders will give a pause to punters in Fannie and Freddie.

This is what Paulson is saying in his news release:

"Fannie Mae and Freddie Mac play a central role in our housing finance system and must continue to do so in their current form as shareholder-owned companies. Their support for the housing market is particularly important as we work through the current housing correction." So far in the news release, it seems shareholder survival of the troubled entity is crucial - this is not Bear Sterns.

and later:

"Second, to ensure the GSEs have access to sufficient capital to continue to serve their mission, the plan includes temporary authority for Treasury to purchase equity in either of the two GSEs if needed."

Treasury is not buying equity today. They want the stock to go higher and see if these two can raise money through public markets. If the two stocks recover to $25 levels, there might be one new round of equity raise possible through public markets.

Are there brave people out there willing to put more equity into these black boxes at $25? My guess is - there are - at least for one more round. After that, if there is further need, US govt will be forced to step in and nationalize.

The point is - if Paulson wants to prevent shareholders from enjoying the benefits of his largesse, he needs to nationalize Fannie and Freddie today. If he is too worried about moral hazard, he should clearly state that Treasury will invest in these companies but at $1/share. From the opening of his press release, it appears he wants these two to remain public entities owned by shareholders.

I think this is like Lehman on March 18. I dont know about the long-term future of these companies. But the chances they double or triple in next 24 hours is high. There is a huge short interest in them, and short covering itself will propel them higher.

Treasury and Fed back Fannie and Freddie

The treasury is increasing its lines of credit to the two mortgage giants. Also saying govt might take an equity stake in the company, if the companies request. Here is my take:

a) Bondholders: Definitely a plus for the bondholders. Fannie Mae and Freddie Mac debt is now treasury debt. This is moral hazard.

b) Equityholders: Isn't this an admission that the companies are undercapitalized, and might have difficulty raising money on their own in the debt market. If the Bear Sterns precedent is any guide, when Paulson forced Bear's board to accept $2, shouldn't the existing shareholders bail out - now.

There are so many people short these stocks that a short covering rally could easily double them in a day. If the stocks stabilize at $20-$25, raising capital at that price is also possible. This is a situation where the current stock price determines the fundamentals, not the other way round. These stocks can go to $0 and they can also go to $25.

Logic will say they should go to 0 - but logic has its limitations these days. I think that Paulson's idea on how to avoid moral hazard in Bear Sterns is going to come back and bite him someday.

c) Treasury bonds: Suddenly, there are many more treasury bonds out there. So yields should up. Still, Fannie and Freddie were always assumed to have govt backing. Don't think it should be a stomach churning spread widening.

d) Dollar: Do you really want to hold the dollar? This is not the last govt bailout. I think the real risk now is any unorderly fall in the value of the dollar. At some point, people will revolt against the printing machine.

e) Oil: If dollar is at risk of going down, oil is at risk of going up.

Moral Hazard, Fannie Mae and Freddie Mac

Apparently, Hank Paulson is against bailing out the shareholders of the two entities - Fannie Mae and Freddie Mac (WSJ). His argument is that bailing out the shareholders will fan moral hazard. This was the same argument he used to suggest Bear Sterns be sold at $2.

However, he is forgetting about the moral hazard that is being created by bailing out the debt holders. Fannie Mae yields might actually tighten if the US govt gives explicit guarantee to its debt. Similarly, Bear Sterns bondholders benefitted when the bigger JPM took BSC over.

What Paulson and co dont want is for credit costs to jump up even more. If mortgage rates in US were to rise - they haven't really come down despite all the Fed cuts due to spread widening - housing will take a further beating. Paulson, Bernanke and co are deciding right now who wins and who looses.

Oxicash

I remember reading 8 years ago - when I was still at IIT and the 3G spectrum bidding was happening at crazy valuations in Europe - that mobile will one day replace credit cards as the preferred way to pay. That obviously hasn't happened. People still prefer their cards or cash.

Now, it seems that Indian mobile companies are trying to push something similar. Airtel is touting mobile bill pay and cash trasfer using Madhavan and Vidya Balan as brand ambassadors. Today I saw an ad for Oxicash on television - a mobile payment gateway. In a country like India where mobile penetration is trending much higher than card penetration, it can be one of the most lucrative business opportunities if developed properly.

And its not only about the revenues. It can also save a lot of costs for mobile companies. At 250 mn subs and Rs 300 ARPU today, mobile companies rake in $25bn each year today. If they pay 2% to card companies, banks, merchants etc to collect all the money, it is a $500 mn annual drain on the bottomline. When India reaches 800mn subs in the next 10-20 years, the drain will be much much more. Lets see how these experiments turn out to be.

Selling KBE

Fannie Mae and Freddie Mac are falling apart. This is that blow that can level financials for a long time to come. I wonder why Dow Jones and S&P are not falling more. Lost 30% on this in 2 months.

2008 is a seminal year in world history. Socialism is about to get a revival. Protectionist rhetoric is escalating. Govt expenditure is going to expand rapidly to contain the fallout from falling consumption and investment demand - worldwide.

Pension and OPEB

I was looking at Qwest the other day. It trades at 15% FCF yield. $1bn FCF, $4bn+ EBITDA, $7bn market cap, $12bn debt. But then I saw its balance sheet, and I remembered that thing called pension and OPEB.

When I had started working in Citi Asset Management in 2003 in the tech-telecom research team, a big problem with the telcos was the hole in their pension liabilities caused by the 3 year bear market. The pension plans in the US assume a rate of return on their equity and debt holdings, apply a discount rate and get the present value of the assets. They do something similar to calculate the PV of the liabilities (payouts to retirees, inflation on healthcare costs etc). The difference is the unfunded liability for the company. It should be thought of as a debt - company will need to borrow money to bridge the gap. There were several companies that would have declared bankruptcy had they been forced to cover their unfunded pension liabilities - I remember people talking of Lucent as one.

It was in Feb 1999 that S&P first hit 1250. Yesterday, almost 9 years after that event, S&P closed at 1244. During this time, healthcare cost inflation has continued unabated. So while the assets of the pension plan invested in US equities have given 0% return, liabilities have gone up. I am sure that several companies will again start reporting widening pension deficits - particularly the old economy companies such as telecom, auto etc.

True several companies have moved to defined contribution (401-K) rather than defined benefit ones. True several companies have renegotiated benefits with their employees (particularly autos). But their is a huge legacy of the defined benefit plans.

It is the same problem with social security. Projected assets might not meet projected liabilities.

Inflation and Deflation

It seems very likely that at least one of the big global corporations is not going to survive another 12 months. GM, Ford, Chrysler, some major bank etc is likely to blow up. If it happens when the inflation scare is still on, then thats the day when bond yields will go through the roof. Thats the day to buy bonds.

Inflation and deflation are two sides of the same coin. Credit contraction today is leading to asset deflation. In another 12-24 months, assuming commodity prices stabilize, this asset deflation might result in CPI deflation. My guess is this is what happened in Japan, with its asset bubble and crash of the 1980s, followed by liquidity trap and deflation. One needs to look at bonds if there is a possibility of deflation out there.

Some Interesting Stuff

1. GM cuts the price of Chevrolet Spark in India when everybody else is raising because of higher commodity prices. Why? Are market share losses in US going to drive GM's competitive behaviour outside US, or is this purely a decision made by GM India? If it is the former, then think of auto industry as one giant global market, irrespective of the import tarriffs that hinder imports (at least in India). So don't salivate on Maruti at 10x PE. The auto industry is on the path of a worldwide bust.

Is public transit the next big thing to bet on? Need to think about that..

2. Merck India: Merck India has a market cap of 500 crore and cash balance of 350 crore. Its PAT from core business is about 40 crore. So on core business, the stock is trading at just 4x PE.

Well I guess the company deserves it. In 2006, they sold a business to a 100% subsidiary of Merck Germany (the parent company of the listed entity) for 4x PE. That business did a PAT of 20 crore and was sold for 82 crore. Isn't that stealing from the minority shareholders?

Going forward - investing in India

There are 4 components of GDP. Which of these is likely to prove the most resilient going forward?

a) Investment growth - This is clearly under threat with rising interest rates and commodity price inflation threatening margins. Domestic savings rate is going to spiral down this year as govt fiscal deficit expands and capital flows are slowing down, so who will finance the investments? Stay away. When a train travelling at 150kmph breaks suddenly, the effects are not pleasant on the commuters.

b) Domestic Consumption growth - This should weather the storm better. Stay away from interest rate sensitives (automobiles). FMCG, telecom, media, retail might do better - but are stocks properly priced? Financials - there has to be a blowup somewhere as credit cycle turns. ICICI is my prime candidate for that . But at 550 - 1.3x P/BV - is the stock interesting? Remember that unlike the west, Indian banks raised significant capital last year, so they are much better capitalized.

c) Net Exports - Rupee is structurally weak. India runs a current account deficit (like USD) and needs capital inflows to support rupee (like USD). Rupee is weakening today (due to widening current account deficit and capital outflows) when RBI is increasing interest rates to battle inflation, and might weaken even more when RBI cuts interest rates 1-2-3 years out - when inflation comes under control, growth slows down and investors take time to rediscover their love for India. Of course a big variable will be oil price.

Problem is - customers are also slowing down. US, UK, Europe are having difficulties. Need to bet on exporters with significant leverage to rupee depreciation, high margins, proven business models. Basically tech.

Tech has huge BFSI exposure and has a potential demand side problem. There are going to be blowups in tech too. Need to wait for those days. Next big event here is Cognizant earnings and whether it cuts its 38% rev growth guidance in the next 2 weeks.

d) Govt Expenditure - Not the time to play govt expenditure growth stories, as fiscal deficit goes through the roof because of oil and fertilizer.

Also as a policy, I am never going to invest in any PSU from here on. I sold HPCL last week - a 4 year investment with -50% returns (excluding dividends), Bank of Baroda - 3 year investment with -10% returns (probably breakeven after dividends). Union Bank is the only one left and I will exit that soon enough. As govt fiscal deficit expands, it can do bizarre things to expropriate the profits of these companies.

What went wrong in the last 3 months?

I had a disastrous qtr in the invested portfolio. From the peak in Jan, the invested portfolio is now down 15%, with almost all the losses coming in May June. For the overall portfolio, losses are close to 8% (as more than 50% is cash). My aspiration is not to beat the markets on a relative basis but on an absolute basis - whatever the conditions. So this is a failure - even if there is relative outperformance against markets that are down 20% or 40%.

I made a wrong bet. In late March - early April, I thought that the entire second half recovery/"govt rebate checks to citizens" optimists in US will give a temporary boost to the US stock market and global equities. I thought that the boost will occur in May and June - closer to the second half - and then the boost will fade in July as earnings disappoint.

What happened was otherwise. Stocks ran up in April. Since ealy May, when I bought some high beta stocks, they have been going downhill. And CY2Q earnings havent even started. 2Q is not the best time of the year usually - all holidays (Thanksgiving, Christmas, Chinese New Year, Diwali) occur in CY4Q or CY1Q.

So what are the learnings from this episode? Bail out quickly if mistakes become apparent. The key trick is not buying but selling, and selling aggressively when proven wrong.

As Bill Gross put it neatly in his May 2008 newsletter, "Investment success depends on an ability to anticipate the herd, ride with it for a substantial period of time, and then begin to reorient portfolios for a changing world. Today’s world, including its inflation rate, is changing. Being fooled some of the time is no sin, but being fooled all of the time is intolerable".

1H08

1H08 - Indian markets down 35%. Amazing. What a turn from January 2008.

CY2Q is often not the best earnings period - the adage "sell in May and go away" has proven very true this year.

This is increasingly becoming one of the most challenging times to invest in the last 15 years. We have the credit crunch - which demands lower interest rates, and inflation - which demands higher. There have been a number of "black swan" events in the last one year, and they are by no means over.

Best thing is to do nothing, unless one has a really compelling idea. Take vacation for 6 months. Inflation is not tamed that easily.

Exit Blue Dart

Got out of Blue Dart yesterday - it is cheap on numbers (14x-16x fwd PE). But air frieght business when oil prices are soaring is dicey. Plus, believe it or not, Parliament might actually pass a bill making it mandatory that packages < 500gm only get shipped by India Post. At least there was a 7% type gain.

PSU banks - I am down 40% on Union bank and 5% on Bank of baroda (have held it for 3 years). I will wait for the quarterly numbers before I sell. On the ground, economy is still solid and growing and NPAs are low, so any hit is 6 months away. They have already been hammered so much.

Looks like the Nifty call options are going to expire worthless. The Fed trade didnt work, it actually went the other way.

Oil Price Speculation

There is a fairly large number of people who believe that blaming the oil price rise on speculators is wrong. It is purely supply-demand mismatch etc etc. These include people like Krugman, Ftalphaville, etc.

Surprisingly, these are the same people who believe it was speculators playing on no-down payment loans in a low interest rate scenario who caused real estate prices to go up earlier this decade. Why then isnt it possible that speculators playing on 6% margin in a low interest rate scenario (as it exists today) are behind this sudden crude oil spike?

To the question as to what could have been done to prevent the mortgage boom, their answer is - more regulation by the Fed. But, they are aghast if Congress talks of more regulation of the oil futures market.

It is bizarre. People believe Greenspan failed in not detecting and defusing the real estate bubble in time, but they are in arms if Congress tries to do something on oil. They want oil "markets" to work. Greenspan let mortgage markets work - the outcome is here.

Buying Aban at 3300, and the Fed trade

Today I bought some more of Aban at 3300. Also I had bought Nifty July 5000 call options on Friday. With the kind of inflation (11%) that is there in India and the chances of a policy error high, it is not right to be a bull on India. But then, nothing ever goes down in a straight line. These are all trading positions with a fair chance of losing capital.

The most significant event of this week is the Fed Reserve meeting. Bond yields had risen sharply in the last three weeks on anti-inflation rhetoric from the Fed earlier this month. They have eased a bit in the last week as Fed suddenly turned soft again. WSJ rightly says that Bernanke is squandering his most valuable commodity - his credibility. It will be interesting to see the post-meeting statement, and how it deals with inflation.

Can the Federal Reserve trade work again? Remember Jan 22 and March 18, when markets were falling before Fed met, only to reverse course later. Yes there are no more interest rate cuts coming. But the Fed's statement carries a lot of power. No harm betting that it will stabilize the currently falling equity markets.

Fighting Inflation in India

A favorite topic of WSJ and FT and other personal finance websites these days is - what is the best investment in these times of inflation for retail investors?

My take on somebody investing in India is:

It is not bonds - anyway one can't buy any
It is not stocks - contrary to what everyone else says
It is not real estate - this is a global real estate bust and it is reaching India - so wait for 4 years.
It is cash

Yes, one will earn less than inflation today on cash. One year down the line though, when bonds are cheaper and so are stocks and so is real estate, that same cash can be deployed into other assets which have fallen much harder. Think about relative valuation between assets one year down the road, rather than value of an asset against inflation.

That bonds will fall as inflation rises - that is clear.

That stocks will fall as inflation rises - that goes against conventional wisdom which says stocks return 10% + every year over long periods. That is incorrect. Anyone who invested in US in 2000 has earned 0% over last 8 years. The starting point is important.

And today, the starting point for investing in equities to protect against inflation is not right. Corporate ROEs are at all time highs - inflation will hit margins and lead to downwards earnings revisions, and stocks will find it very hard to go up in such an environment. Besides, if bond yields rise because of inflation (as they have in India and around the world over the past 1 month), the economy gets its third shock of the year.

First shock - subprime and credit crunch
Second shock - oil prices
Third shock - rising inflation and bond yields

A one year FD in India is yielding 9.5%. Why take the risk? Sit in cash and do nothing. As they say, when to hold it and when to fold it is important in poker. This is the time to fold and not to hold.

Restarting Aban Loyd, taking stock of portfolio

I restarted the position in Aban Loyd at 3580. If the stock falls to 3200, then I will purchase more. At that price, it starts trading at an appropriate discount to Transocean. The biggest risk is that when this company publishes its consolidated results in its annual report, investors won't like it and will run away. Investors have no clue of the earnings of its Singapore sub which has 70% of the assets. It is a risky stock.

I had bought Indiabulls securities at 132. Now it is at 92. Down 30% in 2 months, 25% with dividend. I was quite bullish 2 months ago and brokerages are the highest beta stocks, so I bought it. The biggest risk to the bull thesis was oil prices, so I had also bought Aban Loyd (which I sold later). This effectively became a hedged transaction.

I like the brokerage business model - from peak-to-peak, brokers are the biggest beneficiaries of capitalism and the societal push to make pricing transparent for a lot of goods. But can some of the Indian brokers get blown away if a downturn happens? Very likely. One needs to find the best one to back.

Another stock to keep on radar is ICI. It seems like some of the big institutional owners push this stock up as the qtr end approaches to window dress their NAVs. If it doesn't happen, one incurs unnecessary trading costs. Risk of losing money at 500 is low because company keeps buying stock at 525.

I have lost a lot of money (down 20% in 2 months) on US financials. But as it is my "value" pick, I want to stick to it for five years and see whether one can really make money by buying when the hour is the darkest. So far, I have always invested in the easy-to-see or cheap on valuation stories. This is the first deep value (or deeply stupid) investment. If I don't make money, I will have such hallowed names like TPG (WaMu), Warbug Pincus (MBIA), Temasek (Merrill) and other SWFs in my company. The misery of others lessens one's own misery :)

This is a historical year in the history of the world. Possibly the first black president in the White House. Oil at 135. The return of inflation. Bear Sterns in smoke. A bloodied Wall Street. At least the most significant year since 2001 (9/11). 2003-07 seems so boring in retrospect.

Portfolio allocation now is 30% stocks, 20% bonds, 50% cash.

What is Moral Hazard?

Excellent speech by Richmond Fed President Jeffrey Lacker is here, where he discusses the Bear Sterns bailout and moral hazard.

http://www.richmondfed.org/news_and_speeches/presidents_speeches/index.cfm/id=107

Moral hazard is the central problem that the financial safety net necessarily brings with it. And this problem exists even if central bank lending ensures that the resolution of a problem institution leaves its shareholders with nothing. Market discipline on risk-taking by financial firms comes more from the cost of debt finance than from equity holders (given the limited liability nature of equity). So it is the potential consequences of central bank lending for creditors that raises moral hazard concerns by reducing the cost of debt and potentially leading to greater leverage than would otherwise be chosen.

In the Bear Sterns bailout, it is the equity holders that got hit - they got only $10 for a company whose book value was presumably north of $50. It was the debt holders who were the winners. They would have lost big had Bear Sterns gone into bankruptcy, now they have been made whole by the Fed. So, the risk of lending to an I-bank has gone down following the Bear Sterns precedent.

Closing RPower June Puts

I am closing out the position which I discussed 2 days ago. The June Puts are not really June puts - all futures and options on Reliance Power will expire on May 29 - i.e. tomorrow. On NSE, if one finds the detail on this option, one will still see June 26 as the expiry date. However, there is another section on circulars, where one can find the circular reproduced below. The good thing is - I did not lose money.

What this implies is this - people who have been buying RPower to take advantage of bonus shares have no way to hedge themselves today. There is going to be a rush to short futures after May 30. The right time to short is not today but May 30.

-------------
NATIONAL SECURITIES CLEARING CORPORATION LIMITED

FUTURES AND OPTIONS SEGMENT

Download Reference No. NSE/CM PT/10634 April 29, 2008

Circular No. NSCC/F&O/C&S/831

Subject: Adjustments of Futures & options Contracts in the security Reliance Power Limited (RPOWER)
In pursuance of Byelaws of NSCCL pertaining to Clearing and Settlement of deals, Circular no NSCC/F&O/C&S/654 dated February 09, 2007 (download reference no CMPT/8498) and Circular No NSE/F&O/052/2008 dated April 28, 2008 members are hereby informed that the settlement of futures and option contracts in the security Reliance Power Limited (RPOWER) on account bonus issue in the ratio of 3:5 shall be as under.

The ex-date in this regard shall be May 30, 2008.

The following action would be taken by the NSCCL in this regard.

1. All existing contracts in the underlying RPOWER i.e. contracts with expiry dates May 29, 2008, June 26, 2008 and July 31, 2008 shall expire on May 29, 2008 and shall be finally settled at the relevant settlement price.

2. The settlement price to be reckoned for the purpose of final settlement shall be the closing price of RPOWER in the Capital Market segment of NSE, on May 29, 2008

3. The details of final settlement in respect of RPOWER shall be available in the F_PS03 and F_PS04 reports downloaded to members on May 29, 2008

4. All positions in the existing futures and options contracts on the underlying RPOWER shall cease to exist pursuant to the final settlement on May 29, 2008

5. The Pay in/pay out of final settlement of all F&O contracts on RPOWER shall be on May 30, 2008 (T+1 day).



For any further clarifications Members may contact the following officials of the Clearing Corporation: Mr.Chinnaraja C and Mr Ganesh Rangaswamy

Phone Nos. 022-26598165 Fax Nos: 26598243

Yours faithfully,

For National Securities Clearing Corporation Ltd.



Rana Usman

Manager

Buying R-Power Rs 400 June puts

I am trying to figure out futures and options. So today, I did the second option trade of my life. I bought some R-Power put options.

The IPO of R-Power in Jan 08 was a seminal event in the history of Indian markets - it called the top of the Indian stock market euphoria. But while Indian markets have fallen from 21K to around 16K since then, R-Power is sitting close to its IPO price of Rs 450. Why?

To figure this out, lets recollect the series of events around R-Power.

Early Jan 2008: Anil Ambani is able to con people to give his paper company a $25bn valuation.
IPO price = Rs 450.
Public shares outstanding = 228 million.
Public shareholding =10.09%. Rel Energy (now Infra) holds 45%, Ambani junior holds another 45%.
Total shares outstanding = 2.259 billion.

Early Feb 2008: R-Power lists and tanks.

Late Feb 2008: Anil Ambani comes out with a 3:5 bonus offer for all public shareholders. That is, the company will issue 136.77 million more shares but only to the public shareholders. This will bring up public shareholding to 15% in R-Power. Anil Ambani also transfers some of his shares to Rel Infra, so that Infra's stake in Power remains 45%, while his stake in Power falls to 40%

June 2, 2008: record date to determine eligibility of shareholders to receive bonus shares.

This is a very unique bonus issue. It is being offered to only one set of shareholders and not to others. So, it is a transfer of wealth from one shareholder to another. There are two possible adjustment factors - 62.5% (=5/8) and 94% (1 - 6%) for the stock post the dilution event, which has created confusion and opportunity.

Let us buy 5 shares of R-Power stock today at price x. We will get 3 additional shares and will have 8 shares of the same company in a few days. If the price at that time doesn't fall below 5/8*x (=62.5% x), we would have made an arbitrage profit. And why should it fall below 5/8x? After-all, the company is issuing only 6% more shares (136.77 million additional shares divided by 2.259 billion shares shares outstanding earlier). So the price should fall by only 6%, and should be 94% of the price pre-dilution. If that is how it works out, we will make 50% profit (8 shares * 0.94 *x - 5 shares * x)/5x = 50%

Note that x is immaterial. By this logic, we should be willing to buy RPower at any price - 350, 400, 450, 4500. Clearly, that is wrong.

I think this is the logic that has kept RPower stong over the last couple of months. Even today, it is a $25 billion company without any real business, except the $2.5 billion raised in IPO. It has outperformed Sensex and it has outperformed other ADAG companies like RCap, which have similar fluff.

Once June 2 comes and goes, I think investors are going to start selling massively. They won't receive the bonus shares for a few more days, but they can definitely sell whatever they have to lock in part of the profits.

With options, there is the trickiness of the adjustment factor. What does the exercise price adjust to post issuance of bonus shares? Does it adjust to 94% (1-136.77/2259) of the strike price, or does it adjust to 62.5%? I think it will be 94% - (the exchanges have yet to come out with the clarification). The stock should, however, adjust much more - ideally, it should fall to 62.5% of the pre-dilution price - otherwise there is free money for public shareholders.

So, the Rs 400 put option will adjust to a Rs 376 put option. I am betting that R-Power is going to fall far below this level once the record date for bonus issue is out of the way. 62.5% of Rs 450 is Rs 281, and that is where the stock should go. Even then it will be a $17 billion company. Contrast that with Tata Power - $8 billion market cap, with an ownership stake of 30% in Bumi Resources, which is worth $6bn at today's prices.

Of course, I could be wrong. Exchanges could decide the adjustment factor is 62.5%, and markets can decide the adjustment factor is 94% - this is after all a Reliance stock.

The premium for the Rs 400 June put option was Rs 4. My downside for 1 lot of 450 is Rs 1800 while upside can be huge. So that is why I did this trade. Lets see how it works out.

I was also thinking - can one make arbitrage profit today by using futures? That is, I buy 5 shares of RPower, and sell 8 shares in the future markets. Suppose futures adjust to 94% post issuance of bonus shares. I would have made risk-free profit. Unless futures adjust to 5/8x, I will make profit at any x. Maybe this is also what has been pushing R-Power price up. I dont know how futures adjust for issuances of bonus shares, so this is going to an excellent learning experience.

Oil at 133

I am less bullish now than I was last month (So where do we stand). As I had mentioned, oil price rise was the most significant risk to any bull theory. If oil price substain above $120 for the year - GS is out speculating $150 - equity markets will struggle.

This is a major shock - not because of the absolute price, but because of the speed at which it has gone up - up 70% in 9 months. Any recession requires multiple shocks. We now have multiple ones in the US - (a) the housing blowup starting late 2006 (b) subprime debacle and ensuing credit crunch starting mid 2007, and (c) sharp oil price increase in late 07-early 08. The one that is coming next is a sharp uptick in corporate bankruptcy rates.

US imports 12mn barrels of oil per day * $30 price hike this year (from $100 in Jan 2008 to $130 today) = $130bn of -ve exports = 0.9% hit on GDP on a $15 trillion economy). Oh, by the way, that is what the Fed expected growth will be this year (0.3%-1.2%) before oil prices moved up, so the new forecast should be 0%.

India imports 700 mn barrels of oil per year * $30 price hike = $21 billion hit = 2.1% hit on GDP ($1 trillion economy). Expected growth rate of economy w/o the impact of oil = 8% - 2.1% hit from oil = 5.9% GDP growth. India will grow below 6% if oil remains at $130.

Asset Prices as Driver of Fundamentals

This is quite random stuff, and like everything else, completely wrong.

I am increasingly getting convinced that the price of an asset (like a stock) impacts its fundamentals. Traditional economics will say that price is determined by supply and demand,
i.e. P = f (S, D).

I think
P = f (S, D, P).

And to refine it even more:
P+ = f (S, D, P+)
P- = f (S, D, P-)

i.e. the probability whether the next move in price is up is determined whether its last move was up or not, and vice-versa. (This is not a good mathematical representation of what I have in mind, but lets have it like that for the time being)

This is what price momentum is. Essentially, what this implies is that any fundamental analyst who ignores price momentum because it is a hobby of technical analysts doesn't appreciate that prices impact fundamentals, and misses out on an important variable in his/her thought process.
This will also explain why markets can deviate from prices determined solely by supply-demand arguments. If markets were efficient, there shouldn't be boom and busts. That is clearly not the case.

In the new framework laid out above, markets will necessarily go in a boom-bust phase, depending on the price momentum. A boom-bust market is an efficient market, not an inefficient one.

Isnt this what Greenspan is saying? Boom and bust is a part of capitalism and markets. You can either have a state controlled communist society where prices don't change and neither does anything else (except misery which keeps on increasing) or a market based society with its episodes of booms and busts. There is no third alternative.

Aban Loyd as a trading stock

I am taking my money out of Aban Loyd. I sold the stock at Rs 3900. Consensus EPS estimate for this stock is Rs 400 for FY09 and Rs 500 for FY10.

I am sure consensus is overestimating EPS because: (a) This company has extremely poor disclosure, nobody knows the numbers for its Singapore subsidiary. Costs for drillers are rising fast - there is a shortage of manpower. I dont think analysts are capturing that properly. (b) I am sure some of the new rigs are going to be delayed, as they have been over the last few years. So revenue and EPS is going to be pushed out. (c) Not sure whether people are capturing drydocking days properly.

But that doesnt imply that I am bearish on the stock. I think this sector has no problem till oil remains above $80. I simply dont see why I should buy Aban at 10x next year PE when Transocean is available at 11x PE - when Transocean has much bigger deep water fleet that is contracted out (in some cases) till 2016 and a much better disclosure.

The entire offshore drilling sector is getting valued at low multiples, when the visibility into the earnings of companies (esp RIG) is getting longer and longer. These are deep cyclicals, and the market is valuing them like that. But this cycle is just getting longer and longer, as oil hits new highs.

This creates one of the best opportunites to trade. Market is valuing Aban like a deep cyclical while fundamentals are strong for the next 2-3 years. Aban is an extremely volatile stock and gets hammered when market falls. So, there is lots of money to be made with this stock if one trades properly. That is what I have decided I will do with this one. I am going to use this as a test case to figure out how one can trade stocks, as I feel very comfortable with the underlying fundamentals.

Oil at 130

Oil is in contango. Surprise for the Fed - which has been looking at future markets over the last few years to justify why it thinks oil prices will head down in the future. Not only have future markets underestimated oil prices , now they are in contango. So I am sure the Fed is in a dilemma.

Why are oil prices going up? I dont see any good reasons for it, except the so called supply-demand imbalance. But gasoline is overflowing - as WSJ points out today, Iran is storing gasoline in tankers because there is not enough demand. Apparent problem is with diesel. But is it suddenly so huge that oil needs to go up by $30 in 1 month? Bulls will argue that problem is not with near-term supply, but with long-term supply demand - as a market in contango indicates.

I think there is one big positive with high oil prices. This is much better than a carbon tax to cut down greenhouse emissions. As altenative energy demand increases and these business models scale up, they will become viable without government subsidies. Global warming activists should be jumping with joy.

Cutting out of KRBL

I had bought KRBL at 139 a month ago and sold it at 119 last week. This is a very interesting stock as it illustrates the risk that govt can expropriate wealth that capitalists might consider theirs. Some people get govt to transfer public assets to them at low value - witness the real estate deals and how FSI's get increased and tax status changed after the deals have been stuck. Others can't stop govt from stealing what is theirs by passing taxes that are 'legal' - after all the government decides legality.

Basmati is an interesting commodity. It is probably the only commodity which India has marketed well enough that it is now a brand. It has also fought hard to make sure other pretenders from Vietnam etc don't steal the brand. India and Pakistan are the largest producers with India accounting for the lion's share. 90% of Basmati production is exported, as the rice is expensive (3x-4x price of normal rice). India exports about 1mn tonnes, at $1000/ton, this is export earnings of $1bn - 4000 crore for the rural economy. Not bad.

KRBL is the largest basmati rice miller and exporter in India. Surely - one would have thought -with rice prices shooting up throughout the world, this company should benefit. And with the stock at 4x Fwd P/E, this should be a multibagger. At least, this is what I thought.

Export taxes: Well, I was wrong. Rice prices are going up and feeding into inflation, so the govt has come up with an export duty of Rs 8000/tonne (or Rs 8/kg) to prevent exports. Last I remember, Basmati was selling for Rs 80/kg, so this is a 10% tax. This will reduce exports of Indian Basmati, which will then get sold locally pressuring domestic rice prices.

Now one can argue that it is all in the interests of the common man, so govt has done a great job. It is making sure that some capitalists dont benefit at the expense of vast majority of poor people. I disagree with this. I think this tax will hit Basmati supply in India - the very outcome that the govt wants to avoid.

Thin margin business: The margins are thin for millers (5%-7% PAT margins), so a 10% tax can effectively destroy their economics. So they will be forced to raise prices, which will hit export demand.

How elastic is the export demand? Some people will argue the following to justify price hikes can be absorbed without impacting demand: a) Basmati is a brand of which India produces the lions share, b) It is the rich man's rice, so price elasticity is less, (c) Indian basmati is anyway more expensive than Pakistani variety, and (d) there is a supply constraint of rice globally.

I dont think thats the case. I think argi commodities have high price elasticities and are almost perfectly substitutable. Besides, if export demand doesn't slacken and domestic rice prices remain high, govt will again increase export taxes. So there is going to be a big demand impact.

Long-term supply reduction: As exports take a hit, millers will dump rice domestically, which will cause a fall in domestic Basmati rice prices. So thats good for the common man.

But what about next year? Millers won't again procure the same quantities of Basmati paddy that they did this year - after all export demand will be down. Some farmers will switch to other crops.

More importantly, this will give an opening to Pakistan, Vietnam and other countries to capture market share in the international Basmati market. If demand is there, and India is willing to fulful that only at exorbitant prices, demand will find other supply sources. The longer the Indian govt persists with this tax, the more likelihood it is that Pakistan takes away the market.

Of course, the govt will say that this is a temporary tax, and as soon as rice prices normalize, this tax will go away. I just look at HPCL and BPCL and think that it might not turn out to be the case.

This tax reduces incentives to create supply. Indians won't buy a lot of Basmati at the price it normally sells, and govt wants to discourage exports. How can govt incentivize people to produce something if they end up losing money in the process?

India's fiscal deficit..

This is my first attempt to understand finances of Indian govt, so this analysis could very well be wrong.

As can be seen from RBI data above (all numbers are % of GDP), there have been two big swing factors that have pushed India's saving and investment rate from 23% in FY02 to 36% in FY07. First has been corporate saving (or corporate profits), which has improved by 4.4%. Second, and even bigger, has been improvement in public sector saving by 5.2%. It has been better fiscal management of the budget and much improved finances of PSU's that has led to the biggest savings which have been used to finance investment.

Now, the fiscal situation threatens to turn ugly. Combined state and fiscal deficit in FY08 was close to 5.5% and will become worse.

First, India imports roughly 1bn barrel of oil. Oil prices have jumped by $20 since budget was presented => a hit of $20bn = 1.6% hit. (assume GDP at $1.2 trillion)

Second, fertilizer prices have gone through the roof. Mosaic CEO was saying that India's fertilizer subsidy this year will be higher than its defence bill. Defense bill is $25 billion for India. Last year fertilizer subsidy was $2billion. That is an extra $23 billion hit on account of fertilizers. That is close to 2% of GDP.
So, in total, these two add up to 3.6% of GDP.

Third, farm loan waiver of $15 billion = 1.2% of GDP. Lets ignore it.
Fourth, pay commision will impact state finances. Lets ignore it.

This will be offset to a very small degree by tax growth, better tax administration etc. Still, a 3% extra hit to fiscal position will happen from oil and fertilizer subsidy, if the prices of these don't moderate over the next year.

It is not that suddenly India growth story is over. In the short run, govt can do a lot of things, esp selling stakes in PSU's to improve its situation. But, if this situation were to persist for 2 years, it would be alarming.

I am not sure how the public sector savings number are computed above, and how it ties to the fiscal deficit of state and centres. Do PSU's get consolidated here, which implies that the oil bonds get taken care of? What about fertilizer subsidies?

So where do we stand?

Here is my theory of what is going to happen, some of which are facts and some of which are guesses which might turn out to be wrong.

Growth Rates:
a) Is US amidst a slowdown? Yes. Expect several quarters of -1% - +1% growth. However, it is not falling off a cliff. Strong exports are helping US.

b) Are Europe and Japan going to slow down? Definitely yes. UK, Spain etc have the same housing problem as US. Japan will be impacted, but it has hardly contributed anything to global growth in the past few years, except for its cheap yen. So I wouldnt worry about Japan.

c) Are emerging markets slowing down? Definitely yes. Emerging markets will get a lagged impact of US slowdown. Plus these countries face higher inflation from food as it is a bigger portion of their consumption basket, so their central banks are tightening.

If emerging market growth rate slows, US export growth will also slow down over the next few months. If not offset by something else (like govt spending, or the lagged benefit of substanital monetary policy easing) this could hit expected US GDP growth, and lead us into a vicious cycle.

d) Credit Crunch: Is there a credit crunch? Yes. Are banks more cautious than before? Yes. Will credit growth not be as fast as before? Yes. Does it mean that US falls off a cliff? No. It might merely stabilize for a long period of time. If credit contracts, it is dangerous, which is what we have had over last 9 months with runs on the shadow banking system. If it stabilizes, then we will avoid the worst come outcomes, which is where I think we are.

I believe monetary policy works. I think the US economy stabilizes around here for an extended period of time. The risk is more in Europe and emerging markets.

Inflation and Interest Rate:

a) Commodity Inflation: There has been a surge in commodity prices since Sep 2007 since Fed started cutting rates. For some commodities, rate cuts, dollar depreciation and speculation explain quite a bit of this latest surge. For some others, there could be supply-demand argument. After all, steel companies have negotiated iron-ore price increases with BHP - these are not being set on any exchange. Commodity price inflation is the real wildcard right now in any bull theory.

Of the various commodities, the most easiest and most difficult one to tackle is agflation. All one needs is a few good rains and monsoons in the world and wheat and rice prices go back to normal. All we need is a few rains not to happen and we get political and social unrest to change everything.

b) Will US inflation explode? No, because of various reasons. First, food is not a big part of consumption bucket. Second, rents and house prices are 30% of CPI, which are headed down because of housing oversupply. Third, Fed has cleverly defined a core inflation number and made sure everyone focuses on it over the last 30 years. Fourth and most importantly, the bond market is not very worried. Inflation expectations remain well anchored, and it is expectations that determine future inflation (inflation expectation theory). There is no question that Fed will cut more if credit markets start worsening again.

c) Will European inflation go up? I think inflation dynamics are the same in US and Europe, except that ECB focuses on overall inflation rather than just core inflation. BOE has already started cutting rates. How long ECB resists a rate cut is the million dollar question.

d) Emerging market inflation: This is the biggest problem, considering US is so heavily betting on export growth. Inflation here is driven by commodity prices, which is why they are wild card. If these countries tighten so much that they significantly slow down before US domestic economy has picked up, it will be a blow and lead to a vicious cycle.


Equity Markets:
a) US: Does 0% growth and higher inflation mean that equity markets need to crash and burn. Not necessarily.

First and most importantly, with dividend yield at 2.1%, savings account yield at 2% and headline inflation at 4%, there is no incentive to save. Any long-term cash needs to be parked in an index fund rather than in a bank account.

Second, the Fed is backstopping the equity markets to negate the effect of a decline in real estate wealth on consumers. While consumption elasticity to real estate wealth is higher than stock market wealth (this is a guess), a surging equity market helps.

Third, US markets are not outrageously expensive. Yes there will be earnings downgrades in the later half of this year, so S&P trades at 18x instead of 14x. But 18x is not outrageous - markets have traded here before. And maybe they are actually trading at 18x. Besides, by 2H08, investors will start looking at 2009.

It is not reality but expectations that sets equity prices. In a funny way, these expectations can then actually turnaround to impact reality. If equity prices remain high for a wrong reason but end up benefit consumer spending, it will help the underlying economy, which will then become a justification for higher equity prices.

b) India: Why US is so important for India is because of the amazing correlation between US and Indian stock markets. If US equity markets go up, the likelihood of Indian markets doing the same becomes very high.

There are a lot of concerns with India today. First, growth is expected to slow from 8.5% last year to around 7.5% this year. Second, inflation is high and is now running at 7.5%. Third, there are elections this year. So inflation becomes even more important. Fourth, fiscal deficit is widening each day that oil and fertilizer prices remain high. It has been the turnaround in fiscal deficit that has contributed the maximum to take India's saving rate/GDP from below 30% five years back to 35% today. If fiscal deficit remains persistently wide for a long time (2 years), savings will fall and investment will take a hit.

Does that mean that Indian markets will crash and burn? No. If US markets remain strong and Hong Kong and Brazil move up, India wont remain a terrible laggard. As equity prices go up, they create their own dynamic - where they impact reality as much as reality expects them. In the next post, I will discuss the stocks that are the most leveraged to this dynamic - the brokerage stocks.

Equity markets as the solution..

Just expanding on the previous post here, in the wake of much better than expected employment numbers. There are 3 sources of money to drive consumption:

a) Income: If employment doesnt fall as much as expected, income would be better.
b) Wealth: Most of the wealth is tied in either real estate or equity markets. If real estate prices fall but equity prices go up sufficiently, it would be neutral.
c) Credit: which is where the fear is. But it is abating. And Fed is exchanging all sort of securities for pristine treasury securities. Banks are busy raising equity.

Household real estate in the US totaled $20.6bn at end of 2006. (http://www.stlouisfed.org/news/speeches/2007/10_09_07.html) I guess prices peaked in summer of 2006, so it should be lesser now. Lets assume increase in homes offsets that impact. $9.8 trillion were liabilities. So wealth was $11 billion.

Suppose housing prices decline by 25%. Thats a loss of $5 trillion of wealth, or home equity falls from $11trillion to $6 trillion.

The total stock market cap in US is $25 trillion. http://www.world-exchanges.org/WFE/home.asp?menu=436&document=4822. If this goes up by 20%, the negative impact of household wealth would have been neutralized. Of course, the question of rapidly appreciating asset prices to drive up consumption growth will remain. But, the worst possible outcomes would have been avoided.

This is what the Fed is doing. It is making sure that equity markets don't fall and credit remains available. It has now cut interest rates to 2%, below S&P yield of 2.1%, making sure nobody keeps cash in bank. So the wealth effect is being taken care of.

It is all a cycle - either a virtuous cycle or a vicious cycle. Equity markets go up => consumer doesnt falter much => businesses dont take a massive hit => employment doesnt fall much + Fed eases a lot => house prices stabilize sooner rather than later => credit starts flowing more freely. If US stabilizes => Fed looks at increasing interest rates => dollar becomes stronger => commodites weaken, then it takes care of the inflation problem also.

I think there is now a fair chance that we see a massive rally. US economy is extremely resilient - it took multiple shocks in 2001 to take it into a mild recession. Fed has probably eased more than it should have but it is no hurry to increase rates soon. The emerging market bubble that we were all taking about 7 months ago started but burst in between. I think we are going to see a second coming.

Equity markets as the solution to the problem

Bears say that because house prices are declining and savings rate in US is 0, consumer spending will take a hit. That argument is wrong.

For there are two big sources of wealth - homes and stocks. Each is worth about $20trillion. That is where most Americans have put their wealth. So if stocks go up, they take away some of the pain from declining home prices. The wildcard is commodity prices.

Fed has eased a lot since Sep. Whether it is more or less, only time will tell. There is always the possibility now that it has eased more than was necessary and so stocks will rocket from here. I think Dow at 15K, Sensex at 25K before the year ends is now a very distinct possibility.

India vs China, Russia and Brazil

Is clubbing India together with China, Russia and Brazil the right thing to do? Can India decouple more or less than these other countries can from a US-Europe slowdown? Many analysts say that because exim trade contributes less to India's GDP than China, India is relatively more shielded. I am not sure that is the case.

I think a very important question when one thinks about growth is - how is the growth financed? Here, I think India is in a much poorer position (this is still a theory, I need to get the hard numbers).

a) Current account deficit - India has a current account deficit. As oil and fertilizer prices go up, this deficit is increasing. BRC run a massive current account surplus which they can use to finance growth, India relies on capital flows - FDI and FII. In the 1990s, east Asia financed its growth through capital flows. Because they didnt have forex reserves, they were hurt badly. India is not in that bad a situation today - forex reserves are high and FDI flow remains strong. Still, it is something to watch out for.

A benefit of having current account surplus is that forex can be used to contain domestic inflation. So China can led yuan appreciate to control inflation because there is a massive current account surplus, India can't.

b) Fiscal deficit - With pay commision award and subsidies on oil and fertilizer, the fiscal position of India can become very bad very soon. If high oil and fertilizer prices for another year, govt will need to cut down on its spending. Whether that will be subsidies or investments is anybody's guess. Most likely, it will be a mix of both.

To do: I need to collect some hard numbers around this.

There is now an inconsistency in the way commodites are priced and the assumption that Chindia can keep growing at 8%+ to support these commodity prices and to also power US out of its slowdown - at least India cant. If Fed is betting on export growth, it should help Chindia tackle inflation by supporting the dollar.

There are two major wildcards now. First, the average price of the US home, and how low it goes. Second, the price of oil, and how high it goes.

Any recession requires multiple shocks - the US economy is extremely resilient. In 2001, there was tech meltdown, Enron-Worldcom-junk bond blowup, and 9-11. This time, we had subprime blowup and the credit crunch. Now, we might be at the onset of an oil shock.

SMN

I am still trying to figure this one out. It is very dangerous to stand in front of the momentum train. Nasdaq at 3000 can become Nasdaq at 5000 before it become Nasdaq1500. At the same time, in retrospect it becomes one of the easiest trades to make. What event needs to happen to change the sentiment on commodity/agriculture? Dollar strengthening? Monsoons? Already India is predicting a record wheat production this year.

Philip Morris Int came out with very strong results this qtr. So thats good. My thinking has changed a bit on the stock. Earlier, I was thinking this stock should command a 20x multiple like Coke and other FMCG companies, as its EPS growth is around 10%-12% like Coke. That is incorrect. Volume growth for PMI is close to 0% and there is always the litigation risk. So 16x is probably a good enough multiple for this, which is where it trades. So I bought this stock at fair value - the best I can hope now is EPS growth.

Blue Dart came out with phenomenal numbers. It is now trading at 13x-14x FY08EPS. If this stock falls again to 10x-11x, as I am sure it will, I will pick it up.

What about Crisil? This is the S&P arm in India. Its ratings business is growing at 50% (due to Basel-II norm implementation driven business), but Irevna is flat (as it does I-banking outsourcing work). Both contribute about 45%-45% topline for the company. At its current price, it is trading at 25x FY08. For a 25% EPS grower, isnt that the right multiple to pay? If Irevna comes back, the growth could be even higher.

Eaton Vance's Tax Advantaged Dividend Fund

Couple of people said I was wrong that this fund used leverage. This fund uses a covered call strategy to enhance its dividends. So I went back to check the annual report of this fund.

From Page 2 of the Annual Report of this fund: "As of August 31, 2007, the Fund's $700 million issued and outstanding Auction Preferred Shares (APS) equaled approximately 24% of total assets and maintained a weighted average reset period of 21 days, which is comparable to what it was when the Fund's leverage was originally issued. Use of financial leverage creates an opportunity for increased capital appreciation and income but, at the same time, creates special risks (including the likelihood of greater volatility of net asset value and market price of the common shares). In the event of a rise in long-term interest rates, the value of the Fund's portfolio could decline, which would reduce the asset coverage for its APS."

I also dont find anything on the covered call strategy in the report. Rather, they use a approach called dividend capture strategy - which is basically trading to capture dividends.

Time to short commodities?

Futures are now pricing in just a 25 bps cut next Tuesday and then a stop to the rate cuts by the Fed. That should be bullish for dollar and bearish for commodities (because commodites have been pushed up on the theory of the weak dollar).

I can't understand the supply-demand arguments to justify sharp movements in commodity prices on a daily basis. Suppose oil is in short supply. So why should it be priced only at $115 and not at $1150? I can understand that suddenly there have been port closures in Australia, so coal prices go up. But how come everything goes into short supply at the same time. I suspect the movements in commodities that we have seen in the last few months has a lot to do with the theory that because real interest rates are now -ve in the US, commodities should go up. But they can't go up ad infinitum, right?

Should I go long SMN? It is already up 10% in last few days, but has been absolutely hammered in the last few months. This ETF has shorted stocks of companies through derivatives and is leveraged 2x. Its biggest position is Monsanto, which is a play on agflation. All these companies have seen their stock go vertically up in the last 7 months since the Fed rate cuts started.

I guess what is extremely important for this to succeed in the short run is the nature of the commentary out of Fed next Wednesday. If they as much mention inflation, it will be a good bet. If they do not, it might become a problem - this is again leveraged 2x like SKF, so moves can be magnified. But with now everyone on the theory of agflation, it might be the time to go against it. It might not be a bad bet for the longer term if one has the stomach for it (I don't).

A technical point - how do dividends get adjusted for SMN? If I short a stock that pays dividends, I pay the dividend to the person from whom I borrow the stock to short. In SMN, who pays dividends? Or because of derivatives, that consideration doesn't arise?

Eaton Vance Tax Advantaged Dividend Income Fund

WSJ is out recommending EVT today as it pays a 7% dividend and trades at discount on NAV because of ARPS issues, but I have my reservations.

This is an equity close-ended fund. None of the big stocks that this fund owns has a 7% yield. So the only way the fund is able to pay out the high cash dividend is through the use of leverage, or auction rate preferred shares. Unless the fund can figure out a way to replicate the low-cost leverage that it has so far used, it will be difficult to sustain the level of dividend payments.

Eaton Vance mentions that is has replaced ARPS with debt for this fund, which will surely have higher cost than ARPS. I wouldn't be surprised if leverage goes down for this fund, which will also reduce its dividend, which is perhaps the only reason to buy this fund.

Capital gains with this fund will be correlated to the stock market. As shown in the literature on the website, this fund has always traded at a discount to its NAV, which can fall if underlying securities fall in price. If that happens, debt holders can force the fund to liquidate - akin to a margin call. Probably debt closed-end funds facing ARPS issues are better than equity closed-end funds.

This gave me an idea - is there a way I can borrow money at low cost and invest in high-dividend yielding stocks to profit from the spread?

Valuing Citi

I was thinking about how should one value Citi. Its peak EPS in 2006 was $4.24. I think it will be another 5 years before it returns to that EPS level, because (a) The company has diluted by about 10%, so peak EPS on today's share count is more like $3.80, (b) leverage in SSB is going down for sure - I think its earnings are impaired for at least half a decade (c) there is a recession/slowdown in US. So some impact on banks is bound to happen.

So lets assume Citi hits $4.24 in 2012. At 11x PE, I will value it at $46.80 in 2012. Assuming 12% discount rate (why will I invest in a financial today if I dont double my money in 4 years, so 12% discount rate + 5% dividend = 17% effective return over 4 years = double money), I will value Citi today at $29.74.

Selling SKF

I sold SKF today at a loss of 10% - gave a market order to sell before the market opened. From +10% to -10% in 3 days illustrates the power of leverage. It was a good learning as it reminded me of what I learnt from the Motorola fiasco two years ago.

I think financials are now out of the gate - sentiment is as imporant as reality, the big writedown cycle is most likely over and the regulators are on the case. I have bought KBE at $41 - it is the financials ETF. Plan to hold it for long unless it suddenly jumps to 47 and above.

I also bought Philip Morris International at 16x 08PE and it is now the largest position I have. I like cigarette companies as the free cash flow generation is huge.

Another lesson - buying/selling at open doesnt make sense on a day like this, wait for 30 min for the initial rush to pash through and one can get 1%-2% better for sure.

Google Earnings

We all know that Merrill and Citi will have lousy quarters when they report in next 48 hrs. The more interesting earnings report will be, however, from Google. comScore data suggests that click growth slowed down dramatically last quarter. Bulls say that Google has tweaked its algo so that the yields have gone up, so there will be no pressure on revenue. But analysts always have lofty expectations from Google, so even a small miss can be penalized heavily.

SKF is still at breakeven, after having been up more than 10% Tuesday when Wachovia announced its capital raise. That was indeed my target. So, why didnt I sell? As I had learnt two years back with Motorola, the more important decision is not buying but selling. Selling when the target price is hit, or selling at a loss, requires great discipline, especially with these speculative positions. There are all the books and experts on the buying decision, but hardly anyone talks about when to sell.

Anyways, ML and Citi report in next 48 hrs. So lets see. I dont think there is much downside left in banks - they have already been pummeled.

I think oil prices are going into dangerous territory, especially for countries like India. Commodities have risen too fast. Ultrashort Materials (SMN) is something to keep a close eye on.

Portfolio as of 11 April

In the US,
a) CCS - Comcast's unsecured debt with a 7.5% yield. A better place than my bank account to park money. I am sure Comcast is not going bust. Best thing is that it trades on the exchanges like a stock.
b) PYN - Pimco NY Muni Fund III. I think that (a) municipal markets will stabilize slowly but surely, (b) interest rates would fall more, so funds with high yields will become more attractive and (c) tax rates will rise in the next 3 years - deficits need to be reduced at some point of time - so tax-free muni bonds will become attractive. This trades at a discount to its NAV which has started recovering since Feb when the ARPS crises hit. Hold for long term.
c) SKF - Ultrashort Financials. This is a speculative position. This is a levered play to short financials. Breakeven here - this position was established last week. Citi and ML report next week, so we can see some action here.
d) Am looking at some stocks to buy for the long-term. Philip Morris International seems a good one. It just spun out of Altria. FY08 EPS of $3.10-$3.20 gives it a PE of 15x-16x.

In India,
a) Aban Loyd - leveraged bet on shallow water E&P capex. Lost 10% so far. It is not a 5 year buy kind of stock. As long as oil remains above $80, I think we are safe.
b) Some PSU's - Union Bank, Bank of Baroda. Underwater by 10%. I sold Allahabad Bank last month at a 40% loss to save taxes.
c) Blue Dart - should I add more? This is down by 20% and is a good company.
d) Deccan Chronicle - Down by 20%. It's financials are fraud. But it is newspapers + the only way to play IPL. Wouldnt add more.
e) Sold Tata Power at 20% loss last month to save taxes. This is the only utility stock I will buy if I get it at around Rs 1000. It bought a stake in Bumi resources (Indonesian coal mine) last year, which has been a home run now that coal prices have run up. Plus, conglomerate discount should vanish as it starts monetizing stakes in other Tata group companies to fund its own aggressive capex plans.

I am still 85% uninvested. Cash has been a good bet so far. But now is the time to start buying good quality companies that have become cheap.

Same language subtitling helps improve literacy

In today's Times of India, Gurcharan Das has a very fascinating article on a creative method to improve literacy - same language subtitling of Chitrahar and Rangoli on Doordarshan. People often anticipate the next word of a song. If they are able to immediately associate it with the written word, the literacy improves. I immediately turned on Doordarshan to see Rangoli after a gap of maybe 14 years. And yes, it was there. Neat, simple and apparently very effective. Hats off to Dr. Brij Kothari for recognizing such a common sensical approach to improve literacy.

It is strange

that Dow Jones is where it was in Dec. Since then, there has been one bad news after another. Still, the major US indices have remained resilient. Why is that? Is the market signalling something? These 400 point moves on Tuesday must really be killing the shorts.

Learnings over the last 9 months

The last 9 months have been really incredible. The best way to learn about monetary policy, central banking and stock markets is to be in a financial crisis like today. So here are my key takeaways:

a) Markets can be manipulated - Witness the fall of Bear Sterns and the volatility in Lehman's stock price. Bear Sterns was brought down by feverish rumour mongering. If it can happen in a liquid stock like Bear Sterns, there is also truth to allegations that the 1997-98 East Asian crises was caused/exacerbated by hedge funds. That is not to say there weren't real issues, but the decisive blow could have come through manipulation.

b) 5-year financial models that linearly extrapolate last 3 years of data are useless - In 1997, could anyone have predicted the East Asian crises and then the tech bubble? In 2002, could anyone have predicted a 5-year global bull run? If one cannot predict such defining macro trends, how can one really do a "bottoms up, company specific analysis". Because any such analysis assumes stable macro trends. Except for some defensive companies (FMCG, healthcare etc), almost everything else is impacted by macro trends, most importantly interest rates and currencies. While financial models do help understand a company better (especially if there are one-offs, tax rate changes etc), one should be careful in not getting too bogged down.

c) Speculation is possible: I disagree with those avowed value investors who think speculators are gambling and will lose money in the long run. Sorry. You are wrong. The definitiveness with which you claim that traders are gamblers reminds me of my MBA school's insistence that markets are efficient. They clearly aren't. Otherwise Bear Sterns wouldn't have gone belly up in 24 hrs. Value investing is great, and so is speculation.

d) It pays to be a contraian: Nobody in emerging markets predicted in January that markets are going to crash. But they did. Similarly, if confronted with the fact that UBS had a $19bn write down, a logical person would have said that markets would go down. They didn't. Media commentary tries to justify restrospectively why certain things happened. It is useless. The simplest answer to why markets went up yesterday is - they went up.

I guess what Warren Buffet says is true. Markets are efficient, but not all the times. And we are living in such a time.

Marathon

So after years of procrastinating, I have decided to finally prepare for a marathon this year. I have yet to figure out which one. The longest I have ever run is 28 km last year in New York (now I live in Mumbai). Then, I had run from my house on 58th street and 9th Avenue to George Washington Bridge on 181st street and Riverside Avenue along the Hudson. I have tried running beyond 28km but have failed as my knees start wobbling around the 24-25 km mark.

Of the 4 aims I list above, only two are work-in-progress - stock markets and learning French. So I will discard the other two and focus on marathon this year. I think I will maintain a diary so as to really make sure that I practice.

29/03 - 5 km at the gym
01/04 - 6 km around Five Gardens

Some Interesting Facts from UBS Writedown

1. Shares are up 8%. I think all market prognosticators are scratching their heads. Just tells how impossible it is to trade this market. Time has come to start taking longer term views - that is, if one is possible (see point 2).

2. "The Mandatory Convertible Notes issued in March 2008 are subject to anti-dilution provisions, which will result in downward adjustments of the applicable conversion price to reflect the theoretical value of the Subscription Rights." - I guess it is almost impossible to figure out what the share count of the various banks will be once all this fund raising is over. How does one then calculate the normalized EPS (and the target price) for any bank? Or, should one simply try to time and enter at the dilution price which is the minimum price of all the dilutions. That way, one has benefited from the dilutions that happened at the higher price. But then, how does one figure out that minimum dilution price?

3. While positions in subprime and Alt-A declined, auction rate certificates increased. We all know about the turmoil in ARPS market. Didn't realize that brokers will take them on their balance sheet. But this shouldn't be a major cause of concern, as any writedowns should be low (compared to subprime). "Over 1Q , UBS's exposure to US residential sub-prime mortgage related positions declined to approximately USD 15 billion from USD 27.6 billion on 31 December, and the exposure to Alt-A positions was reduced from USD 26.6 billion to approximately USD 16 billion. Auction rate certificate positions increased from USD 5.9 billion on 31 December to approximately USD 11 billion."